For rental:
do the following numbers seem accurate?
Vacancy and Collection Loss-10% of gross monthly income
Accounting/Legal - 5% of annual gross income
Insurance - 3% of annual gross income
Property Mgt - 10% of annual gross income
Real Estate Taxes - 3% of tax assessed value
Repairs/maintenance - 10% of annual gross income
Utilities - 10% of annual gross income
Supplies - 1% of annual gross income
Miscellaneous - 15% of annual gross income
Do these numbers look too high?
Your numbers are too high. The operating expenses as you have listed come out to a whopping 67% of gross rent. Actual operting expenses (including capital expenses) in the United States run 45% to 50% of gross rents.
A better way to evaluate a property is to take half the gross rent for operating expenses and then subtract the mortgage (principle and interest). The result is your cash flow and is very accurate over the long term.
Mike
What is “miscellaneous” exactly? And why is it 15%?
Vacancies are usually 1-2 months (8-16%).
10% for maintenance? I use 3-5% depending on age.
Utilities 10%? Do you pay the utilities?
Insurance 3%? I just figure 0.6% FMV for the year.
I add marketing/agent fees = 1 months rent.
But property manager is right … 50% gross rent is a good metric to use for operating expenses.
I had never heard of evaluating this way…
Mike,
Are you saying that generally speaking…using the above formula covers just about everything…(property taxes, insurance, etc).
If so…here’s a hypothetical:
A 4-plex is offered for sale.
$500 per unit…fully occupied…$2000 gross per month.
For quick evaluation purposes, (I’m assuming you don’t figure in any rehab cost), you simply take 1/2 of the $2000, and with that $1000 figure you then only consider what is left after you have backed out just the recurring monthly mortgage, (principal and interest).
I know I’m beating up the issue…but you think this is a good yardstick?
Thanks,
-Mike
Hi Mike,
Yes, that’s right. Subtract the principle and interest from half of the gross rent to find cash flow. This is BY FAR the most accurate method that I’ve seen for calculating cash flow.
When I first started REI about 3 years ago, I believed the guru nonsense and calculated cash flow by taking gross rent and then subtracting taxes, insurance, vacancy allowance, maintenance allowance, utilities paid by the owner, and the mortgage payment. What a bunch of guru nonsense. I discovered on my own that these are not even close to the actual expenses. Either the gurus do this on purpose to make REI seem more attractive to newbies or they really don’t know what they are talking about.
Several months ago, I saw a post that referenced the National Apartment Association. They are a trade group that represents literally hundreds of thousands of rentals nationwide. According to them, throughout the entire United States, operating expenses run 45% to 50% of gross rents. Through my own experience, I have found this to be extremely accurate. I only wish that I knew of this professional association when I first started.
Fortunately, I bought all of my properties at a hugh discount and still have a significant positive cash flow, even with the real expenses. If I had bought my rentals relying on the guru nonsense numbers, I would certainly be losing money (as many others are).
So, to answer your question, using 50% of gross rents for operating expenses is the most accurate method that I have seen to date.
Mike
PropertyManager, a couple of newbie questions for you.
Does your formula apply to SFR too?
When one evaluates Cash Flow, is the tax savings included in the Cash Flow or is the Cash Flow strictly the Cash you have left over after paying everything?
I am using the Landlordpro Analyzer product to evaluate cash flow and it includes the tax savings in the Cash Flow Analysis.
Thanks,
VV
VV,
While I would like to take credit for this formula, I can’t. It is from the National Apartment Association’s annual operating expenses survey.
This formula does not have anything to do with tax savings and does not consider any appreciation of the property. It only considers actual cash flow.
Mike
Thanks PM. Not to belabor but just to confirm – so when a RE investor on this board says they have $100 cash flow a month on a property, this is actual amount of money left over after expenses and debt service? If they acrue some tax savings that is over and above the $100 cash flow)?
