realistic cash flow?
Hello all-
I am in the process of looking for my first rental property, and have been told by me RE agent that breaking even is pretty good. That is, PITI should equal total rent roll. Does this sound realistic, or is it possible to get initial positive cash flow?
Ted
Oh, one thing, I'm using the equity in my current place for the down payment--so I'm basically doing 100% LTV
Quote:I am in the process of looking for my first rental property, and have been told by me RE agent that breaking even is pretty good. That is, PITI should equal total rent roll. Does this sound realistic, or is it possible to get initial positive cash flow?Ted,
It all depends. Breaking even by just having enough income to cover PITI is not good enough for me.
It is good enough for you if:
1. You have a lot of disposable income from other sources, OR,
2. You have a good cash reserve to use when you need to make a major repair
AND (one or more of the following)
3. You expect to raise the rent quickly to generate a positive cash flow, or,
4. You expect a rapid increase in appreciation, over a relatively short holding period, and will sell to take your profits,or,
5. Your ordinary income from other sources is not greater than $150K, and you can use the passive losses from your rental activities to offset other income, or,
6. Your passive losses from your rental activities can offset income from other passive activites.
To summarize, you need sufficient income to cover repairs, major systems replacements, and rental vacancy (1 or 2 above). Additionally, you also need a compelling reason to settle for just breaking even (3 through 6 above). If you don't pass this test, a break even property is not good enough for you.
In my opinion, a real estate agent who suggests that this approach to breaking even (i.e., rent = PITI) is good enough is either too new to know any better, or, just anxious to sell anything to generate a commission -- perhaps both.
To me, breaking even means that after allowing for a one month vacancy during the year, contributing to a reserve account for major systems replacement, and deducting home owners association fees, utilities, management fees, leasing commissions, license fees, legal fees, and minor repairs from the rental income, there is just enough left over for PITI.
If you have followed discussions elsewhere in this forum about Debt Coverage Ratio, breaking even means that your DCR = 1.0
Hey,
DaveT could not be more correct.
If you are looking at rentals as long term holdings, anyone who tells you the rent equal to PITI is "good enough" is dangerous to your future in RE.
The first time you need to fix a leaky faucet, you would be reaching in to your pocket.
We all have probably read the "gurus" who say it is okay to have a rental that just covers PITI or, even worse, a small loss. That you will make so much on appreciation that it is okay. Well, these guys are good at selling books and programs but very, very bad at mangaging RE. In my houses, I NEVER consider the appreication of the property. If it goes up in value, then that is just gravy.
Dave & Bruce,
Thanks so much for the replies. It is nice to get a dose of reality before I run out and get something just to own another property.
As far as DCR, are you saying that the rent should equal 1% of the purchase price, or am I off base?
Hey,
For me, I almost always use 1% of the home's value, which hopefully is much less than the purchase price .
It is also a very good "Quick & Dirty" method to see if Sandwich L/P will work for me.
Cheer!
Quote:As far as DCR, are you saying that the rent should equal 1% of the purchase price, or am I off base? Ted,
Look at these discussions to get an idea of how to use Debt Coverage Ratio.
Fair Market Rent – What is it and what should be considered fair?
informative web site
Debt Coverage Ratio (DCR) is computed by dividing your Net Operating Income by your Debt Service. If the DCR is 1.25 or greater, then you have a positive cash flow with enough income to cover vacancy and unscheduled repairs.
I have seen the 1% rule in Carleton Sheets materials. I don't use this rule of thumb because it ignores operating expenses. I just picked up a condo for $54K. Using the 1% rule, I should cash flow if my rent is $540 per month. In this property, breakeven cash flow does not happen until $600 per month. I am looking at another property with an asking price of $64K. The market top rent for this property would be $650. The 1% rule suggests that this property should cash flow, but my own cash flow analysis tells me that at $650 monthly rent, breakeven happens only if I purchase for $45k. I prefer to use my own cash flow analysis tools to determine whether the property will cash flow.
Hey,
DaveT makes a good point.
For me, 1% is what I can expect to in the way of rent. This is the first number in my spreadsheet. Then I list all the expenses.
