There are millions of lavish retirement lifestyles funded by the cash flow from rental real estate. In residential markets, single-family rental homes are the entry point for many investors. They often stick with residential properties, as they can build their portfolio over time, adding homes until they have solid cash flow in retirement.
There are other financial benefits of rental property investing, from tax breaks to appreciation in value, but positive monthly cash flow is the big draw. When mortgage interest rates are low, financing rental properties and covering expenses with money left over is not difficult. The trick is to understand cash flow, the expenses of ownership, and the area’s market rent prices. Like most financial concepts, the best way to understand rental property cash flow is through an example.
Rental property cash flow variables
The inputs for determining probable cash flow for a rental home include:
- Rental income at prevailing market rates.
- Mortgage payments with escrows.
- Marketing for tenants.
- Property management fees or costs.
- Utilities not paid by tenant.
- Repairs and maintenance.
- Taxes and insurance (usually escrowed in payments).
- Vacancy and credit (non-payment) losses.
Some of these variables are easy to determine, such as taxes, insurance, and mortgage payments. Property management fees are also consistent and usually ranging from 6-12% of the monthly rent. That makes these costs somewhat predictable to plan for and calculate.
On the other hand, repairs and maintenance are estimates at best, but some maintenance that is regular, such as pest control, is easy to estimate. Vacancy and non-payment losses are more difficult if the investor does not have other property experience. These are the rent losses due to tenant turnover and non-payment of rent.
A rental home cash flow example
Let’s say a rental home investor has done their research and due diligence in their market area. They find a home that they can purchase for $197,000, and their rental market research says that it should rent for $1,750 per month. They can qualify for a 4.9% interest rate mortgage with 20% down. Their research shows that vacancy and credit loss numbers are running between 3% and 5% of rents, and the decision is made to use 4%. Here are the numbers for the income side:
- $197,000 X .20 down = $39,400 for a down payment, financing $157,600.
- With taxes and insurance escrowed, the payments will be $913 per month.
- 4% of gross rents for vacancy and credit loss is $744.
- Gross Potential Income of ($1750 x 12) $21,000 if all rent is paid for a full year.
- Subtracting the estimated vacancy and credit loss $21,000 – $744 = $20,256.
So, with taxes and insurance in the mortgage payment, $20,256 is the effective gross income before other expenses. Annual expenses are estimated as follows:
- The mortgage payment total for the year is $10,956 (taxes and insurance included).
- Utilities (tenant pays electric) are $127/month or $1,524.
- Marketing is estimated at $250 for the year.
- Repairs and maintenance estimate is $975 for the year.
- Effective gross income of $20,256 – $10,956 – $1,524 – $250 – $975 = $6,551 net operating income.
This would mean a monthly positive cash flow of $545.92 per month.
This is a simple example, but not outside the envelope of probable rental investments. Add the tax breaks and the depreciation deduction (27.5 years) of $7,164 per year (operating at a loss considering $6,551 net income, so no income tax on cash flow), and this home is an excellent investment.
Before getting started in rental property investing
If you are serious about getting started in rental property investing, the first thing you should do is make sure that your finances are in order, especially if you plan to acquire a property through a loan/mortgage. Buying a rental property is a little more complicated compared to just hopping online and buying some Hulu stock or something.
The first thing any lender will want to know about is your credit history and current/past income.
If you are planning to purchase a property and immediately start renting it out, you need to factor in things like a little bit of initial vacancy and potential expenses getting the property ready for tenants, etc.
You should also do plenty of upfront research before buying a property to make sure you know the market rent rates and can be both confident and sure the rent rate you set will bring plenty of interested and qualified tenants to apply.
Finding the right rental property to buy
Finding the right rental property to purchase in your area can be done a few ways:
- Check local FSBO (for sale by owner) real estate listings and classified sites
- Browse the local MLS (multiple listing service) on most real estate agency websites
- Contact a real estate agent directly so they can help you find what you want exactly
- Contact a local property manager to see if any of their clients are interested in selling any of their current rental properties.
Once you are looking and further defining a list of properties that interest you, it’s time to start comparing rental rates for similar properties in the area so you can understand which makes the most sense in terms of your projected cash flow and return on your investment!
