Real estate investing can provide you with an additional stream of income, helping you build wealth and reach your financial goals more quickly.
One of the most popular ways to invest in real estate is owning a rental property.
Whether you’re a new investor considering real estate for the first time, or a current owner trying to decide on your next step, there are a few common skills every real estate investor should have.
To determine whether investing in rental properties is a worthwhile source of passive income, you need to know how to calculate property cash flow!
Until you know your numbers, you won’t have a clue on how to evaluate a property for cash flow, cash-on-cash return, IRR, or any of the important figures you MUST know as a property owner.
Quick Tip: Use Avail’s free rental property calculator to calculate the Cap Rate, Cash-on-Cash Return, GRM, and IRR in 5 minutes!
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How to Calculate Rental Property Cash Flow or NOI
Below is a look at an actual cash flow analysis using a property I own.
The summary below is for our first home, a townhome we converted into a rental home back in 2012.
I manage everything through a single checking account, which lets me download all of the previous year’s data into a single spreadsheet for easy organization.
If you have multiple properties, it might be helpful to use a more sophisticated expense tracking tool, like the tools from our long-time partner Avail.
Here were my specific numbers from last year.
Cash Flow (aka NOI) Analysis
We’re blessed with an excellent tenant who pays on time each month. Unlike the year before, we had no interruptions due to major incidents forcing a loss of rent.
This was our best year of rent collected yet. We raised the rent slightly last year and it’s nice to see a full year of collections at the new rate.
No matter how much rent you collect, your rental property is only as good as its actual cash flow (after expenses).
We still had a mortgage on the property, so you’ll see the principal and interest paid below. HOA dues are relatively high because it’s a townhome and the dues cover the outside maintenance and the roof.
As a reminder, we purchased/built this townhome new in 2007 (it was our first home), so maintenance has historically been very low.
We pay our own property taxes directly at the end of the year and stash the savings in a high-interest savings account.
Here’s a breakdown of the expenses, line by line:
You can see one of the downsides of owning a townhome rental property above, as our HOA raised the fee by $420.
Beyond the HOA increase, our expenses were low. Insurance premiums went down a bit, property taxes dropped, and we didn’t have a single repair.
Total Cash Flow, or Net Operating Income = $6,000.84!
As a result of record rents collected and one of our lowest years for expenses on record, we hit our highest recorded cash flow in the history of the property.
Over $6,000 in cash flow!
Here’s our cash flow/net operating income through the years:
- 2019: $6,000.84
- 2018: $4,318.35
- 2017: $5,929.24
- 2016: $1,933.72
- 2015: $3,158.47
- 2014: $2,104.44
- 2013: $4,256.41
- 2012: $(53.93)
Our Goal of Creating Passive Income with Rental Properties
If you’re like me, you want to make the most of rental property investing, with as little hassle as possible. This means generating more passive income.
While your individual goals for real estate investing might differ from someone else’s, here are some common considerations to help you find success.
Understand the Definition of Passive Income
By definition, passive income is money you earn through a venture which takes little to no time or effort to keep up.
Truly passive income lets you put the least amount of hours in and get the most amount of money out.
While investing in rental properties is lucrative and comes with a range of benefits, it can also require some time, money, and effort.
In other words, it’s active. But if you understand the cost and have some of those resources to spare, it can be well worth your while.
And the further along you get, the less hands-on you can be, if you choose.
Do Your Research
You shouldn’t walk blindly into real estate investing. Before you purchase a property, you need to do some pretty extensive research.
This could include:
- Exploring the local housing market
- Reading up on right to privacy, discriminatory housing, and eviction laws
Laws regarding landlords and tenants can vary from state to state, so it’s crucial to educate yourself on policies in your area.
Violating one of these laws could result in your tenant taking serious legal action against you.
There are plenty of online resources and courses that can educate you on these laws and help you decide whether real estate investing is for you.
Buy at the Right Time
Seasoned investors may invest in real estate while carrying debt as part of their investment strategy, but should you?
If you’re newer to investing and looking to dip your toe in a few passive income streams, you may want to pay off your debt before investing in a rental property.
While you don’t necessarily have to be completely debt-free to buy a rental property, this type of investment isn’t a good call when you’re weighed down by student debt, medical bills, or extensive credit card debt.
Focus on paying off your major debts and building up an emergency fund before you dive into rental investing. Also, work on saving as much you can for the down payment.
Consider the Costs
There are a few expenses you can expect to pay when you own a rental property.
Be sure to factor these in as you assess the ROI(return on investment):
- Property tax: Annual property taxes are a given, whether you live on your property or not. You can use your county tax assessor’s website or online tools to gauge a property’s tax rate.
- Landlord insurance: This type of insurance protects you from financial loss with property and liability coverage. While it might not be legally required, it’s almost always a good idea to purchase a policy. See our list of the best landlord insurance companies.
