Before we continue, we need to define operating expenses. Operating expenses are very simply those expenses that are associated with operating your business. Now, before we go too far, let me tell you that THIS definition of operating expenses is not strictly in line with the way that many accountants would define operating expenses, but my definition is a practical definition that includes ALL of the real world expenses that rental property owners incur. So, basically, operating expenses include all the expenses that we incur EXCEPT DEBT. In other words, operating expenses are ALL of the expenses except the mortgage payment (the principal and interest only).
Let me go a little farther and list most of the operating expenses that a typical landlord will have: property taxes, landlord insurance, management (even if you do it yourself), maintenance, advertising, vacancy expense, office supplies, utilities (even if only during vacancies), entity maintenance (LLC expenses), legal fees, evictions, set out
Now that you understand what operating expenses are, let's talk about the main thing that causes most new landlords to fail. Throughout the United States, operating expenses for rental properties run 45% to 50% of gross rents. To be conservative, let's just say 50%. This is whats call The 50% Rule!
So, now that we know the little secret of rental properties (how high the operating expenses are in the real world), how do we apply that knowledge? This is the beautiful part of The 50% Rule - its simplicity! We know that the operating expenses take 50% (half) of the monthly rents. If we carry that logic one step farther, the remaining half of the gross rents minus the mortgage payment (principal and interest only) will give us the cash flow for the property. If the cash flow is positive, you should make money over time. If the cash flow is negative, you will lose money over time.
Before we try a couple of examples, we need to define one more term: Net Operating Income. Net Operating Income, abbreviated as NOI, is the income from a property after the operating expenses are deducted but before any debt (mortgage payment) is paid. For instance, if we had a rental property that had a monthly rent of $1,000 and the operating expenses were $500 (from the 50% rule), then the NOI would be $500. SIMPLE!
Now that you understand the basics, let's take a look at a couple of rental properties to see if they will make money (cash flow).
This is a 3 bedroom, 1 bath, single-family house on a beautiful street. The house is located near a school and shopping center, and the area is generally considered to be a nice place to live. The purchase price for this property is $80,000 and the monthly rent is $800. Is this a good deal? Let's take a look:
The gross rents are $800 per month.
The operating expenses will be $400 per month (per the 50% rule).
The NOI is therefore $400 per month (subtracting the operating expenses from the gross rents)
The mortgage payment is found by entering the pertinent information into a mortgage calculator. Let's just assume that we are borrowing the entire $80,000 purchase price and that we get a loan for 30 years at 7% interest. With those terms, the mortgage payment (principal and interest only) is $532 per month.
With this information, we can now find the monthly cash flow, which is determined by subtracting the mortgage payment from the NOI. Therefore, in our example, the cash flow would be $400 - $532 = - $132. In other words, we would LOSE $132 per month on this property! OUCH!
Now, let's look at another example:
This is a also a 3 bedroom, 1 bath, single-family house. The house is located in a working class neighborhood that has many other rentals. The owner has lived in this house for more than 20 years, but lost his job about 6 months ago. He is DESPERATE to sell this house NOW and even though it has a market value of about $60,000, he is willing to sell it to you for $30,000, which is what he owes on his loan. He just wants OUT! The monthly rent is $600. Is this a good deal? Let's take a look:
The gross rents are $600 per month.
The operating expenses will be $300 per month (the 50% rule)
The NOI is $300 per month (subtracting the operating expenses from the gross rents)
Let's assume that we are borrowing the entire $30,000 purchase price and that we get a loan for 30 years at 7% interest. With those terms, the mortgage payment (principal and interest only) is $200 per month.
With this information, we can now find the monthly cash flow, which is determined by subtracting the mortgage payment from the NOI. Therefore, in our example, the cash flow would be $300 - $200 = $100. In other words, we would MAKE $100 per month in positive cash flow on this property! That is good!
Throughout the United States, operating expenses run 45% to 50% of the gross rents.
To determine the cash flow you'll get (over time) from a rental property, subtract the mortgage payment from one-half of the gross rents (the NOI). If that number is positive, you will make money. If that number is negative, you will lose money.