ANALYZING RENTAL PROPERTY TO DETERMINE CASH FLOW

THE SCENARIO

Duplex for sale for $70,000.00. You put it under contract for $65,000.00, with financing as follows – 5% down, with $1,500 in closing costs, at 7.25% for 20 years. Total debt service for the year would be $5,856.72 in this scenario. Your total acquisition costs are $4,750 (5% down or $3,250 + $1,500 closing costs). The property is currently rented with good tenants for $400.00 per side for a total of $800 per month rent. How do you analyze the deal?

First, some rules of thumb. For rental property, the rule is to figure on a 5-10% vacancy rate per year. If you have less than a 5% vacancy rate, you are probably charging too little. 5% vacancy amounts to about 18 days per year where your property is vacant.

Second, on maintenance, a good rule of thumb is to figure around 10% of gross rents per month to go toward maintaining the property. From experience, this figure can be low if you have older properties but can also be high if you have new or like new properties. For our purposes, we’re going to assume a 7.5% vacancy rate as well as a 7.5% maintenance allowance because this duplex is in good condition.

We know what the property will bring in, so the next step is figuring out what expenses we will have for the year. We’ll assume that we will have property taxes at $876 per year (or $73/mo), insurance at $435/year (or $36.25/mo) and electric/utility expenses at $120/year (or $12/mo). Now, as you know, there are a lot of other expenses that you can figure in, and many of these do come into play, including management fees (if using a property manager), lawn care (if the tenants don’t take care of their own lawn), and annual pest control, etc.

With all of our income and expenses entered in, let’s take a look at how to calculate cash on cash return. We want to analyze our real estate investments in comparison to other alternative investments, and one of the best ways to do that is to look at the cash on cash return on our investments. Cash on cash return is basically your net cash flow from the first year’s operations divided by the total cash outlay that you had to make to purchase the property.

Here's the math on this one:

Gross Income -                $9,600

- Vacancy Allowance          $720

- Expenses (annual)         $2,151

TOTAL NET OPERATING INCOME - $6,729 

- DEBT SERVICE $5,856.72

TOTAL ANNUAL CASH FLOW - $872.28

Now, remember that our initial cash outlay was $4,750. So we divide $872.28 by $4,750, and find out our example property has cash on cash return of 18.36%. Not bad compared to a CD, right?

But cash on cash return is just the tip of the iceberg for rental property analysis. Once you take into account the tax benefits such as depreciation, as well as the long-term appreciation in value of the property, you can get a real picture of how good your real estate investment can be over time. A good financial analysis program can help you run the numbers and make great decisions about your rental property.

DISCLAIMER: Obviously, these investments rarely pan out exactly the way we’d expect. Sometimes you get a better deal than anticipated – the appreciation rate for the property or market rents may be higher than you guessed. And sometimes you get a worse deal – the roof starts to leak the month after you take title and you have to put a new roof on. That can kill your cash flow for a few years and is a good reason to keep several thousand dollars in reserve for your rental activities. I hope this analysis helped you as you search for rental property. Have a truly wonderful day and God Bless! Greg