- HOA fees: Depending on the type of property you purchase, you might also be responsible for monthly or annual homeowners association fees.
- Maintenance: It’s up to you to make sure your rental property is in tip-top shape. Don’t forget to factor the cost of maintenance and upkeep into your expenses.
- Mortgage: If you aren’t buying the rental property outright, you need to consider the cost of monthly mortgage payments and ensure that you can easily manage them. A mortgage calculator can help.
Note that mortgage requirements are stricter for rental properties than primary residences.
As such, you’ll have to make a 20-30% down payment, at minimum.
Factor in Time
In addition to money, you also need to consider the amount of time you’ll need to invest.
From learning the ins and outs of real estate investing to managing the property and dealing with tenants, owning a rental property takes time.
One way to free up some time and make real estate investing more passive is to use a platform like Roofstock.
You can buy and manage properties yourself or purchase a turnkey home that comes with certified property management, allowing you to step out of the day-to-day administrative tasks.
Learn How to Calculate the Cash Flow
To determine how profitable your investment will actually be, you need to calculate your NOI, or net operating income.
Annual Net Operating Income = Annual Rent Collected – Annual Expenses
Knowing the property’s cash flow can help you make important decisions, like whether or not to buy more properties, refinance the mortgage, or pay it off.
If your NOI isn’t quite as high as expected, you may also decide to sell the property.
In addition to checking up on your current investments, you can also calculate NOI on a property you’re interested in.
If you’re analyzing a rental property for purchase, you’ll have to estimate your rental income and expenses.
For a conservative projection, assume a vacancy rate of 2-5%. You should also consider the age and condition of the property to estimate repair costs.
Check out comparable properties in your area and factor in supply and demand to set your rental fees.
There are several online resources to help you appraise the property and estimate its potential rental income. I like the free calulator from Avail. Use it to calculate the Cap Rate, Cash-on-Cash Return, GRM, and IRR in 5 Minutes!
Choose the Right Property
One of the biggest keys to success in real estate investing is picking the right property to purchase.
If you’re going to manage the property yourself, it’s ideal to choose a home in your area. Otherwise, you can broaden the search.
Here are a few additional factors you should consider as you sift through properties:
- Area: Choose a home in a desirable neighborhood whose real estate value is increasing. You may also factor in crime rates, transportation access, the job market, amenities, and proximity to schools.
- State of the home: Fixer-uppers are great for flipping and selling, but you should probably buy a rental home that’s close to move-in ready, unless you can renovate it affordably and quickly.
- Cost: The pricier the home, the more costly it will be to maintain. If you’re new to rental investing, buy a modest home in a good area, opting for middle ground rather than the nicest or dumpiest house on the street. And don’t forget to factor in property taxes.
Pros and Cons of Rental Property Investing
Investing in rental properties can be very rewarding, but there are also some drawbacks to consider.
Here are some real-life pros and cons of investing in rental properties to earn passive income.
- Appreciation: If you choose your property wisely, it should become more valuable over time. It’s a tangible asset that you can improve.
- Inflation protection: Real estate value increases as inflation does. As your property value increases, your mortgage rates do not, allowing your cash flow to grow.
- Tax benefits: The IRS does not put a self-employment tax on rental income, and rental properties come with tax-deductible expenses.
- Consistent cash flow: Renting can provide you with a steady flow of somewhat passive income, especially if you have long-term tenants.
- Equity: Every rent payment you collect makes you wealthier. You get equity, while your tenants basically pay your mortgage for you.
- Leverage: With rental properties, you get to use borrowed money to own a sizable asset and build your wealth, only having to invest the down payment.
- Costs money: Investing in rental properties cost money upfront for the mortgage and closing costs, and down the road for upkeep, taxes, and insurance.
- Liquidity: Rental investing is a long-term investment. You’ll have access to cash flow each month, but there’s no guarantee you’ll be able to sell quickly if you need to liquidate.
- Learning curve: Before you can successfully start investing in rental properties, you have to learn about landlord laws, the local housing market, property management, and calculating cash flow.
- Landlord duties: Unless you use a property management company, you’re on the hook for dealing with difficult tenants, collecting rent, and keeping the property up.
- Not truly passive: While rental investing is rewarding and you can hand off a lot of duties to a property management team, it isn’t the most passive form of income.
What’s Next for Our Rental Property?
So far we haven’t had any ill-effects from the COVID-19 mess.
There are two big things I expect to deal with next:
- Renewing the lease. Our current tenant’s lease is expiring soon. Therefore, we will have to draw up a new lease renewal agreement. I will likely add an additional $25 (the minimum increase) to the rent.
- Paying off the mortgage. We recently paid off the mortgage, which will have a massive effect on our future cash flow.
Looking for your first rental property?
Do you have a rental property? If so, how did yours do this year? If not, have you ever considered it? Do my results give you confidence or pause?