In my previous blog, I gave you some solid lessons for doing your homework before purchasing a property to see if that property will really create the cash flow that you are trying to achieve. Doing your homework can really show you if the monthly rent amount will cover the PITI (Principal, Interest, Taxes, and Insurance) that will be included in your mortgage for the property. If so, that’s great! That’s what you are working for, but there are some other considerations to research further to really know your numbers before buying a home. Be sure to start with the last blog post (Ditch the Homework? Absolutely Not!) to get the full picture of your financials.
Formula for Costs Outside the Mortgage
Gross Operating Income (the amount of rent payments in 12 months)
– Potential Vacancy (10% of your Gross Operating Income)
– Operating Expenses
– Debt Service
= Net Income (What you can make off of this property in a year)
Gross Income Amount
First, start out with your gross operating income, which is, “How much money can I make a year off this property?” For example, you maybe able to collect $1,000 per month for rent and that’s $12,000 a year – if you are fully occupied for 12 months, your gross operating income is $12,000.
Potential Vacancy Amount
Next, take away any potential vacancy you may have during the year. Normally, with a single-family house you may be occupied all 12 months. If that tenant moves out during that 12 month period, you will need to consider that the property might be vacant for a couple of months because you’ll need to advertise the property and vet any new tenants. I use a standard 10% vacancy rule for almost all of my properties – it’s roughly a month’s worth of time.
So returning to the formula, you’re going to take 10% off your Gross Operating Income. In our example, out of the $12,000 annual income, you’re going to take away $1,200 just in case you are vacant, leaving a balance of $10,800.
Amount of Your Operating Expenses
Then you will have to consider other kinds of Operating Expenses. This would include other items you may be responsible for as a landlord like:
- Pool maintenance
- Lawn maintenance
Keep in mind that these are annual expenses, so you will need to include the 12 month costs in this line item then take that away from the balance of $10,800.
Debt Service Amount
Then you’re going to take off what I call your debt service, which is basically what debt you have to pay back, whether it’s mortgage to the bank, money borrowed from a credit card, or money borrowed from a family member or some other outside person.
Anybody you had to borrow money from to secure the property, you have to pay back as a debt. This is your debt service. It is your principal and interest payment, subtracting out taxes and interest, which leaves you with your net income.
Remember, these are all estimations and things can happen. The roof could start leaking, you could have a fire, you could have damage from a tenant, anything along those lines. But this is what’s called “doing your homework in advance” and estimating the true expenses that you’re likely going to incur throughout the term of the year. It’s all part of doing your homework.
If you are serious about buying an investment property and you want to hold it long-term, I highly recommend doing your homework and research outlined in my last blog post and then using this formula to calculate the true cost of the home to you. If you (or your kids) are computer savvy, you can easily put this formula into a spreadsheet, then plug in your annual rent amount and it will calculate all the numbers for you. Or you can purchase and download this one that I’ve created. You can then quickly know if the property is worth your investment.
To learn more about property management and how it can generate a sustainable income, read The High Heels Landlord on sale at Amazon.