I will show you exactly how to accurately estimate rental expenses.
Don’t be the investor who believes the rental expenses he’s given from the property seller!
Intro to Estimating Rental Expenses
I will give you formulas and methods to make accurate estimates even if you don’t have someone local in the area you can compare notes with.
There are several different methods for doing this. I’ll let you know which work best.
The ideal situation for accurately estimating expenses is to get the information directly from another investor that has rentals in the same area as you.
You can find these people through local clubs like a real estate investing association (REIA) or other investing group. Often these groups are on Facebook. You can find by searching key terms such as REIA or real estate investing and the name of your city.
If you can’t find investors that will help, talking to property managers is the next best thing.
Whether you get information from these people or not, it is still a good idea to use the tools here to make sure their rental estimates make sense.
Maintenance and Repairs
Maintenance and repairs are variable costs. These are difficult to predict and change often.
There are several “rules of thumb” that can help you estimate what repairs will be. I’m gonna break them all down for you, and tell you my favorite:
The 1% Rule for Expenses
The Square Footage Formula
The 5X Rule
The 5% Rule
The 50% Rule
Repairs are the most underestimated and neglected rental expenses in real estate investing.
Here are the rules to help estimate them:
1% Rule for Expenses
Don’t confuse this 1% rule with the more common 1% rule for rent. (Rents should be at least 1% of purchase price)
1% Rule for Expenses Definition: Maintenance and repairs will cost about 1% of the property value per year.
A property valued at $100,000 should cost $1,000 a year for repairs on average.
Pros: Easy to do in your head. Accounts for higher prices in high cost of living areas. Labor and supplies cost more in these area.
Cons: Not accurate on older properties under $100,000
I can tell you from personal experience owning 30 properties with an average cost of $75,000 each, this isn’t accurate at the low end of home prices.
Often when you find a property that cash flows well under $100,000, it is going to be a bit older and comparatively in worse condition. These two traits make repair prices higher.
From my experience, a 1.5% calculation off purchase price would be more accurate for run down properties purchased under $100,000.
Square Footage Formula
Plan on $1 per square foot for yearly maintenance costs.
A 1,000 sq ft home should cost about $1,000 in maintenance per year
Pros: More conservative than 1% rule above. Makes sense that larger homes have more costs due to increased area.
Cons: Does not accurately account for cost of living differences.
My average costs for repairs in Montgomery, AL are a lot lower than those in high cost of living areas (HCOL) like San Diego or Honolulu. This rule doesn’t account for those differences on the same size house.
Labor and supplies will cost more in high cost of living areas. To estimate rental expenses, adjust as needed.
Yearly maintenance costs will be approximately 1.5 times the monthly rental rate.
If your home rents for $1,000 a month, the estimate should be about $1,500 a year.
I’m not sure why it’s called the 5x Rule, but that’s how its described in several different places.
Pros: Rent prices tend to correlate with age, condition, and desirability of neighborhood
This rule is actually not widely used compared to the rest, but I find it the most useful because of its flexibility.
Cons: No rule is perfect, but this one is pretty good.
You should expect to spend 5% of your total income (total rents) on repairs and property maintenance.
$100,000 property rents for $1,000/mo X 12 months
$12,000 a year x 5% = $600 a year budget for repair expenses
Pros: Easy to calculate. Half of ten percent. You can do it in your head.
Cons: Estimates come out too low.
While this a fairly well-known rule, I find it to be an unusually low estimate.
First, this is out of line with the 5x Rule, which states expenses will be 1.5 times monthly rent. I felt the 5x rule was the best estimate so far. If you do the math, that rule works out to 12.5% of total income on repairs.
The 5% rule here is way too low.
Not even half the estimate of the 5x rule.
Unless your property is close to new and in excellent repair, 5% expenses would be unlikely in reality.
That being said, I often see pro formas (estimate of expenses) on turnkey real estate or on other promotional literature about real estate investing that claim a 5% maintenance estimate.
To add insult to injury, they often don’t include an estimated expense for capital expenditures, which means the 5% is meant to cover both.
This it why uniformed investors lose money on rental properties they buy.
Total operating costs will equal approximately 50% – or half – of your yearly rental property income.
This is probably the most popular formula for expenses, but it applies to all rental expenses, not just repairs and maintenance.
The 50% rule also applies to capital expenditures, property management, taxes, insurance, vacancy, and all other operating expenses.
Since property management is included, if you self-manage, you could probably use 40% as your rule, although the value of using your own time for management is worth something.
The estimates you get from these rules may need to be adjusted based on the following criteria:
age of the property
condition of the property
amount of turnover/crime in the area
cost of living
You should consider how much your prospective property differs from the average property. If yours is much older or in a much higher crime area, you should consider raising the estimates for your rental expenses to make up for the increased likelihood of higher expenses.
I believe the best formula is the 5x rule (1.5 x monthly rent). It can account for these variables better than the rest, and it’s conservative enough to keep you out of trouble.
To accurately estimate your expenses, you need to know the difference between maintenance/repairs and capital expenditures.
