Buy and hold deals are my favorite kind of real estate deals. They provide you with monthly income and generate long-term wealth.
With buy and hold deals, cash flow is the name of the game. The deal must generate positive cash flow. A property is not a deal if it just breaks even. It is not a deal if you have to write a check to cover expenses every month. You want to collect checks, not write them! Do not bet on price appreciation. Appreciation is a nice benefit to get, but it is almost completely out of your control.
So how do you determine if a property will generate positive cash flow? First, you need to determine how much potential income a property will generate. Most of the time income equals rent, but there could be other sources of income such as utility and vending income. For now, let’s keep it simple with rental income.
Expenses are more varied. Let me list those:
- Most of us need to borrow money to acquire the deal (if you do not, good for you!). So your first expense is your principal and interest payment or the cost to borrow other people’s money. This is the one major expense that we as investors have control over on the front end. This control comes in the form of the price we can offer for the property. Too high a price will skew the principal and interest costs up turning a potential deal into no deal. Remember you make money in real estate when you buy. So buy them right on the front end.
- The second expense is property taxes. Be sure you include everyone who can add a little piece to your bill. Where I am today I just pay city and county taxes. I recall living in Fort Lauderdale, Florida where there were no less than six or seven different taxing authorities.
- Property insurance is third on the list. The cost of this expense will vary depending on your location. These first three make up the major expenses and are sometimes collectively referred to as PITI (Principal, Interest, Taxes and Insurance).
- Repairs and maintenance are next. Something always needs to be fixed and there is routine maintenance such as keeping the yard cut, raking leaves, cleaning gutters, painting, etc. Budget approximately 10% of your gross rents in this category. In other words, if monthly rental income is $1,000, budget about $100 per month for repairs and maintenance. It will not always be exactly $100 per month. Some months will be higher and some will be lower but over the course of time 10% is surprisingly accurate.
- Vacancy is another expense you will have. Your rental unit will never be 100% occupied 100% of the time. If it is not occupied, it is not generating any income and you still have to pay the bills. So a good rule of thumb is again to budget about 10% of your gross rental income towards a vacancy credit. Depending on your location and market, this number can be higher or lower. Use your own experience and expertise and adjust accordingly.
- Utilities should also be figured into the deal. There may be house electric meters or it may be common for the landlord to pay for water in your market. Market conditions will vary, as will rates. Some properties for example will be charged residential (lower) rates while others will be charged commercial (higher) rates. Make sure you know your market and your rates.
- Reserves are an expense that more and more bankers are asking about these days. Reserves are funds that you set aside for those big future expenses such as roof replacements. A lot of banks got burned in the real estate bust because landlords did not budget for this (among other things) and left the bank holding a ruined property. If you are going to borrow bank funds, show them that you are going to set aside 10% of gross rents for future major repairs. Plus it is nice to have that money there when something major happens (notice I said when not if).
- Other expenses could include trash removal, homeowner association fees, advertising, professional fees (for lawyers and accountants), license fees and other various taxes. These types of expenses will all vary depending on your local laws and market conditions. Sometimes I just throw in a miscellaneous category of about 2.5% gross rents just to be safe.
Once you have determined your potential income and expenses for a particular deal, you can then list them to determine the potential cash flow. Let’s say I am looking at a single family house that will rent for $1,000 per month. The owner is asking for $50,000. Is that a deal?
I always look for at least $150 per month positive cash flow after all expenses outlined above are paid. I will also have to pay 7% interest with a 20 year amortization to borrow $50,000. Those terms make my principal and interest payment $387.65 per month.
Let’s outline it.
Income (monthly) $1,000
Expenses (monthly)
Principal and Interest $387.65
Taxes $50
Insurance $30
Repairs/Maintenance $100
Vacancy Credit $100
Utilities $0
Reserves $100
Misc. $25
Total Expenses (monthly) $792.65
So is this property a deal? You bet it is. Using the numbers above this property should generate a positive cash flow of just over $200 per month. Not to bad. If you buy 10 of these type properties they would generate $24,000 per year in positive cash flow. What could you do with that extra money? This positive cash flow is why buy and hold deals are my favorite deals.
