Summary: Do you know how to use a cash-on-cash calculator to decide if you should purchase a property? Do you know what values to include and where to find them? This three-part series covers why a cash-on-cash calculator is a vital tool in any real estate investor’s toolbox. It also explains where each variable of the calculator should be sourced. Finally, in part three, we cover an example property and explore whether it’s a good deal.
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In part one of this series, we explored why you need to become facile at using a cash-on-cash calculator as a real estate investor. We also introduced you to our calculator, which you can download for free here.
In this part, let’s spend time covering the variables of the cash-on-cash calculator and where to find them.
The peach-colored cells in our cash-on-cash calculator are the assumptions and these cells can be edited. The rest of the cells have calculations and change based on the data in the peach-colored cells.
Purchase Price
The first variable to enter is the purchase price. We often include the for-sale price here initially. However, once the cash-on-cash calculator is completely filled out, we’ll go back and change the purchase price to see at what sales price this deal actually makes sense to buy.
We also will spend time altering the purchase price after we have our inspection report and we’ve put in the rehab/repairs, to figure out what reduction in sales price we should negotiate with the seller based on the cash-on-cash return.
Down Payment
The down payment amount can change depending on the type of loan. For most residential loans (for fourplexes and smaller), 25% down is generally required by lenders. The down payment for commercial loans is highly variable and can range from 25% to 35%. You might also be able to snag a doctor loan or an FHA loan if you’re house-hacking a property. Or perhaps you are early on in your career and put less down upfront. If you’re paying cash, this bracket would obviously be 100.
Closing Costs
Closing costs generally range from 2-5% of the purchase price. You can get actual numbers from your banker to put into here during the due diligence period for more accuracy. However, when you’re first checking out a property, it’s fairly safe to put in 3% as a ballpark.
Repairs/Renovation
When you’re initially evaluating a property online or hearing about an off-market deal from your agent, you’re going to have to put in rough numbers. We do this by using the breakdown estimation method. This method involves identifying items that need to be rehabbed/repaired and breaking down the cost per item.
For example, if you look at the pictures online and the roof looks older, you might include $10,000-15,000 for a new roof. If you see the outside needs re-painting, you might estimate another $10,000. If you want to add another unit, so you need to build a kitchen, you might add another $30,000.
How to Estimate Repairs/Renovation
How to estimate the costs of each of these projects takes skill and experience. One way to start to build your skills is to start reading books like The Book on Estimating Rehab Costs by J Scott. You can also lean on the experience of your investor agent, your property manager, and your contractors.
The only caveat is that you’re likely not going to have the time to get your property manager and contractor’s input before locking up the property. (Things move fast when there’s a good deal!). So, especially in the beginning, you’re just going to end up doing a few more inspections and walking away from a few more deals than you will once you have some experience. That’s just the price of your education.
There are also obviously components that you will need to rehab that you’re not going to be able to tell from online. These are the components you’re going to find out during your inspection.
One example is your water heater. Let’s say you find out during inspection that it’s 15 years old. So now you know you’ll probably have to replace it in the next couple of years.
In this case, we’d build this into our initial rehab costs. Not because we’re planning on replacing it right out of the gate, but rather because we know this expense is going to come up in the next couple years, so we’d rather budget it into our initial calculations and take it into account for decision-making before we buy the property. That way we have the best estimate of what the cash-on-cash return will be the first several years of ownership.
Where are the capital expenditures?
Now, some of you have been reading this far wondering why we don’t have space for capital expenditures (CapEx) in our calculator. This is the reason. We build the near-term CapEx into the rehab costs and cover the rest with our “maintenance” cost deduction.
We do this because building a flat 10% CapEx into the calculator not only complicates the cash-on-cash calculator, but it also takes a huge chunk out of our COC return, since we’d just be building another large yearly loss into the property. (We’d do a lot less deals if this was the case.) Moreover, we generally fix up our properties upfront and then reduce our maintenance costs and capital expenditures out of the gate, so a 10% CapEx is a gross overstatement of actual costs.
For those of you who don’t know what CapEx is, it’s basically an extra cost allotment to cover big-ticket items that need to be replaced or repaired less frequently. These are for things like roofs, hot water heaters, electrical systems, etc. CapEx is especially important to consider when you’re buying a large apartment building since replacing 60-100 hot water heaters is a very big deal. This is why a lot of cash-on-cash calculators contain a column for CapEx, and often allot up to 10% for this column.
Loan terms – Interest rate, years, payments per year
The next section includes the loan terms. Specifically there are three columns that can be edited: interest rate, the number of years of the loan and payments per year (generally set at 12).
Before you know the exact terms of your loan, you can often guesstimate at these variables based on what is currently going on in the market. Roughly, for a residential loan, you’re going to need to take the current primary residence interest rate and then add a half to a full percent on top since it’s a non-owner occupied investment property.
