Understanding Net Operating Income When Purchasing Rentals

Well, I didn’t exactly go with a cute or subtle title did I? There are very few things in life that I am sure of, but I can definitively say that you must understand the net operating income if you are going to be a successful rental property owner. When you are purchasing a rental property, whether it is a condo, single family home, or a large apartment building, it is imperative to think primarily about the cash flow that the property will produce for you. Don’t get me wrong, Daddy loves some appreciation/ buying with equity, but without the property producing a solid stream of income you are building a house of cards.

Growing up in Florida is a unique experience, you can get a sunburn at the beach on Christmas day, you are not southern enough to be a southerner and the rest of the country seems to have varying levels of contempt for the state. Don’t believe me? There is a regular bit on a Charlotte radio station called “It happened in Florida” where people call in to guess which one of the three ridiculous events happened in Florida. They are not exactly Chamber of Commerce moments for the state. Truth be told, it was a great place to grow up, and I do miss it. My Dad always told me the greatest gift he gave me was raising me in Florida, you have to know that man to appreciate how sincere he is. My man lives in his condo on the beach, loving every second of his life. Growing up I witnessed a very drastic real estate market, where prices would rise and fall quickly compared to the majority of the rest of the United States. It was very common to see a developer make a massive amount of money on one deal and then see the market soften as they were doing the next development, and they would lose everything and end up filing for bankruptcy. It is very much a boom/bust real estate market.

That reality has ultimately led me to appreciate that the most conservative way to invest in residential real estate is to purchase a property with the intent to hold it for a long period of time and benefit from the income that it produces. Please understand that the goal is always to buy with substantial equity, so that you have a margin of safety in your investment. I acknowledge that rental rates can fluctuate during different parts of the financial cycle as well but typically not as drastically as the price to purchase most assets. During the worst of the 08′ financial crisis, rental rates went down about 15% in Charlotte, NC while the value of the homes went down as much as 50% in some neighborhoods, truly devastating.

As I hear newer investors talk about their cash flow on rental properties, I find that there is a lack of consideration for the full scope of expenses that you accrue when owning an investment property. I commonly hear something like, “I’m turning my home into a rental, I’m going to do really well with it. My mortgage (we will assume taxes and insurance are counted) is only $1,500 and a property manager said that they can get me $1,800 so I will make a few hundred bucks a month.” Nuh, nuh you won’t my friend. Let’s just dig into the main event-

The true cash flow from a rental property is determined by understanding the Net Operating Income (NOI). Your NOI identifies everything but the Principle and Interest that you pay on a property, don’t worry that will be included in the overall analysis as well.

STEP 1- RENTAL VALUE

In order to calculate the NOI, you must first know what your property will rent for. There are a number of tools that you can utilize to assist with this from looking at what is for rent by driving the neighborhood and looking online at websites such as zillow (remember just because it is offered for $1,000 doesn’t mean someone will rent it for that) to asking investors that own properties in that area and getting insights from property managers. I would strongly caution you to be conservative with this number, if the consensus is a range of $1,050-1,200, I always use $1,050 for my calculation.

STEP 2- VACANCY RATE

In short, the vacancy rate is the percentage of the time that the property should be vacant over a 12 month period. If a property is rented for the full 12 months, that year the property had a vacancy rate of zero. Keep in mind that you may have a property rented for 5 straight years but when the tenants move out, you may have to paint and do some repairs that could take a few weeks and then you have to market the property to get a quality tenant. The vacancy doesn’t end until the new tenant has moved in and paying rent so even a short vacancy can be a month between tenants. Which would mean a vacancy of around 8% for that year. Once you have the vacancy rate, you can multiply the rent amount by the vacancy rate to assign a value to the cost of the vacancy. For example, a property that rents for $1,000/month and has a vacancy of 8% will have a vacancy cost of $80/month (1000 X 0.08= 80)

STEP 3- ADJUSTED GROSS INCOME

Once you have the rental value for the property as well as the vacancy rate, you simply subtract those two numbers to identify your Adjusted Gross Income. In the above section we reference a rental rate of $1,000 for the house, a vacancy rate of 8% ($80/month) for an adjusted gross income of $920/month (1,000 – 80= 920)

STEP 4- PROPERTY MANAGEMENT

Even if you manage the property yourself, it is imperative that you are setting aside a portion of the cash-flow to pay yourself for showing the property and dealing with your tenants. Many property managers will advertise rent rates of 6-10% however, you must keep in mind that this does not typically include their commission for renting the property up. Many property manager charge anywhere from 1/2 of the first months rent to the entire first months rent! I like to use 10% for my calculation even though my manager charges me 6% because I believe that properly factors in the lease up fee as well. You should factor your property management expense from the Adjusted Gross Income, NOT the gross rent. If your property manager is charging you fees while the property is vacant, call him/her a scumbag and find a new property manager. There is no way on this planet that they should be able to create an income stream by NOT having your property rented!

