Earn More Than You Spend

• Money: 0
• Commitment: 0
• Time: 1/2 hour

In the last post, we introduced some real estate basics including how mortgages work and what a PITI payment is. We also recommended that you distinguish between a house that you'd buy to live in VS a house you'd buy as a rental property. The rental house is a business venture and it needs to make money.

How can you tell if a house will make money? To run a successful business, your income should be greater than your expenses. Pretty basic stuff, right?

Pros Use a Pro-Forma

Real estate professionals have developed a strategy to analyze rental properties. It's called a PRO-FORMA. It sounds like a fancy Latin word, but it's just a glorified list of income and expenses.  

Consider Income vs Expenses on an example rental property. 

• Income: That's easy. The monthly rent payment is your income.

We are looking at a house that costs $100,000 and it would rent for $1,000 per month (an upcoming post will describe how to estimate what a house would rent for. For now, just come along).

• Expenses: There are several to list:

The first main expenses is your mortgage payment (the PITI payment from our last post (LINK). Your PITI payment covers Principle, Interest, Taxes, and Insurance. These amounts will be fixed and predictable. 

The P and I components of the PITI payment are calculated by the bank using a mathematical equation. (If you like Excel Spreadsheets and formulas, you can see the calculation in this linked sheet. Skip this if you're not into Excel). 

A very handy free calculator is here: 

• For a $100,000 property with a 20% down payment, you need a mortgage loan of $80,000. 
• A 30 year fixed rate loan at 5% interest results in a PI Payment of: $429

Property Taxes and Insurance will vary from one town to the next. We'll get to that, but for now assume taxes and insurance would each be $65 per month.

• The combined PITI payment would be: $559

But wait, there are more expenses involved in owning a rental property. Other expenses for a rental property are typically analyzed like this:

1) Property Management: For your first project, we recommend using a property manager (we'll discuss this more later). The typical fee for a Property Mgmt is 10% of the monthly rent. This fee is fixed and predictable. 

Now we get into less predictable expenses and we're forced to make educated guesses about the future. 

2) Repairs/Maintenance: Every property needs repairs and maintenance from time to time. It's impossible to predict what your expenses might be in the future, but they will definitely be more than Zero. As a savvy investor, you have to make an educated guess how much you might have to spend on repairs and maintenance. The technique that investors use is to calculate a percentage of the monthly rent as a maintenance reserve. Analysts often use a number from 5 to 15%, depending on the condition of the home. A nice, newer home is likely to have lower expenses than an older home with more run-down amenities. 

3) Vacancy: Your property may be vacant from occasionally, when one tenant moves out and you have to advertise for another lessee. Again, it's impossible to predict. If you assume that your property would go vacant for 1 month every 2 years, that equates to 4% vacancy. To be safe, we usually estimate 5% vacancy (meaning that we "lose" 5% of monthly rent to vacancy). 

4) Contingency: There are the other, unexpected expenses that you can't predict. Contingency can be thought of as a "safety margin". Estimate 5% contingency in most cases.

4) Utilities: If you, as the landlord, are responsible for paying for water, trash, lawn care, or any other utilities, you need to factor this expense into your Pro Forma. Most of the time, we recommend houses where the tenant pays all utilities, so this can be left Zero for now. 

Add up the list of expenses and estimate how much you need to deduct every month from your rental income. Even though these expenses probably don't occur every month, we need to estimate the average monthly cost to determine if our property will generate cash flow for the long term.

Here is a sample of our completed Pro-Forma: 

As you add up your expenses, do you see anything troubling?

• Property Management: 10%
• Repairs: 15%
• Vacancy: 5%
• Contingency: 5%
• Total = 35%

Whoa! 35% of the monthly rent is being used up on expenses? Well, yes. Don't let that startle you. Most businesses have much higher overhead, so as a business venture, 35% overhead for real estate is actually pretty low. 

The 1-Percent Rule

The sample Pro-Forma illustrates that this property would generate $91 a month in cash flow. Any positive cash-flow is great, because it means that your rental income is completely offsetting all of your expenses, and essentially your tenants are paying off the property for you. But we can probably do better than just $91/month profit. 

The sample above includes a $100,000 house that rents for $1000 per month. I used those numbers deliberately. In this sample, the monthly rent is 1% of the house price. That's a concept known as the "1 Percent Rule". 

• $100,000 x  1%  =  $1,000

For a typical buy-and-hold rental property, we want the monthly rent to be 1% or more of the price of the house. This is your first rule-of-thumb when hunting for rental properties.

For example, if you are looking at a house that costs $350,000, you'd hope for monthly rent to be at least $3,500. Here is another way to think about it: If you know that a property would rent for $800 per month, you would hope to buy it for $80,000 or less. 

The 1 percent rule is a loose guideline and it can be flexible, but it's a nice general tool for beginners to use.

Another way that investors calculate the same idea is with the "rent ratio". This is monthly rent/ price of home. 

You'll find that the majority of cities in the US do not have rental ratios that support the 1 Percent Rule. 

Now you have the Pro-Forma tool in your toolbox. That's a big step forward! Many amateur landlords never make it this far. To be a savvy investor, you'll need to seek out cities, neighborhoods, and properties that can do even better than the 1% Rule to earn your full cash flow potential. More to come on that topic in the next Baby Step!