How We Calculate Return

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How We Calculate Return

In this guide, I show how we calculate returns and what we include and do not include in our calculations.

Return Calculation Limitations

ROI and cash flow are only a snapshot in time. Return calculations predict how a property is likely to perform on day one under ideal conditions. Return calculations tell you nothing about the future.

Relying primarily on initial returns when making purchase decisions can result in poor long-term results. For example, the chart below shows the inflation-adjusted rent (or buying power) over time for two properties. The rent for Property A kept pace with inflation, while the rent for Property B did not.

However, just because Property B's rent did not keep pace with inflation, does not mean that the rent did not increase. For example, if the inflation rate is 5% and the rent increases by 5% per year, there is no actual increase; the rent only kept pace with inflation. This is what occurred with Property A. On the other hand, Property B's rent rose by only 2%, which did not keep pace with inflation, resulting in a decrease in buying power over time. See the table below.

If you make a purchase decision primarily based on day-one return, you are likely to fall into the trap illustrated below. Property B initially had a higher initial return than Property A. However, Property B's rent did not keep pace with inflation, so it is only a matter of time before Property B's buying power falls below that of Property A.

The takeaway is that investment decisions should be made with a long-term mindset; return calculations only predict the return on day one.

The Formulas We Use

Many different formulas for calculating returns can be found online. Some formulas exclude recurring costs, such as taxes and insurance, while others include unrealized gains, such as appreciation and principal paydown. We use formulas that include all recurring costs and consistently match what our clients see in their bank accounts.

Below are the formulas for cash flow and ROI.

Cash Flow

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - MaintenanceCost - VacancyCost) x (1 - StateIncomeTax)

We do not include maintenance or vacancy costs in our calculations, which I will explain shortly. Also, Nevada has no state income tax. The simplified formula is below.

Cash Flow = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax – PeriodicFees)

ROI

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees - MaintenanceCost - VacancyCost) x (1 - StateIncomeTax) / ( DownPayment + ClosingCosts + RenovationCosts)

Our return calculations do not include maintenance or vacancy costs, which I will explain shortly. Also, renovation costs are not included until an estimate is available.

ROI = (Rent - DebtService - ManagementFee - Insurance - RealEstateTax - PeriodicFees) / ( DownPayment + ClosingCosts)

Below is a screenshot showing an example return calculation.

Maintenance and Vacancy Costs

A frequent question I receive concerns why we do not include vacancy or maintenance costs. There are two reasons.

The primary purpose of return calculations is to compare investments. Calculated return is only an indicator of what your actual return will be; taxes have a significant impact on actual returns.
There is no way to estimate maintenance or vacancy costs for an individual property.

On some websites, you may see vacancy and maintenance costs estimated by multiplying rent by 5%. Using a rent multiplier for estimating maintenance or vacancy costs, invalidates the calculation. Here's the problem.

Using a rent multiplier artificially lowers the maintenance and vacancy costs of low-rent properties and artificially increases these costs for higher-rent properties. In reality, the opposite is usually true. For example, below are two properties. The one on the left rents for $1,050/month and the one on the right rents for $2,000/month.

According to the property manager, the average annual maintenance cost for the older property on the left is over $2,000/Yr. The newer property on the right has an average maintenance cost of about $350/Yr.

What does the rent multiplier method predict?

Older property: $1050 x 5% x 12 = $630/Yr
Newer property: $2000 x 5% x 12 = $1,200/Yr

The rent multiplier method fails for both properties. Never use the rent multiplier method, while popular, it always fails.

Does the rent multiplier method work for vacancy costs? It fails for similar reasons. An example will show the problem.

In Las Vegas, the average length of stay for tenants in C-class properties is about one year. In contrast, tenants for the properties we target typically stay for over five years. The table below is from an article I wrote on estimating vacancy costs. For ease of reference, the tenant segment that stays in C-class properties is named Transient. The segment we've targeted for the last 15 years is named Permanent.

What does the rent multiplier method predict?

Older property (Transient): $1050 x 5% x 12 = $630/Yr
Newer property (v): $2000 x 5% x 12 = $1,200/Yr

As you can see, the rent multiplier method fails. The problem is that the amount of rent has no relationship to vacancy cost.

Maintenance and Vacancy Cost Elements

What are the cost factors for maintenance and vacancy costs?

Maintenance cost is a function of:

Property condition
Property age
Climate
Construction and renovation materials
Target tenant pool - Turn frequency
Property manager skill in selecting tenants.

I conducted a study on annual maintenance costs and found that the average for our client's properties was $350 per year. I did not include monthly cash flow in the study, which generally covers the cost of most maintenance calls.

Vacancy cost is a function of:

Property condition
Property age
Climate
Construction and renovation materials
Target tenant pool - Turn frequency
Property manager skill in selecting tenants

With an average tenant stay of over five years and a typical time to rent of one month, the average vacancy cost is approximately $400/Yr.

Although I know the average cost for vacancy and maintenance, the population average is not representative of maintenance and vacancy costs for individual properties.

As shown in the table below, the average annual maintenance cost for the ten properties is $500 for years 1 and 2. However, maintenance costs for individual properties varied widely. This is why population averages are not representative of the individual properties within the population. This was the issue I faced when deciding whether to include population averages for maintenance and vacancy costs.

What I Decided to Do

Because there's no way to predict maintenance and vacancy costs for an individual property, I decided not to include maintenance and vacancy costs. To balance these costs, I decided not to include depreciation, which increases effective return. By leaving out all three items (and adding two additional pads, which I will explain shortly) I believe I have more than compensated for maintenance and vacancy costs. See the table below.

The screen snapshot above oversimplifies the tax benefits of depreciation. The benefits you receive from depreciation are greatly affected by the amount you earn, the passive income you receive from real estate, and other factors. Please use the above only as a general concept, and consult with a tax professional to determine your specific tax benefits.

If I included maintenance and vacancy costs and depreciation, the cash flow is $917/Mo. Not including maintenance and vacancy costs and depreciation, the cash flow is $107/Mo. Not including depreciation, vacancy, and maintenance is a much more conservative approach as shown in the above table. This is why I chose this method.

Additional Cost Pads

I added two additional cost pads to cover the unexpected.

Closing Cost Pad

I evaluated more than 90 properties that we've closed and found that the average closing cost was approximately 1.75% of the sales price. To provide an additional cushion to cover unknown expenses, we use 2%. For instance, on a $400,000 property, .25% equals $1,000. On average, you will have two repairs during the first year. If the property has a home warranty, the call-out fee is $75 each. This leaves an extra $850 ($1,000 - 2 x $75) to cover any unforeseen expenses.

Cash Flow Not Considered

In most cases, individual repairs are under $300. The average monthly cash flow for most of our client properties is greater than $300/Mo. Therefore, cash flow will cover most repairs. Not including monthly cash flow in the maintenance cost calculations is in effect, an additional cost pad.

Summary

I believe that the conservative method we use provides a realistic representation of each property. If you have suggestions for improvement or any questions, please leave a comment.

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