Over the past 16 years, I have worked with around 200 beginning investors, and in my experience, most investors are entirely focused on ROI and cash flow until they receive training.
Here are some key points for new investors to keep in mind:
1. You’re not buying real estate
Yes, you end up buying real estate, but that’s not what you’re buying. You’re buying an income stream. You’re buying a way to step out of the routine of a day job for good and live life on your own terms. So it’s not the real estate itself that’s important, it’s the income that it generates.
Net rental income is called cash flow. It is calculated as follows:
- Cash Flow = Income – Expenses
To make money, your income must exceed your expenses, and we’ll focus on income (or rent) here.
2. It’s the estimated income that matters, not the total income.
Many people calculate their annual income as 12 times the monthly rent, which would be correct if the tenant was always in the property.
But the reality is quite different. Here’s a more realistic look at your annual income:
- Annual Income = 12 x Monthly Rent – Vacancy Costs – Expenses
Ignore expenses and focus only on vacancy costs.
There is no way to know exactly what future vacancy costs will be. However, you can estimate average future vacancy costs based on the segments of tenants your property attracts and their past behavior. Such historical information can be obtained by interviewing property managers.
We show you how to estimate vacancy costs using a tenant segment survey in Las Vegas.
Las Vegas has three primary tenant segments: temporary, permanent, and transitional. Each segment is named based on the average length of stay. This table provides additional information that we use to estimate the average length of stay, average rent, and average annual vacancy costs for each of the three segments.
| temporary | Persistence | Transitional period | |
| Average length of stay | Less than 1 year | 5+ years | 1 year |
| Average monthly rent | $900 | $2,200 | $3,000 |
| When to re-rent your property | 2 months | 1 month | Three months |
| Typical costs for preparing a property for re-renting | $2,400 | $500 | $3,000 |
While the actual cost calculation for a property will be complicated by property-specific maintenance costs, this example will help explain the concept. For simplicity’s sake, let’s assume that the monthly recurring costs for the property across all three segments (debt service, taxes, insurance, utilities, etc.) are $2,500 per month.
The formula for calculating vacancy cost is:
- Vacancy cost = rental period x maintenance cost + renovation cost
Calculate the cost per available space for the three segments.
- temporary: 2 x $2,500 + $2,400 = $7,400
- Persistence: 1 x $2500 + $500 = $3,000
- transfer: 3 x $2,500 + $3,000 = $10,500
To convert cost per vacant room to annual vacant room cost, divide the cost per vacant room by the average length of stay for each segment.
- Average annual vacancy cost: $7,400 / 1 year = $7,400 per year
- Average annual permanent vacancy cost: $3,000/5 years = $600/year
- Average annual migration vacancy cost: $10,500 / 1 year = $10,500 per year
Once we factor in the vacancy costs for each segment, we can calculate the potential annual income for each of the three segments.
- One-time expected income: $900 x 12 – $7,400 = $3,400 per year
- Permanent estimated income: $2,200 x 12 – $600 = $25,800 per year
- Transition income estimates: $3,000 x 12 – $10,500 = $25,500 per year
Based on these calculations, you can modify your cash flow calculation to use estimated revenues instead of gross revenues, as follows:
- One-time cash flow = Gross Revenues x $3,400 / ($900 x 12) – Expenses or Gross Revenues x 31% – Expenses
- Perpetual Cash Flow = Gross Revenues x $25,800 / ($2,200 x 12) – Expenses or Gross Revenues x 98% – Expenses
- Transition Cash Flow = Gross Revenues x 25,500/($3,000 x 12) – Expenses or Gross Revenues x 71% – Expenses
While real estate may seem like a cash cow when you look at total rent, it can become a money pit when you include vacancy costs.
It is important to keep in mind that vacancy costs are a function of carrying costs, time to rent, and turnover costs. These factors vary depending on the property and the tenant segment it attracts. Contrary to popular belief, there is no relationship between vacancy costs and rental amounts.
3. Know your ROI and cash flow limits
ROI and cash flow only predict how a property will perform on Day 1 under ideal conditions. They don’t tell you anything about Day 2 and beyond. You’ll own the property for many years, so what happens after Day 1 is much more important than what happens on Day 1.
For example, say you’re choosing between two properties in different cities.
Property A:
- price: $300,000
- rent: $2,000/month
- Rent Increase Rate: 2% per year
Property B:
- price: $300,000
- rent: $1,500/month
- Rent Increase Rate: 8% per year
Based on this data, it’s pretty clear that Property A is the better investment, right?
Now, let’s think beyond day one performance. Assume inflation is 4% per year. What will the inflation-adjusted rent (or purchasing power) be for both properties over the first 10 years?
| Property A (inflation-adjusted rent) | Property B (inflation-adjusted rent) | |
| Purchase year | $2,000 | $1,500 |
| 1 | $1,962 | $1,558 |
| 2 | $1,924 | $1,618 |
| 3 | $1,887 | $1,680 |
| Four | $1,851 | $1,744 |
| Five | $1,815 | $1,812 |
| 6 | $1,780 | $1,881 |
| 7 | $1,746 | $1,954 |
| 8 | $1,712 | $2,029 |
| 9 | $1,679 | $2,107 |
| Ten | $1,647 | $2,188 |
Property A’s rent has not increased as fast as inflation, so its inflation-adjusted income has decreased every year. In comparison, property B’s rent has increased faster than inflation, so its inflation-adjusted income has increased every year.
By year 5, both properties will provide roughly the same inflation-adjusted income. After year 5, Property B is the better long-term investment. Buying Property A would be a financial disaster if you plan on holding the property for more than 5 years.
The lesson is that valuing real estate solely based on day one metrics like cash flow and ROI can lead to poor decisions and losses in the long run.
4. “You can only count on today”—is that really true?
The most common reason we hear for choosing a property based on day one cash flow and ROI is, “You can only count on today.” However, this assumption assumes that the world is static and nothing ever changes. This isn’t true because the only constant in life is change.
For example, if you purchase properties in cities where rents have not kept up with inflation, it will be impossible to achieve financial freedom with these properties. This is because the amount of goods and services your rent can buy decreases every day due to inflation. This is demonstrated by our examples of Property A and Property B.
The best analogy for rising rents and inflation is that of an escalator. Imagine a person trying to go up a downward escalator. The person going up represents rising rents, and the downward escalator represents inflation. If you don’t go up fast enough to keep up with the downward escalator, you’ll move down.
So even though rents rise and inflation falls sharply, purchasing power, or the actual value of your money, falls.
Final thoughts
I have compiled some important tips that real estate investors should consider. These are not just suggestions, they are essential elements to successful real estate investing. If you ignore them or don’t take them into account, Serious long-term negative economic impacts.
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BiggerPockets notes: These are opinions expressed by the author and do not necessarily represent the opinions of BiggerPockets.
