Appreciation is a long-term benefit of real estate investing, but each deal should be evaluated on a cash-on-cash basis. That is, if you put $25,000 down on a $125,000 property, what is the annual return (net cash flow) on your $25,000? The mathematical formula is easy: Revenue-Expenses divided by cash invested. When projecting investment returns on a property, it’s easy to under-estimate expenses, and thereby miss your targets. This is especially true when purchasing older, single family rentals.
Hidden rehab costs can quickly mount. You might budget for a simple kitchen cabinet replacement, and then discover hidden mold or dry rot that needs to be repaired first. Or a prior water heater or HVAC unit that was replaced without a permit, and now the city wants to charge you to bring the property into compliance.
Operating costs should be relatively easy to project, but if the owner is paying the water bill, and a significant leak goes un-reported, that can add hundreds of dollars before it’s discovered. So too can unexpected pest-control and any number of preventative maintenance and repairs that are a cost of doing business, not your tenants’ responsibility.
Eventually roofs, HVAC units, driveways, etc. will need replacement. These capital expenses, or CapEx, should be budgeted and planned. If you create a separate account and put money aside every month or year, when the need arises, you’ll be spending money already reserved, instead of scrambling to come up with a cash infusion to cover the costs.
The cost of vacancy or uncollected rent should also be considered. Most real estate investors operate on cash-basis accounting, and when reported on a Profit & Loss statement, revenue is only what was received. On the other hand, proforma projections are usually based on accrual accounting, and it is assumed that rent is collected every month, thus the need to look at the expense (reduction in revenue) incurred in turn-over and vacancy.
When not taken into consideration, these factors can add up to investment returns that are far below wide-eyed expectations.