Due Diligence & Cash Flow Analysis Calculations
Continued from the Simple Guide on Real Estate Investing Pt1. This guide on real estate investing will show you how to do cash flow analysis to see if a property rental is a good buy.
Here are the four steps to take to figure out if a Real Estate deal is a good one
1. Calculate Income
With every property that you consider, you need to be able to forecast your rental payments. In a certain city, rental payments can vary from neighborhood to neighborhood. They can also vary from the type of rental, number of bedrooms, garages, and / or amenities.
You should always be conservative in every single number that you calculate (i.e under estimate incomes, while over estimating expenses) to minimize risk.
Cash flow is King. I usually like to ignore home value appreciation, unless it is significant. For example, a house in the midwest, the appreciation is very low, while in the coasts, it may be a considerable factor.
The first step is to add up the rental income of all the tenants in your property.
This is known as the Gross Income.
2. Calculate Expenses
There are various expenses to consider when analyzing a property. Here are the following numbers that are need to know:
|Tax (Monthly)||Property Tax info can be obtained online. If unsure, budget 100 dollars in tax.|
|Insurance (Monthly)||Again, this number can be obtained online, or through research. If unsure, budget 100 dollars for insurance.|
|Utilities (Water, Sewer, Garbage, Gas) (Monthly)||Generally these are paid for by the tenant, however check to make sure. If purchasing a multi unit property (duplex / apartment) make sure it has separate meters.|
|HOA (Monthly)||Can be obtained online or ask your realtor.|
|Lawn, Snow care (Monthly)||Sometimes it is handled by the tenant, but most often by the owner or through property management.|
|Vacancy (Monthly)||This is a number needed to account for future vacancies in your property. I usually put 50 dollars aside.|
|Repairs (Monthly)||Estimated cost of repairs each month. It is hard to estimate, so I usually put $50 to $100 / mo.|
|Capital Expenses (Capex) (Monthly)||These are expenses which you incur to renovate or upgrade the property. I usually put $50 to $100 / mo.|
|Property Management (Monthly)||Usually property managers take a 10% cut off the gross rental income.|
|Mortgage (Monthly)||Monthly mortgage payment.|
These are the basic expenses which you need to consider for every property. Sometimes it’s hard to estimate what these numbers are. It is a definite skill to hone after experience.
This is why I recommend to always put conservative numbers if you are unsure. A good deal will stick out like a sore thumb after proper analysis.
Add up all of your monthly expenses.
3. Determine Cash Flow
Monthly Cash Flow = Monthly Gross Income – Monthly Expenses
4. Determine Return of Investment (ROI)
To do this, you need to calculate the following numbers:
|Down Payment||How much cash up front for the loan?|
|Closing Cost||Fees associated with the transaction.|
|Rehab Cost||Does this property need immediate repairs before renting?|
|Misc Cost||Anything else. (Inspections, etc|
The sum of these items is known as your Total Investment.
ROI = (Monthly Cash Flow X 12) / Total Investment
This is also known as Cash on Cash yearly return. You are calculating how much time it takes to get your initial investment back.
For example if I put a down payment of $20,000, and I net $500, I would get a 30% Cash on Cash return. It would take me about 3 years to get all of my initial investment back.
There are other ways of analyzing return on investment which involve appreciation and other factors, but the immediate, hard money decision making number is the Cash on Cash return.
Is the ROI Good or Bad?
While everyone has different preferences on their minimum acceptable ROI, there are guidelines.
Since you are directly investing, your time and energy must be considered. Because of this, I would consider a good Cash On Cash ROI to be greater than the return of REITs (about 5-8 %). If it isn’t, then you are selling yourself short.
Personally, I own two rentals which give me a 15% or greater ROI, and that’s the lowest number I’d go for.
This guide on real estate investing wouldn’t be complete without mentioning these two tips.
The 2% Rule
This is a guideline for investors who are browsing around and haven’t had the time to do a proper analysis.
The 2% rule states that a profitable property’s monthly rental income should equal to or be higher than 2% of the total purchase price.
This is only a guideline, and not a definitive rule. Use this while you’re driving around town, quickly browsing for deals, or having a conversation.
The monthly expenses of a property should amount to no more than 50% of the gross income.
Generally it is considered to be a good buy if a property meets both the 2% and 50% rules, however you must always consider other factors.
Remember too that it’s not always about the numbers.
Real estate investing is a hard asset and involves interacting with people and social factors (tenant quality, dealing with problems, time investment, etc). A property with a little less ROI but with better tenants or in a better neighborhood might be more worthwhile than a good ROI property that gives you a lot of trouble.
While it can seem daunting, real estate property analysis is pretty straight forward. Even then best investors make mistakes, especially on their first try. Hopefully this guide on real estate investing has softened the learning curve for you.
What matters is that you make decisions with careful analysis, but don’t be afraid of risk. Every investment requires risk and diving into the unknown. But this is why investors create wealth, while those who tuck their cash away in the mattress, become destitute.
By analyzing the four pillars of a real estate deal: Income, Expenses, Cash Flow, and ROI you are sure to make an educated decision.
If you are serious about Real Estate investing, I suggest that you pick a neighborhood, 3 or 4 properties, and do the analysis for fun and practice. It will train your eye to see what’s a good deal and what isn’t. Compete with a friend to see who can find the best deal around town.
Comment Below: Impress me with your back of the napkin deal making calculations. What are some of the best deals you’ve made?
When I first started getting into Real Estate, I was clueless on what to do. Back in the day, there weren’t many online resources and I had to learn everything by word of mouth.
Today with so many resources and guides available, my favorite book is the Bigger Pockets real estate guide.
Please take a look on how you can get started on your journey to financial freedom and abundance today. Especially if you are young, seize your advantage NOW instead of later.