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.
See a more in-depth explanation of the 50% Rule.
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.
Both are treated differently for taxes. Maintenance/repairs are deductible as expenses in the year you make them. They are the typical things you do because things break or wear out.
Capital expenditures are things like replacing major systems (roof, windows, HVAC) as well as doing renovations. They are depreciated over time, like a house or building is.
We need a way to estimate a yearly budget for capital expenditures (Capex) on our property.
I’ve attached a spreadsheet below that shows the best way to do this.
Here are the steps for using it:
- List each capital expenditure and cost.
- Estimate lifespan and current age.
- Subtract current age from lifespan to get remaining life.
- Divide cost by remaining life for annual budget amount.
- Combine all totals for yearly Capex budget amount.
This is a sample. You’ll have to decide which Capex items to budget for. Every situation will be different.
If you don’t think you will replace certain items, like the driveway or cabinets during the time you own the property, leave it out of the calculation.
The total you get in the annual budget column is your capital expenditures budget. It’s money you don’t spend every year. You save it for when that large expense comes.
Here is a screenshot from the IRS publication on residential real estate showing examples of capital expenditures (improvements):
Since these are not considered routine maintenance, and will benefit the property for many years, you cannot deduct the entire dollar amount in the current tax year.
Example: You install a fence for your rental property for $3,000. You can’t deduct the entire $3,000 as an expense this year. You deduct it over 15 years according to the chart below. That means you can deduct $3000/15 = $200 each year.
Keep in mind, your maintenance/repairs rental expense estimate is in addition to capital expenditures.
You need to make allowances for both.
Many investors don’t bother giving these two estimates the attention they deserve, and their actual cash flow is quite a bit lower than their estimates.
Read my post explaining these different calculations:
Cash Flow, ROI, Cap Rate, Cash-on-Cash explained…
The rest of these are fixed costs. These costs are degrees easier to predict, and they tend to stay the same month-to-month.
The best way to get vacancy rates for your area is to ask local investors.
You should be able to find them in real estate investing clubs such as the well-known real estate investing association (REIA).
Also check the Biggerpockets.com forum for your city. These forums are free to use.
Network and get to know other investors in your neighborhoods and ask them what vacancy rates they are seeing.
The next best people to get this information from would be management companies that have been working in your neighborhoods for several years. Call all of them and ask them what vacancy rates they see in your interest area.
This is also a great way to start vetting management companies.
See my post on Finding the Best Property Manager.
Single Family Home Formula for Vacancy Rate
The main difference between calculating a single vs. multi-family vacancy rate is single family rates will be averaged over a year, when multi-families are a snapshot the current vacancy rate at a given time.
You simply divide the amount of time the home was vacant by the total time. Usually, the time period is a year.
Multi-Family Formula for Vacancy Rate
With multi-family, it’s not averaged out over a year, it’s a snapshot of today.
Instead of vacant time/total time, it’s vacant units/total units.
While the answer to the equation is actually .115, you just multiply by 100 to get a percentage.
This is simple because it’s a fixed cost that you can easily look up.
Usually Zillow and Trulia have accurate information on this.
Even if it’s not there, you can check your city or county’s website.
Just google “Name of City ” and property taxes. You are usually able to look up any home by address and see who owns it and what the tax bill was the past several years.
Here’s a video where I lookup rental expense info from the property taxes website:
Keep in mind, when you buy the property, taxes could increase. There tends to be large increases when you make large improvements to the property, changes in tax rates, or you have significant appreciation.
Also, certain cities have lower property taxes for state resident owner-occupants. It’s sometimes called a homestead tax exemption. This means you may pay more property taxes as an investor than locals do when it’s their primary residence.
You can lookup the homestead exemption information for state and figure out how much of a discount it is. This should allow you to accurately estimate the expense.
There are really two avenues to get this info, and you should do both. You can get the price the current landlord/owner is paying as well as calling a few insurance companies to get quotes.
Ask to see the bills, so you know it’s legit. Some shady sellers give you fake info.
If you call an insurance company for a quote, you’ll need to answer a lot of questions about specifics of the property. Take your best guess on stuff you don’t know yet.
They’ll ask what the roof is made of, or if the electric box is upgrade, etc. You have to pretend like you know the answer. They don’t like wasting their time with a quote of a property you don’t own yet (so fake it).
The estimate for insurance price you get should be close.
The mortgage is going to be a simple rental expense to estimate. You can use online calculators to figure out what your mortgage will be.
Keep in mind, sometimes your mortgage payment has property taxes and insurance figured into the bill. Make sure you know this so you don’t estimate those expenses twice.
This is also a fixed cost. Often is it a fee of 8 to 10% of collected rents.
Sometimes there is a surcharge on repairs. Mine was 10%.
Keep in mind, there may also be an additional fee for signing a new lease. That is sometimes one month or half a months rent. You’ll have to calculate how often you think this will happen so you can budget for it.
This only matters when you as a landlord are responsible for paying a utility. This is rare in single family homes.
With multi-family, often landlords pay the water bill, sewer and trash, landscaping, and sometimes electricity for lighting in common areas.
Ask the owners to provide information on these costs. It’s best to see copies of actual bills. They at least should show you records of paying those bills.
There may be an homeowners association (HOA) fee or a condo fee that needs to be paid monthly. This is typically paid by the landlord, so it needs to be figured into the costs. Keep in mind, these tend to trend upwards every year.
This was written to give you confidence in estimating rental expenses, and to be able see bogus expense estimates when they are given to you.
This is a key part of being a successful real estate investor.
The successful ones know approximately what the property will make before they buy it. They can then make smart decisions about what they’ll pay for the property.
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Do you have a different method to calculate any of these expenses?
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Rich on Money