Here is how the typical investor works: you search online or at investment clubs and find a property that you can buy for a decent price, which after expenses will give you a good cash flow. Often you will find two, three or maybe even four of these properties and compare them against each other looking for the best of the best.
You buy the property, find a tenant and start your journey toward great cash flow. Month after month you collect your rents and gain your cash flow. Because we live in a real world, you may experience a hiccup or two but you learn from the experience and move on.
After several months as an investor and landlord, things start happening that effect your cash flow. Maybe a toilet breaks or a water heater goes out, or competition for rentals in the area become competitive and your tenant does not renew their lease. You scramble to find a new tenant so that you do not have any loss of rent. The phone does not ring like it did the last time you listed the property for rent. You discover that competition is getting tougher and fewer people can afford to lease your property. You start to wonder what’s happening as you see your great cash flow rapidly go from double digit returns to non-sustainable single digit returns. You are perplexed and wondering what just happened? Well, you may have missed the most important diligence of them all.
So what is the secret to finding great cash flow?
Identifying the real cash flow up front without any smoke and mirror analysis of the property which means making sure any possible reoccurring expenses are factored into the analysis.
To do this you must set aside funds for both vacancy loss and repairs. Often this is glossed over with a rental guarantee or a home warranty. These guarantees and warranties only cover you for a year. In this year you should be building up a little money into the checking account to accommodate any unforeseen vacancy or repairs. Most people will factor in about three percent to five percent of the rents for repair and another three percent to eight per cent for vacancy. The numbers you want to use for these line items are going to vary based on home price and condition. The vacancy factor can be established by finding out what the average vacancy rate for properties are in your area.
When you set aside these two line items as expenses, you are adding anywhere from six percent to 10 percent of a month’s rent toward these expenses. If you do not need them, congratulations you have larger cash flow. When you do need these funds you have the money to pay expenses and you still have strong positive cash flow because you were purposeful about the investment.
Truth is, great cash flow is not a secret. It is more of a case of completing what is often unfinished – due diligence on expenses.
What is another secret weapon? Find a calculator you are comfortable with that you use for every analysis. There are many free ones on the internet such as this one that I created. Whatever you use make sure that every property you purchase is analyzed the same way and with all expenses including the vacancy loss and repair and your cash flow will grow sustainably.
A consistent way to analyze the returns is a must. You must use the same analysis calculator for every property evaluation and the analysis must always be the same. Most people who do not get the returns they were expecting are using the pro forma reports given to them by the person selling the property. This seller provided reports are always different and rarely ever produce returns based on this suggested numbers that are used. The sad truth is the people looking to sell the property are making the returns look better than perhaps they really are. They may be using good and accurate numbers however they rarely use all the numbers you should be utilizing to create accurate assessment of property.
In addition to what is mentioned above, your analysis should include the following:
- Purchase price
- Closing costs
- Monthly payment including Principal and interest payments
- All Monthly fees including Any HOA fees, utilities fees, landscape fees and property management fees that are paid for by the property owner.
So how does the seasoned investor work?
Knowing the most important aspect of real estate is location, they seek to find sustainable cash flow. Here are the attributes the seasoned investor is looking for:
- Sustainable employment: areas where unemployment is lower than the national average.
- Population growth: when population rises, housing needs remain strong.
- Strong rent to purchase price ratios: the 1% rule should apply.
- Job diversity: areas that have a large variety of employment create sustainable employment. Areas that are strongly dependent on one or two industries tend to go broke quickly when that industry is stressed due to economic factors.
- Job growth: local municipalities which have strategies and incentives in place to attract new businesses and job hires.
- Path of progress: you want to buy in the direction of progress, when a town has huge growth to the north you want to buy in the north as this is where the demand is.