Investors often look at the Net Operating Income (NOI) and the cash flow to analyze the performance of their investment property. These are important figures but it is absolutely necessary for an investor to set money aside for anticipated costs. When doing so, an investor can turn those expenses into a return on investment, and not just a liability. Let’s go over some of the key budgeting categories an investor should consider:
It’s likely that your rental won’t be occupied all the time. Whenever your property isn’t being rented out, you’re losing money. This can be especially hurtful if repairs are needed between tenants before you can get your property ready to put on the market. One advantage multifamily units have over single family dwellings is that if you lose one tenants, you have another door or doors producing income. One way you can mitigate against this cost is to budget for a vacancy reserve. You can do this by setting aside a little bit every month so when your property is vacant, you don’t take the financial hit. Opinions vary on how much a property owners should budget for vacancy reserve, but numbers around 2%-5% of the gross rent per month is common. In markets with low vacancy right you probably don’t need as much of a vacancy reserve than in a high vacancy rate market.
It’s easy for “accidental landlords” to figure their cash flow by simply subtracting their mortgage from their NOI, and begin counting the dollars. But property owners should set money aside every month for potential repairs. This is where budgeting can end up being a return rather than a liability. Because if you don’t budget for repairs, then suddenly a maintenance request comes in that you’re unprepared for, and you’re more likely to skim on the cheap side or possibly ignore the repair altogether. This is caused by the fact that it hurts the pocketbook to pay unexpected expenses. However, if you have money for repairs set aside, then it is easy to get the repair done properly. You even become proactive in preventative repairs because you already have the money that you’ve set outside of the NOI. Once you begin skimping on proper repairs, your property starts to become less desirable. When this happens, you cannot get as high of rents for your property and you attract lower quality tenants who may not take as good of care of your property, which becomes a repair problem again. There’s an old rule of thumb that a property investment owner should budget one month’s rent per year for repairs. Of course, actual repairs would be a lot less than that for newer properties but could be more than that for significantly older properties.
Capital Expense Budget
Another important category for your rental property budget is for capital expenses. Capital expenses refer to the major repairs that all properties will need sooner or later as the property ages. Examples of capital expenses include replacing the roof, carpet, exterior paint, HVAC system, et al. Similar to the mentality of the repair budget above, having money set aside waiting to improve your property will return in the long run for your investment. The major reason to set this money aside before “cashing out” every month is to ensure that your property is actually profitable. If you fail to budget for capital expenses, you can have the appearance of positive cash flow when you’re actually bleeding money out the back door. For example, let’s say you’re taking home $200 a month, but you’re not budgeting for capital expenses. 4 years later, the HVAC system needs to be replaced for $7500 and a year after that, the roof needs to be replaced for $7000. In 5 years, you’ve taken home $12,000, but you’ve had $14,500 in expenses, so you’ve actually lost money instead of gained money. Budgeting for capital expenses, especially when you’re selecting a property to purchase, guarantees that your cash flow is true positive cash flow.