How to Analyze Rental Properties by Estimating Cash Flow
In order to consistently make wise investment decisions and attract good profits, you need to understand how to analyze rental properties by doing the maths that’s usually involved in analyzing rental properties.
If you don’t do your analysis properly or correctly from the onset before investing in any property, you could end up losing money when your expenditure/expenses on the property are higher than the expected income. Poor or incorrect analysis attracts losses.
On the other hand, if you do your analysis properly or correctly from the onset before investing in any property, you would end up earning good profit because the expected income would be higher than the expenses. Good or correct analysis earns profit.
Every real estate investor should understand how to analyze rental properties and know how much money they are going to make before they invest in any rental property. Analyzing a property involves making an estimate of the cash flow expected from the property after investing.
The formula for calculating cash flow after estimating the income and expenses is: cash flow = income ─ expenses. This implies that the cash flow from any property can be either positive (profit) or negative (loss), depending on whether the income is greater than the expenses, or vice-versa.
This article discusses how to analyze any rental property and estimate its cash flow or money-making potential which can help an investor to make a wise decision: whether to invest or not to invest in a particular rental property.
For each property, the income and expenses have to be evaluated before the cash flow can be calculated:
1. How to estimate income
A number of property characteristics are often considered when estimating the projected income that a rental property could possibly generate. To estimate a rental property’s projected income, an investor needs to have an idea of the rate of the average or fair market rent price for the rental property.
It would be fair to state that the average market rent price is at least a huge part of the income, if not equal to it. A rental property could be a commercial building, a large apartment building, a small multi-family property (duplex, triplex, and fourplex or quad), a single-family property, or a small apartment complex.
But, what is the “average market rent” price for a rental property? The average market rent price is the exact amount of money that a potential tenant is willing to pay in order to rent a property during a certain time period.
Property characteristics that are usually considered when determining the income of/average market rent price for a rental property
The nature of each local market influences and determines the average market rent price for different types of rental properties; each average market rent price is determined by the following property characteristics that are usually considered when investors are estimating or deciding the rent price for a property:
1. The area covered by the property: the size of the property.
2. The number of bedrooms and water closets/bathrooms in the property.
3. The presence or absence of modern facilities such as air conditioners, heating appliances, etc.
4. The location of the property.
The average market rent price of a property can also be evaluated by applying the following tips:
- Asking about the average market rent price from landlords and real estate practitioners in your locality.
- Reading the real estate property or market section of local/offline newspapers. Although newspapers are traditional or old school, you can still find valuable information in them.
- Going through the listings in the market section of your local real estate companies’ websites. The listings usually show the areas/sizes of each property, the number of bedrooms and water closets/bathrooms in each property, the amenities or types of modern facilities—if present—in each property, and the location of each property.
- Searching for the prices of available rental properties on your local MLS (Multiple Listing Service). Multiple listing service is a real estate marketing database that is updated by real estate professionals (agents, brokers, etc.) and provides clients with information about the renting, buying and selling prices of properties. In addition to MLS, you can search Craigslist.
- Raising the rent price for your property and waiting to see whether people will actually pay despite the increase in price. You can employ this method when your property is vacant or when there are too many applicants or people interested in your property. If you don’t get a favorable response after a few weeks or so, you can gradually reduce the price until someone pays the rent price for the property. Regardless of what happens, you will eventually get someone who will be willing to pay the average market rent price.
After you are through estimating the income by applying any of the tips listed above or considering the general characteristics of properties listed earlier, you need to estimate the expenses that would be made on your rental property before you can eventually calculate the cash flow.
2. How to estimate expenses
Expenses could be a bit difficult to foresee and estimate, and they usually make many investors lose money, unexpectedly. Even if you know the actual expenses that have to be made on a property, unexpected situations can arise and incur more expenses, and reduce the amount of cash flow or profit you expect to make from the property.
Generally, a number of items are often considered when estimating the expenses that have to be made on a rental property. Some properties will require more expenses than others; not every item (for example, insurance, taxes, renovation, sewer, electricity bills, water bills, etc.) should be considered by an investor when estimating expenses because renters/tenants may pay for some items associated with certain expenses.
Items that are usually considered when estimating the expenses that would be made on a property
To estimate the expenses that would be made on a rental property, an investor has to consider some or all of the following items (Note: Depending on your locality or country, you may need to consider more items than the ones listed above; additional items may include flood insurance, lawn maintenance, snow removal, gas, etc.):
2. Capital expenditures
4. Property insurance
5. Property management
6. Vacancy rates
To determine the expenses for each of the above items, apply the following tips:
- Ask a contractor(s) to assess whether renovation/repairs would be required, and how much the expenses would cost.
- Ask a contractor or consultant to assess whether a property would require long-term improvements or replacements (for example, plumbing systems, roofs, appliances, etc.); if it would, then any expenses due to such works should be included under “capital expenditures”.
- Inquire about taxes from your local or state government parastatal that’s in charge of taxes.
- Ask your insurance salesperson about the expense(s) for property insurance.
- If you’re not managing your properties by yourself, inquire about property management expenses from a property manager.
- Inquire about vacancy rates from local real estate practitioners or property management companies.
- Inquire about sewer expenses from your local sewer company/department.
- Inquire about water expenses from your local water company/department.
- Inquire about electricity expenses from your local electricity distribution company.
- Ask your local waste disposal or management company about the expenses for trash/garbage.
For any other items that aren’t listed above, but are applicable to your locality, inquire about their expense(s) from real estate practitioners and landlords in your locality.
3. How to estimate cash flow
After estimating the expected income and expenses by adding all the items on the list for the income, and all the items on the list for the expenses, you can then proceed to estimate the cash flow that would be generated from the property.
Remember, cash flow = income ─ expenses; therefore, to estimate the cash flow or return on investment (ROI), deduct the total expenses from the total income.
If the cash flow is positive, it means the property would generate profit; therefore, it would be wise to invest in it. On the other hand, if the cash flow is negative, it then means the property would incur a loss; therefore, it would be wise not to invest in it.