“Life is like a combination lock: your job is to find the right numbers, in the right order, so you can have anything you want.” – Brian Tracy
This quote also applies to real estate. Today, I want to touch on the second step of the real estate investment process, which is analyzing potential investment properties. Every article and book I have read includes a similar theme: the biggest mistake a new real estate investor can make is not performing due diligence. As Jordan and I take the leap into real estate investing, we want to make sure that we have a clear idea of what we are getting ourselves into financially. That’s not to say we won’t make mistakes along the way, but we will at least have a realistic plan to pay for possible bumps in the road.
The two ways that rental properties can make money are:
- Cash flow: the cash left over after all expenses
- Appreciation: the equity gained as the property value increases
Although it is difficult to estimate future appreciation, it is unlikely that property values will decrease significantly if you plan to hold the property for an extended period of time. There is generally a lower risk of losing money based on appreciation alone. Therefore, this post focuses on how to estimate cash flow.
What is important to understand when conceptualizing cash flow is that income may include more than just rent and expenses will include more than just mortgage. The following calculator I set up in Tableau will walk you through a full analysis of potential cash flow. The calculator includes the most common (and most commonly missed) expenses for a rental property. Because Jordan works in finance, he helped me with some of the terms and calculations (not sure when I’ll use amortization schedules again!). Since some of these concepts may also be new for others, I have done my best to provide explanations within the calculator: hover over the question marks to get more information about terms used and hover over calculated numbers to see what the calculations mean for you.
(click to view calculator)
It is critical that you set realistic expectations for costs. As needed, contact local water departments, trash providers, electric companies, contractors, other local landlords, etc. to get accurate quotes. Keep in mind that not all of these will apply to every property—for example, you may leave it up to your tenant to pay for lawn care. Also, investigate local rental prices to ensure you do not overestimate monthly income or inadvertently increase vacancy rates because your asking price is too high.
The most important number crunching happens at the bottom of the calculator, where you can view the final cash flow and cash-on-cash return figures, as well as other relevant metrics (e.g., net operating income, cap rate, etc.).
How do you use the calculator to determine if a property is a good buy?
Your chances of success are high if you can answer “yes” to the following three questions:
- Are your estimates realistic?
- Do you have positive cash flow?
- Are you projected to make more money than if you were to invest your cash in the stock market (i.e., are you making more than 10-12% cash-on-cash returns)?
Hope you find this tool useful as you analyze potential rental properties!