Number of Units
In our COC, it’s important to include the number of units since the lease-up fee is linked to this variable. Thus, if you are buying a fourplex, you’d put a four here. A single-family home would be one unit.
Property Taxes
When you look at properties online, you’ll often see a value for property tax. This may not be accurate, however. The way to ensure you have an accurate property tax value to put into this column is to actually search the property by address on the county website. (Apps like Redfin include the county.)
There is a caveat to all this, however. When you get last year’s property taxes, you are not thinking about what the taxes will be the following year after you purchase the property. Generally counties assess property taxes every year or so. Therefore, if you buy a property at a much higher price than the previous owner (let’s say that it was bought 20 years ago and property tax assessments have been based on that value), you may be in for a large raise the year after you purchase the property for a high price.
The way that you can go about estimating what a property’s new tax will be is by searching in the city website for the mill tax rate and then using that to estimate what your new taxes will be.
Insurance
The most accurate way to get accurate insurance costs is to speak to your insurance broker. In coming up with an estimate for a property, your insurance broker will have to consider a number of variables, so it takes quite a bit of effort to come up with a quote.
Therefore, instead of waiting on your insurance broker to get back to you for every property, we’d recommend obtaining a general “rate per foot” on a commercial policy or an average residential policy cost (if you are getting residential insurance coverage) for the type of property you’re looking for and then plugging either in as your insurance cost.
If worst comes to worst, you can just use the current insurance costs in your calculations. Just remember to update the number as you are further into the due diligence period and actually have a real estimate with the coverage you want from your broker.
Monthly gross rental income
The per month rental income is the most important variable to get right! It’s also one of the most difficult ones to gauge accurately. I could literally write an entire article about this section alone.
In brief, though, we run several scenarios with every property to evaluate different situations. We run one for current rents to see the current cash-on-cash. We use one conservative rent scenario based on insights from our property managers and what we’ve found looking at other similar apartments for rent online. And then we often run a scenario based on maximizing rents and/or on tapping other forms of hidden value.
The goal is to make sure the property works. Even if you aren’t able to get the rent up to the max level.
Vacancy rate
The vacancy rate reflects what portion of the year your property will sit empty, without a renter. In general, Kenji and I start at a basic 5% for vacancy rate. Sometimes, rarely, we’ll increase it up if we’re slightly worried about the area a property is located. I say rarely because we don’t tend to buy properties where we’re worried about the vacancy rate. However, if you are buying a single-family home, for example, in a location you know it may be difficult to find a renter quickly, I’d definitely build in a buffer in the vacancy rate.
Property Management Fee and Leasing Cost per Unit
Property managers often charge a monthly fee. Either as a percentage of gross rents or a flat fee as well as a lease-up fee. Fees can vary significantly from property manager to property manager, and they can really affect cashflow. This is why we include both these variables in the cash-on-cash calculator.
The monthly property management fee for small multifamily properties generally runs from 7-10%. In some cases, property managers will charge only a monthly fee and not a lease-up fee.
The lease-up (and renewal fees) generally range from flat fees up to one month’s rent. Most property managers also charge a renewal fee for renters who want to stay a second year and beyond. Though some do not.
Previously, I mentioned that this part of the cash-on-cash calculator can actually help you with decision-making regarding property managers. This is how.
Let’s say you have a unit that rents for $1500 a month vs a unit that rents for $500 a month. In the case of the more expensive unit, it’s going to make more sense to use a property manager who charges a flat lease-up fee of let’s say $500 rather than one month’s rent. In the second case, you’re probably going to want to find a property manager that charges half a month’s rent instead. Your choice of property manager and their fee structure can definitely change your cashflow.
Average Occupancy
This variable reflects how long the renter remains in the property before turn-over. Ideally your renter stays 5+ years (so you have no vacancy) and you get to bump up rents each year. But life is not always the ideal!
To be conservative, we generally keep average occupancy at one year. This means that we assume a lease-up fee each and every year. Because this is usually not the case, whatever we predict as returns on our property will be better in reality.
Maintenance Costs
Maintenance costs reflect how much money you as the owner are going to have to put into the property per year to keep it in functioning order.
We calculate our maintenance costs to be 5% of the purchase price per year. Unless we’re buying an older building or not fixing up the property, in which case we’ll factor in more. This might be another area where you can build in extra room if you anticipate a lot of capital improvements over the next several years.
Monthly Utilities
Monthly utilities reflect the cost that you as the owner are going to have to put towards services such as water, sewer, garbage, etc.. In some of our four-plexes, our only utility that we don’t bill back to our renters is common area lighting. Therefore, this is a low number. In most of our properties, this variable is actually zero. We bill back utilities and other services to the renters.
When applicable we also include recurring costs in here such as landscaping, pest control or HOA dues as needed. Again, this keeps our calculator simple but makes sure we budget for monthly costs.
Evaluate the COC Return
Now you’ve worked through all the variables of the cash-on-cash calculator. It’s time to move forward and work through an example to see how this works in real life!
