Return Estimate Model

I often get questions on how to estimate return. Below is a model of an example property. Before I get into the line-by-line specifics, I want to explain a bit of this model and how it relates to the actual return.

The primary purpose of this model is to compare properties. No simple model like this will predict your actual return because income taxes greatly impact actual return. For example, depreciation alone will typically increase effective return by 3% to 6%. However, depending on your tax situation, it could be more or less. Our decision was not to include depreciation in the calculations, even though the IRS requires it. Not including depreciation also provides a reasonable pad for maintenance and vacancy.

We do not include any cost for vacancy or maintenance because we do not know what a reasonable annual cost would be. Vacancy cost is a function of carrying costs, time to rent, renovation cost, tenant pool, property manager skill, lease terms, and other factors. Maintenance cost is a function of property condition, age, construction materials, renovation materials, climate, tenant pool, lease terms, property manager skills, and other factors. Also, it would no change the difference in return between properties if we included a constant for maintenance and vacancy.

One last note, a negative sign is a convention indicating cash flowing out. A positive sign indicates cash flowing in. For example, rent is a positive number while debt service is a negative number.

Assumptions:

  • Line 1 - We typically do not know the sale price or purchase price so we frequently either use the asking price or what we believe the property will sell for.
  • Line 2 - The rent comes initially from recent comparables. As we go through the validation process, we will update this with the estimated rent from the property manager.
  • Line 3 - This is the sum of all periodic fees normalize to a monthly amount. Usually, this is just the association fee.
  • Line 4 - Landlord insurance cost varies by the property and even the zip code. $450 a year is a reasonable estimate for a $350,000 property.
  • Line 5 - This is the actual tax from the County Assessors office.
  • Line 6 - This is the management rate our clients receive from the property manager we work with.
  • Line 7 - Closing costs vary by lender. We typically use 2% because that will cover the loan and closing fees plus the home warranty, inspection, lease-up fees, two call-outs during the first year, and leave a $500 reserve fund. Note that this is based on a statistical average and will be slightly different for every property.
  • Line 8 - Estimated rehab is property and tanent pool specific. Renovation costs ranged between $500 and $55,000, so there is no "average" cost. Since we have no way of estimating renovation cost at this time, we leave it zero.
  • Lines 9, 10, and 11 - Rates and such from recent closings. This rate will vary depending on your credit score and the current loan rate. Also, occasionally we find a property where the seller will contribute to the buyer's closing costs which will reduce this amount.
  • Line 12 - This is the monthly principal and interest payment (Debt Service). Based on lines 9, 10 and 11.
  • Line 13 - Maintenance cost is an annual cost, not a rent multyiplier. See Vacancy and Maintenance Cost Provisions for more information.
  • Line 14 - Vacancy cost is an annual cost, not a rent multyiplier. See Vacancy and Maintenance Cost Provisions for more information.

Acquisition Cost:

  • Line 15 - Down payment is line 11 x line 1. For this example: 350,000 x 25% = 87,500.
  • Line 16 - This is copied from line 8
  • Line 17 - This is line 7 x line 1. For this example: 350,000 x 3% = 10,500
  • Line 18 - the sum of lines 15, 16, and 17. For this example: 87,500 + 0 + 10,500 = 98,000

Recurring Expenses (Mo.)

  • Line 19 - This is a copy of line 12
  • Line 20 - This is the monthly rent (line 2) x line 6. For this example: 1,895 x 8% = 152
  • Line 21 - This is line 4 / 12 = 450 / 12 = 37/Mo.
  • Line 22 - This is line 5 / 12 = 1,188 / 12 = 99/Mo.
  • Line 23 - If we entered a maintenance amount into line 13, it would appear here.
  • Line 24 - If we entered a vacancy amount into line 14, it would appear here.
  • Line 25 - This is a copy of line 5.
  • Line 26 - This is the sum of lines 19, 20, 21, 22, 23, 24, 25

Income (Mo)

  • Line 27 - This is a copy of line 2

Return (Financed)

  • Line 28 - This is the cash flow estimate per month for a property financed under the terms stated earlier. The calculation in this example is: line 27 - line 26 = 1,895 - 1,558 = 337/Mo.
  • Line 29 - This is the annual cash flow (line 28 x 12) divided by the acquisition cost (line 18). For this example: (337 x 12) / 98000 x 100

Return (Cash)

  • Line 30 - This is the cash flow estimate per month for a property purchased with cvash under the terms stated earlier. The calculation in this example is: line 27 - Lines 20, 21, 22, 23, 24, and 25. All expenses except for the debt service.
  • Line 31 - This is the annual cash flow (line 30 x 12) divided by the acquisition cost for a cash purchase. For this example: (1,552 x 12) / (350000 + 10,500) x 100

If you would like to download the spreadsheet, click on this link and create a copy of the sheet.