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One strategy for real estate investors involves renting out commercial or residential property. You can actively monitor and manage the property yourself, or hire a specialized company to do so on your behalf. Either way, it is important to accurately budget your cash inflows and outflows and measure your return.
Collecting rents should be the fun part of real estate investing. Each month, a rent check is expected to come in. However, there are challenges in measuring your expected incoming cash flows in advance.
There are monthly rents, and your income should merely be this amount times the number of units you own. However, this does not take into account vacancies, which should be factored into your calculations. One approach is to use a historical number. You can also choose to be more conservative and use a higher vacancy figure, particularly given the economy has been growing recently, and the rental market has been strong in New York City over the last several years. For instance, if you own a building with ten units, each with a monthly rent of $10,000, that is a monthly cash flow of $100,000. Assuming a vacancy rate of 10%, your budgeted monthly income is $90,000. Of course, you can also have a more conservative rent figure in case you can’t receive the same amount from a new tenant. Keep in mind; New York City has one of the most favorable laws for tenants in the country. This means you may be stuck with a non-paying tenant for quite a while.
Image by Adrian Kinloch / Flickr
While there are difficulties budgeting for rent collections, doing so for cash outflows presents even larger obstacles. Certain expenses are known, such as your mortgage payment, assuming the interest rate is fixed. However, taxes and insurance tend to go up annually. There are also monthly expenditures for utilities (the property owner is responsible for certain ones such as water and gas), and maintenance/common charges if you own a co-op/condo, which is more difficult to estimate, particularly since these tend to increase over time. Should you hire someone to manage the properties, there will be a fee. Lastly, maintenance is an unpredictable but omnipresent cost.
While certain repair costs will be covered by your monthly maintenance/common charges, that is not the case for all of them. For instance, broken appliances such as a refrigerator or stove may fall under your umbrella. In a condo, you own the airspace, meaning you are responsible for fixing anything that is in the interior of the building.
In real estate parlance, the annual return is called the capitalization rate, or cap rate. Ideally, your budgeting process has proven to be fairly accurate, and your properties should generate positive cash flow. Dividing your net cash flow (income fewer expenses) by the purchase prices equals the cap rate.
Even before purchasing the property, you can determine your estimated cap rate, providing your budget is based on reasonable assumptions. You can decide whether or not the return is adequate. A buyer’s agent can help you examine historical cap rates to put the figure in context. Over a long period, the cap rate has typically been 3%-4%.
We have not factored income taxes into the equation. IRS rules allow you to deduct depreciation on your rental property, providing you own the property, use it in your business or income-producing activity, the property has a determinable useful life, and it is expected to last more than one year. If you rent your co-op, the IRS allows you to depreciate your stock. This deduction serves to reduce your taxes, and increase your after-tax cash flow.
Potential capital appreciation was also not considered. While the cash flow should provide a steady income stream, there are also potential rising real estate values that can increase your wealth. However, focusing on the cash flow basics is the first place for investors to start.