Expenses or debt service? How do rental esimates work?

Question

I understand that a typical rental analysis takes the monthly rental amount, sets aside 5% for vacancies, estimates 50% for expenses, and then makes sure the remaining 45% pays debt service and leaves a profit.

But I've noticed that mortgage calculators often include insurance and tax payments in their monthly mortgage payment estimates. Aren't insurance and taxes typically considered part of the 50% for expenses rather than the 45% for debt service? So when I'm running rough numbers, should I only apply the principal and interest costs to the 45%? Can I presume insurance, taxes, maintenance, and management costs will be covered by the 50%?

Thanks for the help!

Justin

Curtis Mears · Answer

I recommend taking the time to fill in the estimates with actual numbers when you can. Instead of 50% expenses, take the time to go through and research those expenses that are known quantities, then estimate the remainder. For instance, taxes and insurance are big items that you can get the real numbers. In addition to those, are you using a manager or self manage? After you get the actual numbers, now you can estimate the remaining, such as cap expense and vacancies. Some of these numbers will vary based on where and what properties you are researching. Older homes may require more maintenance but newer homes will still need some maintenance. Once you fill in all the numbers you can, now make an informed decision. And once you do buy, go back and compare to your estimates to actuals and adjust as needed.

Greg M. · Answer

No idea where you got these numbers, but anyone who runs a business using such simplistic numbers is destined to fail.

You have real numbers, use them. Put them into a spreadsheet. Factor in your opportunity cost of capital (down payment) and your monthly principal reduction. Factor in the expected life of major improvements and their replacement cost. Does the area typically experience appreciation? Figure out actual vacancy rates. Average tenant stays around 3 years, so if you're guessing 5% for vacancy, you're factoring in 2 months between tenants. That sounds like a long time for most areas.

As for profit, what is a profit to you? I'm OK buying a unit that has negative cash flow as long as the principal reduction and appreciation offset it to an acceptable return. Other people on these forums would slit their wrists if the unit failed to provide enough free cash flow and they could care less about principal reduction and appreciation.

Justin Megna · Answer

The 5%/45%/50% figures I heard from Matt Faircloth here:

And Brandon Turner described expenses being about 50% for a rental property in this video, though he included vacancy as part of the 50%:

And I agree that you can't lean on these percentages in making your final purchase evaluation; you have to have the final numbers quantified. These two guys agree with that as well. They both warn against making a purchase decision based on the estimates.

My point in posting was to make sure that I was keeping the expenses/debt service costs straight. In reviewing these videos again, I see that they describe insurance and taxes as part of expenses, not debt service. When I was practicing analyzing a property, I double-counted taxes and insurance because they were included as part of the monthly payment by the mortgage calculator I was using. I'll be sure not to do that when I quantify costs on properties in the future. ;)