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.