I am a strong advocate that investors should buy rental properties for cash flow and not appreciation. Appreciation is a nice bonus but it is really risky buying properties that do not make money! 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? We will give over all of those questions as well as how to figure cash flow.
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. A lot of investors will count cash flow as the rent received minus the mortgage payment, taxes, and insurance.
However, it is very important that maintenance and vacancies are accounted for as well. 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 very few vacant months with my rentals, but you can’t count on that. I like to live by the philosophy: plan for the worst, but hope for the best. Something else that is often forgotten about is property management. Even if you are managing the properties yourself you need to remember that takes time and therefore money from you.
Here is what the cash might look like on a rental:
- Rent: $1,500
- Mortgage: $600
- Insurance: $100
- Taxes: $200
- Maintenance: $150
- Vacancies: $125
- Property Management: $125
- Total Cash Flow: $200
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 but isn’t! 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! You can still buy without cash flow as long as you understand the risks!
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 do you account for vacancies?
Vacancy costs come about when you own a rental property when it is not rented or you are not collecting rent and from evictions. Vacancies will happen when a tenant moves out, a tenant stops paying or you can’t rent a property as soon as you hoped. Not only will you not be collecting rent during vacant months, but you will also have to pay utilities on the home (if the tenant normally pays utilities).
One of the most costly scenarios when owning rental property is if you have to evict a tenant or they stop paying rent. It can take months and thousands of dollars to evict a tenant. On my rentals, I have been lucky that I have had very few evictions but I have had some and they can take months. We have also seen that things like Covid can extend that time frame greatly!
You can have great tenants for many years and one bad tenant will cost you thousands or tens of thousands of dollars. That is why you need to assume there will be a problem at some point. You will be prepared and it won’t hurt nearly as bad when it happens.
How you account for vacancies varies but I like to use a percentage of the rent. My cash flow calculator has a table to help you decide what percentage to use based on the type of property and vacancy rates in your area. Some areas may have 5% vacancies while others might have 15%. An apartment building will usually have more turnover and vacancies than a single-family home. In my area, I usually assume there will be 5% of monthly rents going towards vacancies.
How to factor maintenance on rental properties?
I repair all of my rental properties before I rent them. When my properties are first rented they most likely will not need very much maintenance because they are repaired. However, I also buy homes that are 30, 40, or even 50 years old. Although I repair homes before I rent them, I am not rebuilding a house and things will break. I don’t know what will break or when it will break, but things break. Tenants also may break things for you and you still have to fix them.
Even a brand new house will have maintenance costs because things breaks and tenants can break them. We just talked about vacancies coming up and often the maintenance comes at the same time when a bad tenant moves out or is evicted.
I figure maintenance costs similar to how I figure the vacancy costs. I use a percentage of the rents received and it varies based on the property. An older house or apartment will need much more maintenance than a newer one and the location and quality of the rental will impact the money needed for maintenance as well. I usually suggest using from 5 to 2o% of the rent for maintenance costs.
It is also important to have reserves in place for these costs so you can pay for them!
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.
Besides cash flow, it is important to know what your return on your money is. You could have $100,000 cash invested into a deal or $20,000 cash invested. If you make $500 per month on both deals they are obviously not the same return on the cash invested. 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.
How much cash flow do I need?
While it is hard for me to tell you how much cash flow you need, I can tell you how much cash flow I look for. On my residential rentals, I would look for $400 to $500 a month in cash flow on properties I was buying for around $100,000. I got really good deals and worked really hard to find these properties! That cash flow was after paying all expenses and the mortgage which was typically 20% down. Not every area has these types of properties but they do still exist.
I buy mostly commercial properties now and I do not look at cash flow per property since they are all very unique. Now I look at the cash on cash return or the CAP rate. I have always wanted to make 15% cash on cash return on the money I have invested. That would be after I have stabilized or added value to a property.
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.