So the 1% does not determine if the property will have postive cash flow, only as a starting point in determing the cash flow.
Hello! This is a really good discussion. Another way to look at the value of a cash flow investment is to determine what the NOI (net operating income) would be. To do this, take the actual rental expected, subtract all expenses (repair reserve, management, taxes, etc) and you will be left with a number. That number is NOI and must cover your monthly payment and ROI (return on investment). This is as accurate as the info you use to figure it and more accurate than rules of thumb.
Allon,
This is what Debt Coverage Ratio is all about.
Why are you buying the property?
Cash Flow?
Appreciation?
To Live in?
Shelter Money?
...the list goes on.
If your best case scenario is a break even point, you'll probably loose money (pre tax) for a while. Properties tend to appreciate and rents tend to go up. If the property is a year old, it may be a good buy and meet your needs even at a break even point. Just a thought. Good luck
hibby76,
Ted started this thread by saying that he was looking at a potential property as his first rental purchase.
Since Ted asked about an investment property, his business reasons for making the purchase can be summarized by the acronym CAT.
I have to give credit to Ron Starr for this:
C = Cash Flow
A = Appreciation
T = Tax Benefits
If the investment meets your criteria in at least two of the three areas, then the investment may make good business sense. However, with a breakeven property, cash flow is zero so this reason is not a factor.
That leaves us with Appreciation and Tax Benefits. With a breakeven cash flow, there will certainly be a depreciation expense that will give Ted a passive loss. If Ted's other income is too high to take advantage of this passive loss to offset other ordinary income, then this factor is also eliminated from consideration.
Appreciation is not guaranteed, and market reversals do happen. Over the long term, it can be generally said that real estate does appreciate in value. The question is how fast is it appreciating, is it located in an area that is experiencing an acceptable rate of appreciation, and do you have to time to wait for your appreciation targets to be met?
Since this is Ted's first rental property, he does not know yet whether he will like landlording. If Ted should happen to experience difficult tenants from the start, and unexpected out-of-pocket repair costs, he may discover quickly that he is not cut out to be a landlord. To get out of the property, Ted may have to sell at a loss and the tax benefit to be gained from this transaction will not recover his losses. Turning matters over to a property manager just makes the cash flow negative, eats into Ted's cash reserves, and may enventually force him to become a very motivated seller.
These are just things I think about when I am looking at a potential rental property. Since Ted is just starting out, his emphasis should be on cash flow, then future appreciation. Tax benefits should just be icing on the cake; never the compelling reason to purchase the property.
Just my opinion.
My first post so be kind!
One consideration missing from the discussion about passive losses is whether the owner of the rentals experiencing the passive losses can be considered a Qualified Real Estate professional. If so, the deductibility of the passive losses are unlimited against other income. There are various considerations for what the IRS considers a Real Estate professional .. if you have a license, how many hours you spend "doing" real estate activities, so look up the regs before you say "Hey! That's me".
True, but once again, Tax Benefits should never be the overwhelming criteria for investing in a rental property, no matter how large an offset against other ordinary income the property generates.
I am not an expert on this topic, but I believe that the criteria for being a qualified real estate professional is (1) more than 50% of the individual's personal services must be performed in real property activities in which the individual "materially" participates, and, (2) the individual must perform at least 750 hours per year in those real property activities.
The kicker here is that if the rental property is sold for a large gain, and the minimal annual losses were previously treated as "active" losses, then the gain on the sale is an "active" gain. This means that this gain can ONLY offset the carryover loss from this property and is not available to offset any other passive losses.
Thanks to everyone for your replies! I really appreciate it. I always learn something here!
Ted
Great analysis! Im looking at one now and after piti and pmi and prop mgmt fees net income should be around 441 with one vacancy. Its 8 units and the gross rents are around 3050 a month with the one vacancy. How much do you guys usually keep in cash reserves for repairs etc?
Thanks Again
Cole
I after taxes, insurance, utilities, and debt service, I plan on $75 per unit per month to stash away for reserves until I get an amount there that I am comfortable with.