VV,
When most people say that they have a $100 cash flow, they probably actually have a $200 or $300 loss per month because they are ommitting many expenses (some of which they haven’t incurred yet). For example, a newbie could easily have a rental for which he has $100 left over each and every month for 2 years (a $100 positive cash flow - right?). Then, a tenant gets mad, has to be evicted, and does $3,000 in damage before being set out by the sheriff. The landlord also had legal expenses, court costs, setout costs, 2 months vacancy, unpaid water bills, etc. How much cash flow did the landlord really have the past 2 years?
Mike
PM – I have planned that I will put aside a fourth to a third of each month’s projected cash flow into a contigency fund to be used for unforeseen expenses etc. Being a newbie, I don’t know if it is naive to think this theory can be applied in practice.
What is “miscellaneous” exactly? And why is it 15%?
You know MISCELLANEOUS the money you spend in beer while working on the house! 
LOL!
You know MISCELLANEOUS the money you spend in beer while working on the house!
15%?!?!?!
They should nix the imports then and buy the cheap stuff - unless 15% is the cheap stuff. ;D
while the 45-50% number is not a bad way to make quick estimate, you can do significantly better than that. I have properties that I have operated for many years below that number. I do have properties that are in that range, but usually because I put money into upgrading the properties slowly over time.
When looking at the numbers, one has to take note of expenses that could be outside your control or major capitial expense that will occur at know time (e.g. roof replacement). For example, I do not own properties where I have to pay heat. If a capitial expense is likely in the next 5 yrs after purchase, I figure this into my ROI claculation and subsquent offer on the property.
AAK,
I must partially disagree with your assessment. Operating expenses (including capital expenses) do average 45% to 50% of gross rents throughout the entire United States. This percentage is not affected by things such as who pays the heat. Obviously, if the owner pays the heat, then the rent is higher and the percentage is still intact. As you said, operating expenses on any given property can vary especially in the short term. However, as the number of properties increase and the time horizon increases, operating expenses trend toward the average.
When I started my business three years ago, I went an entire year and had more than 10 rentals with my expenses exactly following the nonsense guru numbers (gross rent minus taxes, insurance, principal and interest, vacancy allowance, maintenance allowance, equals cash flow). I didn’t have a single eviction, no unscheduled expenses beyond routine maintenance, no damage caused by tenants, no legal expenses, no lawsuits, etc) I thought I had hit a gold mine. Then, over time as my rental inventory increased, all the expenses that the gurus never discuss began to eat away at the cash flow until I only had half of a gold mine. Seriously, the expense numbers began to return to average until they reached almost exactly the 45% to 50% that the National Apartment Association reports.
These are expenses that can’t be avoided forever. The more units you have and the longer you have them - the more the expenses will move toward the average.
You’ll notice that in this formula, cash flow has nothing to do with the operating expenses, since operating expenses are in direct proportion to gross rents. Cash flow is solely determined by the mortgage payment. This accurately reflects the importance of buying the property at a discount.
Also, you’ll note the effect of outsourcing the management, maintenance, etc. The formula considers that you are paying for management, maintenance, etc. So, if you manage and maintain the property yourself, you are paying yourself these expenses and therefore increasing your income.
Mike
I have no issue with the figure and as you stated I wuold have loved to known that number 8 years ago when I got into rentals. Also, by definition, if the “average” is 45-50%, then half the poeple are doing better than that. I now have more than 2 dozen rental unit so I have refined my analysis model over time; I can do better than that. As an engineer who has co-controlled a $6M/yr budget and faced with cutting cost and/or people in the now famous tech bust, I’m all about cost control. If you get motivated (i.e. faced with giving people who bust their butts for you pink slips, you can find cost saving) I’m also personally a tightwad to say the least.
I operated in several other market in the East Coast outside of my “home” market in Calif, but I’m not from here/there either (I’m an East Coast guy). I’ve also analysized deals is in about 10 other states both East and West Coast.
So with that, here a few thoughts:
Rent is based on quality and bedrooms. Most renters don’t really figure in whether trash and water are include or not. A great example is I bought a property a few blocks over from some stuff I already owned (paid no utilities). The Seller seemed to forget to disclose that his utility expense was $2.5k/yr (yes, I asked). It get the same rent as it about similar grade for 2 bedrooms. However, a building with a gross rent of $2000/mn, when I got the first water/trash/swer bill for $200 (per month), I was not a happy camper. I’m still cash positive, but its not the deal I thought it was.
