HOW TO CALCULATE CASH FLOW?
Updated: Jan 1, 2021
As buy and hold real estate investors its important that we ONLY purchase positive cash flowing properties. This will not only secure your return on investment but also protect you against any market fluctuations in the future (interest rate increase). Depending solely on market appreciation is not only risky but speculative in nature. Calculating cash flow is quite simple:
CASH FLOW = [REVENUE - EXPENSES]
The revenue is essentially all the money flowing in from your rental property. This is not limited to just the rental unit(s). It could include other services such as garage rental, coin operated laundromat, and billboard signs. The number one mistake that novice investors make is not capturing all expenses or underestimating some of the costs. The below are the most common expenses for investment properties:
This is the starting point for most investors. We typically will use an app to calculate the total monthly payments. The criteria we put in is specific to our investment strategy and could vary across different investors. We will use 25-year amortization, 5-year term, 0% down, and current interest rate +2%. These options are different from what we finalize at the bank. We put the potential investment under our own stress test to see if it passes. We want to see what the property’s cash flow would look like if interest rates increase. We also, want to make sure that the investment has cash flow even with $0 in the deal. This way we can really take advantage of the property’s leverage. After all that is the reason why real estate investing is so attractive. The 25-year amortization is another buffer that we put in. We typically lock 30 years. This is simply a hedge against any unforeseeable events. If you’re just starting out, we highly recommend that you get per-approved at your local bank. This will ensure that you have a purchase price in mind for when you’re looking at different deals. Essentially you want to look for properties within your price range. You can also check out ratehub.ca to narrow down on different rates, payment periods, and essentially your overall monthly commitment to mortgage payment.
Unfortunately, we must pay property taxes every single year. Our suggestion is that you include these in your mortgage payments. This way you have a fixed amount withdrawing from your account every single month and you don’t have to worry about paying at the end of the year. Talk to your lender to set those up. However, when we analyze a property its important that we know how much we should deduct as part of our expenses. Each city and region should have a website that publishes property taxes for the last 1-3 years. When you’re just starting out, I would recommend looking up every property that you analyze but as you get more comfortable within your market you will know exactly how much to reduce for quick calculations. For example, in your Hamilton market we know that $3,500 is the average tax bill for the type of properties that we purchase. Remember: you can always dive deep into the numbers prior to putting up an offer.
Hamilton Property Tax Link: http://tiny.cc/ecc4lz
We recommend that you pass these expenses on to your tenants whenever possible. At minimum the shared common areas (hallways and laundry rooms) are the responsibility of the landlord. These expenses really depend on how the investment property is set up and/or laid out. You might find yourself in a situation where its best to pay for all utilities (units and common areas) and increase your topline (revenue). These expenses include gas, water, and hydro. The main reason why we want to pass on these costs to the tenants is “OWNERSHIP”. If the tenants are not responsible for the usage of different utilities, they might disregard possible waste. Opening all the windows in the middle of winter or water the grass for hours in the summer are classic examples. When there is a financial impact for waste – the behavior of the tenants naturally changes. When looking for investment properties, we must consider which utilities you will be paying for during regular operation. For example, let’s say you purchase a single-family home and decide to pay all the utilities for the tenants. Knowing this information, the next step would be to figure out what the utilities would cost for a typical household. Most utility companies will provide this information – below is from Union Gas for the Hamilton, ON area. A simple Google search should do the trick.
Now let’s say you’re purchasing a 6-plex. Then you would need to perhaps depend on some of the vendor (sellers) inputs in the Income Statement. You can then cross reference their information with the utility companies’ data to see if it aligns with the average costs. You might find that the vendor (seller) might be under reporting some of their expenses. So always make sure you cross reference and don’t just take it at face value.
This is one of the expenses a lot of novice investors tend to forget. You will have turnover in your units over time and could be vacant during your transition period. Its important that we capture this in our cash flow. If you’re just starting out a good reference would be CMHC. The site has a lot of good material on rental market conditions including vacancy rate(s) in your metropolitan area. Once you have several properties under your belt, you will be able to determine the vacancy rate that applies to your specific portfolio. The calculation should be as follows:
VACANCY EXPENSE = [REVENUE * VACANCY RATE]
Link to CMHC: http://tiny.cc/qbc4lz
This would include any services such as snow removal, lawn cutting, cleaning, and furnace maintenance. The best way to estimate these costs to get quotes. You can simply look up these services in Kijiji, Facebook Marketplace, or a simple Google search. Try to get 3-5 different quotes ranging from high end to low end service providers. This will give you an idea of what to expect on average for all services. A lot of these providers will be able to provide you with a quote over the phone/email. You can ask for a quote on a potential property that meets your investment criteria. It doesn’t necessarily have to be for sale. In fact, you want to make sure you’re proactive and have these numbers ready for when you’re assessing a potential purchase. As you begin to scale your investment portfolio you will start to see some of these costs go down on a per unit basis. Its simply due to purchasing power, otherwise known as quantity discounts.
PRM (PARTS, REPAIR, AND MAINTENANCE)
This expense item is for any repairs that might arise from simple wear and tear on the property. We typically assign 5% of the top line for PRM spend. This covers things like paint, plumbing, drywall, filters, and light bulbs. The list can be quite extensive but remember there is a difference between PRM (OPEX) and CAPEX which we will cover next. We can get quite technical, but the below chart summarizes the difference well.
These expenses will include but not limited to roof, furnace, air conditioner, water boiler, driveway, windows, appliances, and exterior doors. We dedicate 5% of the top line to CAPEX. You can see that the list above is quite extensive with different price points/lifespans. The age of your building will determine the deduction %. An older building will need a higher deduction. A simple way of calculating this would be to take the purchase price of the underlying asset and divide it by the expected remaining life (in months). Do this for all the major CAPEX and this will give you a total dollar amount that you need to retain each month.
The property manager cost will depend on the type of investment property you’re purchasing. The typical fees for single family homes or duplex conversions will hover around 5-8% of your top line. Even if you decide to self manage its important that we include this in our calculation. There are a couple of reasons for this. Firstly, your personal situation might change over time. If you go ahead with a property manager later, you want to make sure that the decrease in your profit margins does not catch you off guard. Secondly, when you’re trying to sell the property to another investor, I would expect them to include this cost as well. If we are purchasing properties that don’t produce cash
flow with this cost, then it will become harder for us to offload it to another investor at a similar purchase price (all other things constant). Remember purchase price for investment properties is mostly driven by CAP rates.
If you’re purchasing a condo or a town home – its important that we include these fees. There is no blanket approach to these fees. They vary not only by price but also by what is covered within the service. Its important that we deep dive into the details of each property to really understand what is included and at what price.
QUICK ASSESSMENT: THE 1% RULE
You simply take your monthly gross rent and divide it by the purchase price. This should not be the primary decision maker in your assessment of the property. Instead its more of an indicator on whether you should proceed to do more homework on the potential investment. The downfall of the 1% rule is that it does not give you the insights into the expenses.
1% < GROSS RENT / PURCHASE PRICE
If you’re interested in finding out more information on how you can invest with us on our next deal – reach out to us directly at 289-242-6294 or email@example.com
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The information provided in this blog is for entertainment purposes only and is not intended to be a source of advice with respect to the material presented. The information contained in this blog do not represent legal or financial advice and should never be used without first consulting with a financial professional to determine what is in your best interest to meet your individual needs.
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