I am a strong advocate that investors should buy rental properties for cash flow and not appreciation. I talk much more about why cash flow is so important in an article here. Another question an investor must ask themselves is how much cash flow is needed on their rental properties? How much cash flow do you need to be secure? How much cash flow do you need to justify spending money on a rental property? How much cash flow do you need to reach your financial goals?
How do you calculate cash flow on a rental property?
The first step in figuring out how much cash flow you need is determining the actual cash flow on a rental property. The easiest way to do this is to use our cash flow calculator located right here.
It is very important that maintenance and vacancies are accounted for. I have learned that even on a completely remodeled home you will have maintenance issues with renters. I have been extremely lucky that I have had no vacant months in the last three years, but you can’t count on that. I like to live by the philosophy: plan for the worst, but hope for the best. For more information on maintenance and vacancies check out this article that describes the cash flow calculator.
Positive cash flow is very important with rental properties
After you enter numbers into the cash flow calculator, you may realize the numbers don’t look as good as you first thought. If you are using a property manager, they can really cut into your returns, but many times are well worth the cost. You have to remember just because the rent coming in is slightly more than the mortgage, that does not mean you are making money.
It is no fun paying money into a property every month that is supposed to be making you money. It is true that you are paying down the mortgage and getting tax benefits from the rental property, but negative cash flow can cause a lot of stress even with those benefits. If you are hoping for appreciation, remember there is no guarantee that prices will increase. How long are you willing to pay into a rental property before it pays you back? The easy solution to this problem is to make sure any rental property you purchase has positive cash flow!
Why should you be conservative with your cash flow estimates?
I like to plan for the worst, but hope for the best. I designed the cash flow calculator to be conservative and account for maintenance and vacancies. My actual returns have been better than what the cash flow calculator estimates, but I have been lucky with vacancies and repairs. The does not mean I will always be lucky and one really bad tenant or big repair can make up for years of smooth sailing.
If your vacancies or maintenance ends up being higher than you think, it is best that you planned for the worst case scenario. Hopefully with unexpected costs you will still have positive cash flow if you were conservative in your planning. I have $500 a month in cash flow on my rental properties and that is plenty of room to absorb unexpected costs.
How much positive cash flow is enough?
Positive cash flow is a great thing, but how much is enough? Obviously the more cash flow the better, but awesome cash flowing properties don’t exactly grow on trees. It really is a personal decision on how high of a return is needed to justify spending a lot of cash on a rental property.
Our cash on cash calculator can help you determine what the actual returns will be on your cash invested. I like to see high returns on my rental properties; over 20% cash on cash. Some people would be happy with 15%, 10% or even 5% returns on their cash.
I also think you need to determine how much cash flow per month is enough. If you only invest a small amount of cash, then you could have skyrocketing cash on cash returns, but only a small amount of cash flow. Much of this determination will depend on your financial stability. Do you have an emergency fund? Do you have cash reserves for each rental property? Is $100 a month enough or do you need $200 or $500 to build up your cash?
The great thing about rental properties is they produce higher returns than the cash on cash returns. Besides cash flow you will have equity pay down, tax benefits and HOPEFULLY appreciation. Plus if you buy rental properties below market value, you will walk into the deal with a lot of equity.
What should you do with the cash flow you make?
I use my cash flow to pay off my mortgages one at a time and I discuss exactly why I do this in this article (I have since changed my strategy). This may not the best strategy for everyone, in fact in a perfect world where I could get as many fixed rate, 30 year mortgages as I wanted, I would not pay off my rentals. If you are short on cash to buy new properties or don’t have an emergency fund you may need to save your cash flow.
If you plan to pay off your mortgages quickly, you can also save and invest that money until you are ready to pay off the properties. At one time I used my monthly cash flow to pay down one mortgage early every month. I now save that money instead and to purchase more rental properties. This can be a risky strategy however if you are instead putting your money in the stock market, which could go up or down in the short-term. I am not a huge fan of the stock market and I have a few other investment opportunities I am looking at.
I think it is a must that you buy rental properties with positive cash flow. How much positive cash flow you need is a decision you will have to make based on your goals, financial situation and local market. It is not easy to find great cash flowing properties, but buying homes below market value is a great way to get started.