There are generally two schools of thought in real estate: invest for appreciation or invest for cash flow (or both). Those who invest for appreciation take a chance on a property, hoping its value will increase over time. The rents are generally just covering costs. Those who invest for cash flow, meanwhile, buy a rental property for the income it generates (or has the potential to generate) each month.
Anyone who invests for cash flow knows that preserving that cash flow is critical. An unexpected expense, such as an overlooked roof repair, can easily kill a year’s worth of cash flow at small properties. Similarly, an unusually long vacancy can quickly erode the cash flow that a property puts out.
Managing Cash Flow at Small Rental Properties: Why It Matters
Managing cash flow is important for a few reasons. First of all, anyone who invests in cash flow made that investment based upon its ability to generate a certain level of income. In running the numbers beforehand, an investor may have determined that the existing cash flow, after expenses, would turn an 8% profit. If that cash flow is interrupted, a rental property may not be profitable at all. The investor may have been better off investing his money elsewhere.
Second, a consistent stream of revenue is important for investors looking to refinance or sell a property. A bank will want evidence that the property is generating enough net income to cover debt service payments.
Similarly, a prospective investor will typically factor the property’s cash flow into his evaluation of the opportunity. A property with strong cash flow is more attractive to an investor looking for an immediate return on their investment, versus one where cash flow is limited or unstable. Buyers will often ask for a copy of the rent roll and record of deposits to confirm that rents have indeed been consistently paid. They’ll usually ask for a record of expenses as well to evaluate the property’s true income-generating potential.
With larger properties, investors can usually withstand a dip in cash flow. There’s usually enough income coming in from the other units to cover unexpected costs. Managing cash flow at smaller rental properties can be more difficult.Own a small rental property? Discover 4 smart tips for managing your cash flow on the #BuildiumBlog! Click To Tweet
Based on our experience, here are a few ways to better manage your cash flow at small rental properties.
How to Manage Your Rental Properties’ Cash Flow
Mitigate the Impact of Vacancies
Vacancies are inevitable. A typical pro forma will usually include at least a 5% vacancy rate to account for annual turnover. At a fourplex, this would be the equivalent of 2.4 months of vacancy throughout the year (4 units x 12 months per unit = 48 / 0.05). Baking in a 5% vacancy rate gives the owner room to make repairs and other improvements to a property before releasing it. This also gives the owner time to find qualified tenants.
Often, novice investors will forget to include vacancy in their pro forma. They wrongly assume that because a property is fully occupied now, it will remain fully occupied throughout the year. Even long-term tenants leave from time to time. Mitigate the impact of vacancies by including at least a marginal vacancy rate in your annual budget. In the event that you don’t have a vacancy, even better! This will boost your cash flow projections, and it can also be used to offset any unexpected costs.
Stagger Lease Expirations
Another way to mitigate the impact of vacancies is by staggering lease expirations. Landlords of small rental properties are often tempted to keep their tenants’ leases on the same timeline. This is especially true if you own property in a college town, where leases tend to mirror the academic calendar.
However, keeping all leases on the same schedule can present a major cash flow problem if the units turn over at the same time and do not re-rent easily. You could be flush with cash one month and unable to cover debt service payments the next.
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Instead, stagger your leases’ terms. You can still use 12-month leases, but start leases throughout the year. For a three-family, you might begin leases on January 1, May 1, and September 1. When a tenant goes to re-sign a lease, perhaps you shorten or lengthen the lease term on a one-time basis to meet those dates. For example, I recently had residents sign a 14-month lease because I specifically wanted it to expire on August 31st. Play around with the dates included in your leases to ensure that you don’t have vacancies hit all at once.
Conduct an Annual Property Inspection
All too often, investors only inspect a property before purchasing it. However, an annual inspection is another way to manage cash flow at smaller properties. This is particularly true for novice investors who may not have a thorough understanding of a property’s condition (for instance: can you really look at your roof and determine how much life it has left? Me either!).
Conducting an annual property inspection will give you a better idea of the repairs and maintenance that are necessary, and when those need to be completed. This helps you to prepare your annual budget. If you know there’s a chance that you’ll need a new HVAC system within the next year, you can start getting quotes and include this in your budget.
Being proactive about repairs and maintenance can also save you money: Instead of being forced into an emergency repair (e.g. a hot water heater blows), you can do your research and vet contractors accordingly. In emergency situations, you’re often at the whim of whichever repair person can get there first—and they know that, and will usually charge a premium as a result.
During your annual property inspection, also take note of any warranties that will be expiring in the coming year. Items that are still covered may qualify for free inspection and maintenance. You may also be able to negotiate a low-cost extension of the warranty; coverage providers are usually more likely to negotiate with you while you’re still under warranty.
Review Your Contracts
When was the last time that you re-read your property management contracts? Are you getting the most competitive rate for the quality of service you’re getting? How does the interest rate on your mortgage stack up to existing rates? Is now a good time to refinance? Have your insurance premiums gone up?
Smaller-scale investors often default to the status quo when it comes to their existing contracts. Any recurring monthly expense should be evaluated to determine whether you could be getting a lower rate for similar service or coverage. Even a modest reduction in these costs can improve cash flow at small rental properties.Read it on the #BuildiumBlog: 4 smart cash flow tips for owners of small rental properties! Click To Tweet
The Bottom Line
Managing cash flow at small rental properties requires a combination of proper budgeting, skill, and foresight. You should be monitoring your cash flow regularly. Implement systems to collect rent payments on time; and likewise, make timely payments to your service providers.
A little preparation can go a long way when it comes to preserving cash flow at small rental properties—and your ability to preserve cash flow can ultimately make or break your investment.Read more on Accounting & Taxes