STEP 5- TAXES AND INSURANCE

The easy part about investing in North Carolina is that the property tax bill for a home is the same whether it is your primary residence or a rental property so it is very easy to go online to the county website or check out zillow or realtor.com to quickly get the property tax amount. Once you have that number, you simply divide that bill by 12 as we want to understand the month cash flow number and the property tax bill is paid once a year. So if the bill is $1,200/year, the month property tax number will be $100/month. For hazard insurance on the property the easiest way to understand the cost is to call you insurance agent and give them a few pieces of information so that they can give you a quote. Again, they will give you a quote for the annual bill so you will need to divide by 12.

STEP 6- MAINTENANCE AND CAPITAL EXPENSES

This is the area where I find that most investors are WAY too optimistic about how much a property will cost to maintain over time. When you think about a property, you must respect all of the ways that the house can cost you money. Some of the expenses are more significant such as replacing the roof or HVAC unit (capital expenses), while other issues are smaller and more common such as a leaky faucet. Over time you will paint the property many times, replace flooring, repair and ultimately replace all fixtures in the house. Cabinets and countertops will also be replaced. Keep in mind that most landlords provide appliances such refrigerators, stoves, and potentially more depending upon your area. Obviously you will not have the expenses at one time unless you buy a house that needs a ton of work but you must budget a portion of the cash flow to be prepared for them. There is nothing worse than the landlord that has $3k in their checking account and the HVAC goes out in the middle of the summer and you get a bill for $5k to replace the whole system. Personally I like simple properties such a 3 bedroom, 1 bathroom brick ranch. Why? Because I won’t have to replace the siding every 15-20 years at $10-15k. I prefer not to have extravagant deck areas in the back. I don’t want to be replacing the boards and repainting it every few years. Depending upon the type of structure that you buy, you will have a wide range in expenses for this section. The better that you do screening tenants, the better off you are, as the tenant turnover is the biggest killer of all. Your cash-flow is SIGNIFICANTLY different with a responsible adult/family that is easy on your property and stays for 7 years in comparison to the tenant that trashes your house after 8 months. Long story short, I put a number of around $300 for this section if it is a straight forward house without a bunch of bells and whistles.

NET OPERATING INCOME

After you have subtracted all of the expenses from your monthly rent, you are left with the figure known as the Net Operating Income (NOI). This is the cash that you receive for owning this asset assuming that you do not have a mortgage on the property. If you have a mortgage, simply subtract that number from your NOI. Be sure to subtract just the principle and interest, many mortgage companies will escrow your taxes and insurance so you want to make sure that you do not count that twice! It will be itemized on your mortgage statement.

REAL WORLD EXAMPLE-

To tie this all together, I pulled the numbers from a rental property that I own so that you can see what income you can expect, on average over time. Heads up, it is less than you might think!

Property Profile- “Eastway Park”

This was my first brick ranch that my wife and I purchased in Charlotte. It represented us pivoting from new vinyl village homes to older brick houses closer to downtown. Shout out to Bryan Alenky for telling me to buy this one. The investing community can be pretty sharky but my boy Alenky is a rare cat that really hooked me up on this one. Eastway Park was an off market deal that I heard about from a wholesaler. One day I will do a whole post on the ins and outs of this one but long story short, it is a 3 bedroom 1 bath house, just over a 1,000 square feet in a great up and coming area. Honestly it can certainly use a fair amount of updating in terms of the kitchen and bathroom but this ole gal has some great bones. It is a 1960’s brick ranch on a great lot, no garage. I purchased the property for about $84k a few years ago and it is worth about $225kish, which isn’t awesome on a long term hold because the property taxes will be much higher this year with the new county valuations. It almost doubled in tax value over the last 7 years!

RUNNING THE NET OPERATING INCOME-
• Remember we are running numbers for the monthly cash-flow
• Rent: $1,250
• Vacancy: – $62,50 (5% vacancy, even though I can rent this thing out in a day when it is vacant but it is best to be conservative)
• Adjusted Gross Income: = $1,187.50
• Property Management: -$118 (10% fee of the AGI)
• Taxes: -134.91 (Annual Bill of $1,618.98). Again, this is about to go WAAAYYY up!
• Insurance: -$35,83 (Annual Bill of $430)
• Maintenance/ Capital Expense: -$300 (Rough Estimate)
• NET OPERATING INCOME; = $598.76

To understand my actual cash flow, I need to subtract my mortgage payment from the NOI. My mortgage payment (principle and interest is $419.30/month). This property is on a 30 year mortgage.

This means that I make a whopping, massive, $179.46 of net income and also a little over $100/month if I decide that I want to manage it myself (I gave that up once we started having the little ones). I can pay this mortgage off tomorrow to increase my cash flow but my mortgage is fixed for 30 years at 4.3% so it hasn’t been a priority to this point. Some might say that the cash flow on this property is not very exciting and on the surface, I totally agree. Keep in mind that I was able to refinance after 6 months to pull my initial down payment and fix up cost out of this property so I no longer have any of my money tied up in the deal and again it has gone up substantially in value, I could sell this property tomorrow for over $200k. As time goes on, I want more of these simple and easy to rent properties that any knucklehead could manage because it is so easy to attract the best tenants due to the house being in a very desirable area.

Do you run a Net Operating Income analysis before you buy a property? What do you think is the most important calculation when buying a rental property.Are you wondering what fast food spot I take my wife to each month to celebrate our massive cash windfall? Let me know your thoughts!

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