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Cash Flow and Expenses

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phardy34

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First, I`d just like to quickly introduce myself: My name is Paul and I`m a beginning real estate investor located in the Niagara Region. I have a learned a ton from reading this forum and would like to thank all the expert contributors who take the time to share their valuable insights.

I`m currently on the hunt for my first property, focussing mainly on duplexes and triplexes. In crunching the numbers on various properties, I`m afraid I`m not quite grasping how to incorporate expenses into my analysis, based on all of the different approaches I have read about. Specifically, I`m not sure how to incorporate things like vacancy, maintenance / repairs, etc. into future cash flow projections. I understand that I should be setting a certain percentage of my rents aside to cover these eventual expenses (i.e. 5% for vacancy, etc.) Are these funds being put aside in order to build a reserve of say 1-3 months rent? If so, once you build that reserve fund, and assuming you haven`t had to tap into it (and yes, I know that eventually you will have to) do you now consider that money to part of your net income?

Here`s an example:

Gross rents: $1225/mth
P & I: 638.25/mth
Taxes / Heating / Water / Insurance: $428 /mth

Now, from the remaining $159 of income, I need to deduct 3-5% of gross rents for vacancy allowance and 3-5% of gross rents for maintenance / repairs, correct? (NOTE: I will be managing the property myself) So we`ll say another $125. Resulting in cash flow of $34. Does that seem about right? If so, can I assume that once my reserve fund is built, my cash flow goes up by $125? One last question, all the expenses in this example add up to roughly 45% of gross rents. Is this where the 50% rule comes from?

Thanks for any insights or advice you can offer about this. I want to make sure I`m on the right track with both purchase analysis as well as future cash flow projections.

Regards,

Paul Hardy
 
QUOTE (phardy34 @ Aug 22 2008, 11:52 AM) First, I`d just like to quickly introduce myself: My name is Paul and I`m a beginning real estate investor located in the Niagara Region. I have a learned a ton from reading this forum and would like to thank all the expert contributors who take the time to share their valuable insights.

I`m currently on the hunt for my first property, focussing mainly on duplexes and triplexes. In crunching the numbers on various properties, I`m afraid I`m not quite grasping how to incorporate expenses into my analysis, based on all of the different approaches I have read about. Specifically, I`m not sure how to incorporate things like vacancy, maintenance / repairs, etc. into future cash flow projections. I understand that I should be setting a certain percentage of my rents aside to cover these eventual expenses (i.e. 5% for vacancy, etc.) Are these funds being put aside in order to build a reserve of say 1-3 months rent? If so, once you build that reserve fund, and assuming you haven`t had to tap into it (and yes, I know that eventually you will have to) do you now consider that money to part of your net income?

Here`s an example:

Gross rents: $1225/mth
P & I: 638.25/mth
Taxes / Heating / Water / Insurance: $428 /mth

Now, from the remaining $159 of income, I need to deduct 3-5% of gross rents for vacancy allowance and 3-5% of gross rents for maintenance / repairs, correct? (NOTE: I will be managing the property myself) So we`ll say another $125. Resulting in cash flow of $34. Does that seem about right? If so, can I assume that once my reserve fund is built, my cash flow goes up by $125? One last question, all the expenses in this example add up to roughly 45% of gross rents. Is this where the 50% rule comes from?

Thanks for any insights or advice you can offer about this. I want to make sure I`m on the right track with both purchase analysis as well as future cash flow projections.

Regards,

Paul Hardy

I`ve been reading a lot on the 50% rule and I`m not sold on it being the best tool to use. From what I understand, 50% of your gross rents go to operating expenses. The thing I don`t understand is if tenants pay utilities, is utilities an operating expense? I think it should be counted in vacancy numbers but not in Operating expenses.

From what I`ve read, operating expenses include

Vacancy (5-8%)
Maintenance, capital projects etc (5-20%)
Taxes (10-20%)
Advertising (2-3%)
Utilities - 15-20%
Property management (You can say 0 because you`ll do all the PM stuff yourself, but then you`re working for free...I almost think that`s what you have to do until you have enough "true" cashflow to hire a PM)

So if you include utilities in your operating expenses, you can see you`re close to 50%, but if you don`t then you should be working in the 35-40% range.

I think you may be underestimating the expenses a bit as well. 5% is not very much to put away a month if you have to do a roof, a furnace or windows.

The most important thing I`ve learned about this rule is how important it is to get a good deal. At market prices, at least where I am (Edmonton), the numbers never work out. You have to get something at least 20-30K below market value for things to work out.

If a more knowledgeable member would like to step in and correct me, please do so as I`m not 100% sure on this, and I too am looking for my first investment property.

Good luck
 
jqq, thanks for your reply and input.

I agree that I`ve probably underestimated the maintenance costs and neglected other expenses. However, what I`m trying to get an understanding of is, if you are able to set-aside a healthy reserve fund to cover things like vacancies and major repairs, and your property is performing well, do you continue to subtract those percentages from your operating income every month? At what point do you say, "OK, I have enough money put aside for this property, let`s move some of that monthly amount into the positive cash flow column." Having said that, I understand you would continue to put aside maybe a smaller amount for routine maintenance and other expenses.

Am I on the right track with my thinking here?
 