Capital expenditures are a separate category from maintenance/repairs. You need estimates for both.
The debate of should you buy or rent your home comes up often.
You’ve probably heard “experts” say owning a home gives the opportunity for significant earnings from appreciation. I make the counter-argument that buying a house just for appreciation is a losing strategy.
You’ve undoubtedly heard that renting is throwing moneyaway, and buying a house is a way of building equity.
I’m here to tell you, it is not that simple.
The following is a list of reasons buying is not always better than renting:
Primary Residences often Don’t Cash Flow Well
Rent does not have Additional Expenses
There are Several Expenses to Pay on Top of a Mortgage
Mortgage Pay-down Doesn’t Happen as Fast as you Think
Appreciation is often Overestimated
Primary Residences Don’t Cash Flow Well
I’m a real estate investor, and I almost never buy the house I’m living in.
Unfortunately, primary residences often don’t cash flow well because they have one or some of the following attributes:
New or Newer Home
Good School District
High Cost of Living Area
Near Beach, Lake, or River
By having any of these attributes, they are more desirable, and cause the price to rent ratio to be off. This means rent often doesn’t cover the mortgage.
Let me illustrate this point about primary residences by explaining what I did when I moved to Montgomery, Alabama for a military assignment.
I don’t buy a house unless it will cash flow well as a rental when I move away.
That goes for a primary residence or investment property.
For me, that means it would need to make more than a 7% return on investment, which is what I believe is easy to make in the stock market.
I use the 1% rule to give me an idea if a property will make a good rental or not.
Most people grossly overestimate the cash flow they are actually getting on their rental property.
At the same time, the people trying to sell you investment properties also have a habit of fudging the numbers on cash flow and return on investment.
I’m here to make sure you can spot these inflated numbers a mile away.
The mistake most people make is believing that your money left over after paying a mortgage each month is your cash flow.
You need to subtract your mortgage from rent, then subtract all other expenses to arrive at your actual cash flow.
In many people’s case, this is a negative number.
That means you are not cash flowing, you are paying money out of pocket to own this investment.
Make sure this doesn’t happen to you.
It is helpful to understand two simple concepts for this all to make sense.
Those two things are the 1% rule and 50 % rule, which are easy to do in your head, and can save you the trouble of breaking out the calculator for rental properties that clearly won’t make money.
The 1% rule is quick and easy. Monthly rent should be at least 1% of the acquisition price. The acquisition price may be a higher number than the purchase price. It is purchase price plus the money to get the house ready to rent.
$80,000 to purchase house plus
$20,000 remodeling equals
$100,000 acquisition cost.
$100,000 home should rent out for at least $1,000 a month, or it would not be a good investment.
What is the logic behind the 1% rule?
If a house will give you 1% of the purchase price each month in rent, then it gives you 12% of the purchase price each year. That apparently means the investment makes 12% a year!!!!
Using a HELOC to pay off a mortgage is an interesting debate.
What’s a HELOC?
A HELOC is a home equity line of credit. If you have equity in your home, you can take out a loan from your bank using that equity as collateral.
Paying off a mortgage with a HELOC is paying off a loan with another loan.
While I’m not so sure paying off a mortgage is the smartest financial move anymore (I used to believe it was), doing it using another loan certainly an idea worth exploring.
I’m going to summarize the issues in a fair and balanced slightly biased way.
So Should I?
My final answer on this is that you should not use a HELOC to pay off a mortgage. HELOCs are variable rate loans instead of fixed rate like a (good) mortgage. HELOC interest is not tax-deductible in most cases. The line of credit can be frozen or reduced by the bank at any time. Also, even if you are making lower, interest only payments on your HELOC, it eventually will revert to a principal plus interest payment that you may not be ready for.
You will often see articles on how to payoff your mortgage early. People seem to make up their minds it’s the best course of action.
What about the question: Should I pay off my mortgage early? Here is my take on both sides of the argument.
Reasons NOT to payoff a mortgage are: It’s an inflation hedge, you can write off the interest, maintaining liquidity is important, and the money would be better off invested in higher yielding opportunities. Good reasons to pay off a mortgage include peace of mind and primary residence equity having special protection from creditors and bankruptcy in many states. Poor, but often cited reasons to pay off the mortgage are decreasing expenses and gain a risk-free return equal to the interest rate.
I rushed through listing these answers. I go into more detail below.
Before You Payoff a Mortgage Early
We will assume you have an emergency fund, your high interest debt like credit cards is paid off, and you are fully maxing out all retirement savings account opportunities.
This means you are contributing the max to your IRA, your spouse’s IRA if you have one, and your 401K, TSP, or equivalent vehicle. You should not bother paying off a mortgage if you have not done these basic things first.
In the end, I’m partial to keeping the mortgage. I feel like the evidence is strongly stacked against keeping it.
It’s a little ironic, because I paid off my primary residence in 6 ½ years. I also have 20 paid-off single family homes.
Yeah, that’s a little psycho.
This certainly qualifies me, however, to make a fair judgement on the subject.
Since I’m partial to keeping the mortgage, I’ll explore the pros of keeping the mortgage first.