Another point is propery management (prop. mger, you’ll love this). I have usually used more “mom-n-pop” places taht have a lock on the local/niche market. I recently started using a big time prop. mgmt company in a college market as they have major marketing muscle. I quickly found out that the local contractor screw them over as they charge crazy prices as they know most owners are either not watching or big corporate owners. I got a charge for $160 to install 4 mini-blinds (!!!); it just so happen in a nearby market about 15 miles away, I have my mom-n-pop prop mgmt do a similar job for $46. Of course, for my Calif. rental, it woudl have been a $15 expense at Wal-Mart, 1 hour time and a few Buds ;D On a property that grosses $1250, $100 (over) charge is significant.
So in conclusion, the 45-50% is great rule of thumb, but you MUST dig into the details to analyze a deal and you must actively MANAGE cost as an owner (especially if you use prop. mgmt). Work the number and figure range of where expense will fall. By statistics, calculating a single number for budget will almost certainly be wrong.
BTW, I’m not a hand off guy either as my stuff in Calif I do most the work myself. My wife and I did some work on a duplex this summer which would have cost $15k+ (we have about $4k in materials into it; plus some chiroptractor bills after I killed my back by working 12 hrs days doing a new deck).
Sorry for the long post; just some thoughts and contribution to a healthy discussion.
MB in Calif.
AAK,
I agree with almost everything you said. Another way to look at the formula is that you’re starting each month with expenses running 50% of gross rents. If you put forth the effort, you can capture some of that money and keep it for yourself. For example, if you manage the property yourself, you have earned the 10% management fee that would otherwise go to a management company. If you do the maintenance yourself, you have earned another 5% to 10%. The same is true for many other factors including evictions, renovations (capital expenses), screening tenants, bookkeeping, tax preparation, etc.
When evaluating an indivicual property, it is very difficult (impossible) to accurately calculate cashflow by listing individual expenses. Most new investors don’t even know what all of the expenses are, let alone have an idea of the numbers to assign to each expense. Even more experienced investors won’t have enough data to assign accurate numbers to the expenses. Additionally, some numbers simply can’t be known. What will your legal expenses be for any given property? There is absolutely no way to know this. If you’re never sued and have not evictions or contacts with local government, this number could be nearly zero. If a child is killed on your property, a multimillion dollar lawsuit with tens of thousands of dollars in legal expenses could occur.
Good Luck,
Mike
so, 50% of gross rents for expenses IN ADDITION to debt services would be a fair margin for variable costs? So if gross rent is 800 month and debt service is 300 a month, variable costs are 400 (50%), that leaves 100 cash flow.
now, what about other fixed debts - such as a salary paid to me, as the operations manager of LLC or the Secretary of company?
please note both questions.
TMCG,
Yes, you are correct although your terminology is a little iffy. 50% of gross rents are Operating Expenses. Gross rents minus operating expenses equals Net Operating Income (NOI). NOI minus debt service gives you cash flow.
50% of gross rents for expenses IN ADDITION to debt services would be a fair margin for variable costs?
Other than the semantics of calling this “variable costs” you are correct. All normal expenses are included in this formula.
Is a salary that you pay yourself part of the operating expense? It depends on what you’re doing to earn it, if anything. If you’re hiring out all services for your rentals and simply getting a check for doing nothing, then your salary is in reality nothing more than a profit distribution (cash flow) and is not included in the formula. If you are actually working for your salary (doing maintenance, management, etc, then your salary would be included in the formula.
Mike
Mike,
Would your advice be to not consider sfh that you can rent for $500 a month if the mortgage is more than $250 per mo.? I’ve been considering purchasing a sfh but I know the mortgage would be more than $250.
BC,
To answer your question - it depends. That 50% formula assumes that you are paying someone else for everything. So, if you are doing everything yourself (maintenance, management, etc), then you may still be able to make some money. Just carefully consider everything and make your best decision.
Obviously, it would be best if you could find a property that shows a positive cash flow using the 50% formula.
Mike