QUOTE (phardy34 @ Aug 22 2008, 11:52 AM)
First, I'd just like to quickly introduce myself: My name is Paul and I'm a beginning real estate investor located in the Niagara Region. I have a learned a ton from reading this forum and would like to thank all the expert contributors who take the time to share their valuable insights.



I'm currently on the hunt for my first property, focusing mainly on duplexes and triplexes. In crunching the numbers on various properties, I'm afraid I'm not quite grasping how to incorporate expenses into my analysis, based on all of the different approaches I have read about. Specifically, I'm not sure how to incorporate things like vacancy, maintenance / repairs, etc. into future cash flow projections. I understand that I should be setting a certain percentage of my rents aside to cover these eventual expenses (i.e. 5% for vacancy, etc.) Are these funds being put aside in order to build a reserve of say 1-3 months rent? If so, once you build that reserve fund, and assuming you haven't had to tap into it (and yes, I know that eventually you will have to) do you now consider that money to part of your net income?



Here's an example:



Gross rents: $1225/mth

P & I: 638.25/mth

Taxes / Heating / Water / Insurance: $428 /mth



Now, from the remaining $159 of income, I need to deduct 3-5% of gross rents for vacancy allowance and 3-5% of gross rents for maintenance / repairs, correct? (NOTE: I will be managing the property myself) So we'll say another $125. Resulting in cash flow of $34. Does that seem about right? If so, can I assume that once my reserve fund is built, my cash flow goes up by $125? One last question, all the expenses in this example add up to roughly 45% of gross rents. Is this where the 50% rule comes from?



Thanks for any insights or advice you can offer about this. I want to make sure I'm on the right track with both purchase analysis as well as future cash flow projections.



Regards,



Paul Hardy




Hello Paul and JGG,



First off, great questions!



I think that without getting into the exact details of each property individually, we can look at a general overview of working the numbers.



If you haven't read Real Estate Investing in Canada, you'll want to pick up a copy as reference as it has the 'Cash Flow Zone' and how to breakdown a property's income and expenses. You can also use the search tool on this site to look for other threads about analyzing properties and what the numbers should flow like.



Here is a link to a thread with one PDF of numbers. It isn't the clearest example - but it will show you a fairly thorough breakdown and projection.



http://myreinspace.com/rein_members_only/Property/84-6591-Please_help_analyze.html



1) The number that you use to factor your vacancy rate depends on which city you are investing in. So Niagara and Edmonton will use different numbers and that will affect your cash flow (CF), as will the other factors like rents. Research your market, check your local real estate board for the numbers. Also, check the current rentals listed on websites to manually track rents and trends - of course use this site as well.



2) Repair and maintenance depends on the age and condition of your property. A newer house with a 5 year warranty will require a smaller repair and maintenance reserve fund than a 1980's home that hasn't yet had their roof and siding replaced. Keep in mind your specific property and adjust the numbers accordingly. Speak with a property inspector and a handyman to get an idea for repairs.



3) Your basic numbers are ok. Try and give yourself enough room for fluctuations. Example: 3-5%, choose 5% - the higher number for your area. It is better to err on the high-side than to be stuck with monthly cash calls from not giving yourself enough of a buffer.



4) I keep the excess (if any) from my repair and maintenance and vacancy reserve fund in the bank account of the property as 'reserve equity'. I can add it as profit, but I don't use it for anything but what it is allocated for.



5) It's a good idea to budget in your PM costs even if you are self managing. As you grow your portfolio, you will want to step out and let someone else take over one day. If not, and you still want to self manage, then yes - pay yourself the 8% or whatever you deem worthy for your time. You may choose to leave that cash in the property 8just track it on paper), but get into the habit of paying yourself for your time. It is a business expense.



6) How much are you using as a down-payment? This amount influence your CF greatly. If you're trying to get by using 10% down, using 2nds requiring debt service, etc.. you're CF will appear much lower than if you used 25% down.



7) Keep in mind the 1% Rule, the 10% Rule, The CF Zone, The 50% Rule... you get the point. Are excellent guidelines of how to operate your property and what to look for. As you learn more, you'll see ways to increase your income or reduce to debt to increase CF, etc and make a seemingly mediocre property turn into a star. Using the 60% Rule is a rough guide only. It is more crucial for controlling inc.exp. on multi-family than single family. But, it is a good indicator of how much you could be spending on costs. I think it is a little high, but a decent safe guard nonetheless. Yes- all expenses can potentially be using 50% of income. I don't use this marker. I prefer to look at the rent yield and then work the numbers back for each deal. Please refer to Cash Flow Zone or Property Analyzer.



8) Yes, after all the expenses it can be tough to find CF in Edmonton and other areas. But, as you go, you'll be able to see where to make the profits. Maybe extra rent from the garage, maybe renting the basement, maybe putting in sweat equity on a repair deal. When I used to invest in Ontario, it was possible to find CF properties. I found the big issue was to really, really account for the utilities or better yet have the tenant pay for them all. When you count utilities, make certain that you round up and include the peak winter costs. Look at upgrading to a fuel efficient furnace (sometimes there are Grants you can get), look for properties where the windows and roof have been upgraded, etc...



Hope this help you!

Thanks,
 
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