Are these good assumptions for comparing many properties?

I am looking at many residential properties along the central coast of California - 1 to 4 units. I created a spreadsheet to quickly assess these properties. My goal is to get a rough idea of which properties have potential before doing more detailed analysis. Here are the assumptions I’m making:

  1. Appreciation = 3.2% (historical inflation)
    I was comparing ROI (return on investment) with and w/o appreciation. Is it advised to include appreciation in the analysis?

Annual Expense Assumptions:
2. Vacancy = 1 month rent
3. Utilities = 3% of gross rent
4. Insurance = 0.15% of property value
5. Management Fee = 15% of gross rent
6. Miscellaneous = 8% of gross rent
7. Depreciation and Mortgage interest for Tax load
8. Other expenses = HOA, property tax, Mortgage (not in NOI)

Are these assumptions reasonable. Should I be considering any other expense?

For Cash flow analysis, I am using the following performance measures:
NOI, cap rate, GRM, cash flow pre-tax, cash flow after tax, ROI, ROI w/ appreciation.

Should I be looking at any other measures? Am I missing something?

Depreciation is not an out of pocket expense. I would not use depreciation as an investment criteria. I would think that all you would really need is the net cash flow and the return on invested capital.

Ignore tax benefits that can change at the whim of Congress, and don’t depend upon appreciation. Any appreciation over the next few years may be speculative at best. Any appreciation that you may accrue during your holding period could evaporate in the next recession.

Two questions really need to be answered YES before I would consider buying a specific property for my rental portfolio.

  1. Is the cash flow acceptable?
  2. Is the return on invested capital better than I could get in another investment vehicle with less risk?

If the net cash flow is positive and at least 25% of my debt service, then I can be confident the property generates enough cash flow to take care of the unscheduled repairs. I am looking for a property to be self sustaining financally.

If the return on investment is only 5% pre-tax, then I would rather buy some other asset class that gives the same or better return with less risk. The return on investment has to be high enough to compensate me for the risk I incur as a rental property owner.

With experience you will learn what investment criteria you will need to meet before you act. I do a detailed cash flow analysis to answer my two questions.

When presented with multiple candidate properties that pass my two question test, I will buy the property with an acceptable cash flow that generates the highest return on my invested capital, then the property with the next highest return.

Rental property investors do not buy a property, they buy the cash flow. When you appreciate that fact, your investment analysis and your purchase criteria will get a lot simpler.

When you are running your figures, you do not include appreciation. You might get appreciation, you might not. Don’t count on it to turn a mediocre deal into a good one.

With that being said, the potential for appreciation is in the forefront when I choose a property to purchase. In my area, some types of property are going to appreciate better than others. Some towns are always going to be a stronger market than others. Some styles of houses are going to be easier to market. All of that is taken into consideration.

I buy and hold, so I am looking for long term strong value. I also look for a solid property that I can add serious value to with a bit of creative work.

But counting upon appreciation? Iron clad rule: real estate fluxuates. Prices go up, prices go down, and timing the market can be a gamble.

Question for Dave T.:

You mentioned that you need cash flow to be 25% of debt service. Is this assuming a 20% down payment?

It is very difficult to get positive cash flow on anything in California unless I’m willing to put down a 50% down payment, let alone having cash flow at 25% of debt service. Is this indicative that California is still not a good place to invest, regardless of the huge price drops?

2nd question - I assumed 8% of gross rents go into miscellaneous expenses, such as unscheduled repairs. Would you suggest I increase the misc. expenses to at least 25% of debt service, and then see if I can get a positive cash flow? Or should I make miscellaneous expenses higher to cover other expenses besides unscheduled repairs?

Thanks for the clarifications.

DO you want to spend $25,000 to just breakeven on a monthly basis. Do not speculate, invest. Look for the deals. They are out there in ALL markets, just some are harder to find. Networking is very important.

As for expenses. Many people use the 50% rule which is, if your mortgage is $1000 a month, expenses are $500 a month so you would want a rental income in the $1700 a month range.

There are many variables that pop up that will cost you money during a rental. Roofs, electric, bad tenants, toilet leaks, EVICTIONS, ADVERTISEMENTS, LEGAL FEES, ACCOUNTING FEES, do not forget postage and paper. Lawn care, snow removal, carpet cleaning/prep work for new tenants, unpaid utilities in certain areas, insurance, fines, etc… SO many fees…

You mentioned that you need cash flow to be 25% of debt service. Is this assuming a 20% down payment?

It is very difficult to get positive cash flow on anything in California unless I’m willing to put down a 50% down payment, let alone having cash flow at 25% of debt service. Is this indicative that California is still not a good place to invest, regardless of the huge price drops?

For my cash flow analysis, I always assume a 20% down payment because that is what the institutional lenders require. If I can’t get an acceptable cash flow with no more than a 20% down payment, then I pass on the property.

Remember, there are two questions that both must be answered. If you make a larger down payment to produce a positive cash flow, then you lower your return on invested capital. Make a large enough down payment then your return on invested capital could get so low that even your bank account interest rate would be competitive.

You want a positive cash flow property, but you also want the income your property generates to be a good return on the capital you have to bring to the table. The cash flow makes the property self sustaining, the return on investment keeps you from overpaying for the property. The combination helps you make your money work for you efficiently for the level of risk you are willing to tolerate.

My conditions just make California a more difficult place to invest but I am sure you can find property that will generate a positive cash flow.

2nd question - I assumed 8% of gross rents go into miscellaneous expenses, such as unscheduled repairs. Would you suggest I increase the misc. expenses to at least 25%, and then see if I can get a positive cash flow? Or should I make miscellaneous expenses higher to cover other expenses besides unscheduled repairs?

Do your cash flow analysis with the expenses you know and can quantify. If your miscellaneous expenses include preventive maintenance, legal costs, advertising expenses then you might have 8% of gross rents already. Hard to tell because these costs are usually easily quantifiable. Advertising rates depend upon your medium. Craigs List is free; newspaper advertising has a weekly cost you can easily determine with a phone call to your local newspaper. If you are planning only one month vacancy, then plan for seven weeks of advertising expense. Legal fees might include the attorney fee to draft your lease, and an annual review of your lease form to update it for changes in the landlord-tenant law. Preventive maintenance includes the annual fire safety inspection for your fire extinguishers, battery replacement for your smoke detectors, termite bond renewal, and semi-annual HVAC tune-up. All these things are easily quantifiable. Whether they add up to 8% of gross rent is hard to know for your market and for your market rent.

Unscheduled repairs are needed when things break. You don’t plan for something to break. You don’t know whether you will have a leaky pipe, a clogged toilet, an electrical problem, or an appliance repair or carpentry repair. Maybe none of these will happen during the year, but that is why I want a 25% cash flow margin. Many experienced landlords set a $ limit, such as $100 per month for their cash flow and they let that cover the emergency repairs.

The point of your cash flow analysis is to determine whether the property will generate a positive cash flow, and if that cash flow gives you an acceptable return on your invested capital. You won’t really know until you have real numbers to work with. Just approximating percentages works for something like the property management fee but can be way off for other expenses such as property taxes and hazard insurance premiums.

You can spend a lot of time building a model to approximate costs using percentages as a quick and dirty screening tool, but that wheel has already been invented. Do a Google search for the 50% rule.