I don't want to create slumlords here, but maximizing cash flow as your rental real estate investment strategy is a best practice. The components are of course CASH IN-CASH OUT. So, we're looking at rents coming in and expenses going out. I'm not talking about the tax return expenses that include depreciation, as that is not cash going out.
That's not to say that you aren't getting a cash infusion due to the depreciation deduction. That's because you will have a lower tax payment because of the deduction. But, keeping cash flow simple is a good way to get it right without mistakes.
Non-cash expenses are of course important components of return on investment, but I want to keep this instruction and example simple so that you can have a comfortable feeling that you've made the right decisions to protect your long term investment.
There is no magic bullet that will protect you from another real estate crash if it happens. But, if you haven't used excessive leverage, keeping cash flow on the positive side should protect you and leave you in a good position when the ultimate recovery is in place.
Getting the Rent Right
This is where you can get into real trouble in the long term. You must have a clear picture of the current rental market, even historically to be sure that you're not making purchase decisions based on a rent bubble. You should also be conservative with your analysis, not letting enthusiasm for what looks like a great deal get you into trouble.
• Study the rents being paid for similar homes in similar or very nearby neighborhoods.
• Check, even if you have to call and pretend to be a renter, if incentives like free rent are being offered to get those tenants into the home. If it looks like they're paying $1,200/month in rent, but they're getting a free month, they're only paying effective gross rent of $1,100/month.
• Look at the economy, particularly major employers. The first people to flee the area with economic issues are the renters.
So, you've done your homework and you have a reasonable expectation that you can rent a home out for $1,200/month going forward. This is a reasonable expectation, as rents are running in a normal range, not a bubble. The economy of the area is stable, even growing with new business moving in.
Now, if you really want to feel good about buying this home, knock this reasonable rent down by 20%, which would make it $1,000/month. You're not expecting to have to discount rent this much, but you want to see if you can keep the home and not pay in money every month if the market has a temporary hiccup.
If, after doing the expense calculation below, you are still in the plus column with this $1,000, you're looking good. Again, you don't expect this to happen, but if it does and you're only banking $50 every month, you're still paying the bills, enjoying the tax advantages, and you're better able to wait out the downturn.
Getting the Expenses Right
The normal expenses of single family rental property investment if you manage it yourself are repairs, taxes, insurance, the mortgage, legal, marketing vacancy and credit loss. Factoring all of these in before a buying decision and subtracting them from the rent is going to give you your cash flow. This is very simplified, but sufficient to make my point.
So, when will property taxes rise? Notice that I asked WHEN, not if. Local governments are prone to spend more than their budgets, and often the biggest piggy bank is the property tax income. It isn't likely to be a major increase, but you should at least anticipate one within the next three to five years of ownership. Insurance will likely increase a little bit as well.
Are you getting depressed yet? Don't, as I'm presenting pretty much the worst case scenario here. Discounting rents and rising costs can be real problems in the long term. Of course, if some costs are rising, you may be able to raise rents, so don't assume all bad news.
The point I want to make here is that you should take a conservative and educated approach to pulling together the numbers in your due diligence for a rental home purchase. If things get weird, it's nice to sit back and say you aren't making as much money, but you're still on the positive side of your rentals.