Financial planning in real estate investing is the process of determining all aspects related to the financing of your property. From acquiring a mortgage that suits your investment, to calculating the expenses and cash flow of your rental property, financial planning is a crucial step for your investment, and it is a step that can make your investment either succeed or fail, depending on your skills and foresight when it comes to financial planning.
Without further ado, here are the most important aspects and metrics in financial planning, their importance for your real estate investment, and how to put them in action to determine the value of your property:
Financial Planning: Mortgage
When it comes to real estate financial planning, the cornerstone of your plan should revolve around the mortgage. Most real estate investors, especially first-time investors, rely on a mortgage to finance the purchase of an investment property. This means that most real estate financial planning should include mortgage and mortgage payments in the expenses section of the plan.
As a general rule, when setting a financial plan for your real estate investment, you always need to make sure that your monthly rental income exceeds your monthly mortgage payment so that you have positive cash flow. Additionally, financing your real estate investment with a loan can, in fact, increase your cash on cash return on investment as this calculation does not include the mortgage payment, but it gives you an estimate of the time needed for your investment to pay off the down payment that you’ve made when acquiring the loan.
Related: Cap Rate vs. Cash on Cash Return
Financial Planning: Cash Flow
What is cash flow, and how important is it for real estate financial planning?
Cash flow is simply the amount of monthly or annual income that you’re making off of your investment after paying all its expenses. Naturally, you will want your cash flow to be on the positive side and not the negative; meaning you will want a rental income for your investment that exceeds the expenses that are related to your investment, including mortgage payments and taxes.
While cash flow is mostly related to rental properties, it can also be used in the valuation of buy-and-hold real estate properties as well.
Financial Planning: Expenses
The exact expenses that should be included in a real estate financial plan can vary widely depending on the property, its location, and the investor’s strategy for investing in the said property. A financial plan should include all expenses related to the investment; whether these expenses are guaranteed or not, an estimate of these expenses should be made to determine how they may or may not affect your investment in the future.
Some of the metrics that are most likely to be included in all real estate financial planning include:
- Mortgage payments
- Electricity bills
- Water bills
- Property management
In addition to several other expenses that may be included, these expenses should always be taken into consideration in your real estate investment’s financial plan, and they will be used to determine your cash flow and therefore the value of your investment.
Financial Planning: Appreciation
This section will not be as crucial for your financial plan as the other sections, but it should be taken into consideration nonetheless. Property appreciation is the increase of the investment property’s value in the future, which could be predicted or estimated based on different factors that may affect the property’s value such as the area the property is located in and any future developments in this area.
Why is appreciation not as important for your financial plan?
Because appreciation cannot be truly predicted, meaning that your predictions or an expert’s predictions about the appreciation of your property are nothing more than an estimate, even if the property is predicted to appreciate greatly.
This is why appreciation is usually considered the “icing on the cake”, as it gives an increased value for the property, but your investment decisions should not be based on appreciation, or at least not on appreciation alone.
Financial Planning: Vacancy Rate
This part of financial planning is only included for rental real estate properties. The property’s vacancy rate is the expected portion of the year that a rental property will be vacant. If a rental property has a vacancy rate of 10%, for example, then it would mean that this rental property is expected to not have tenants in it for the duration of 10% of a year, or 1.2 months.
Vacancy rate is included in the expenses section of a rental property’s financial plan. As to how this rate is determined: it is determined through research. In order to get an estimate of the investment property’s vacancy rate, you will have to study the area and other similar rental properties in it. In other words, estimating the vacancy rate for your rental property is based on comparisons between your property and other competing properties in the same location.
Financial Planning: Calculation
So, how do all of these metrics add up when it comes to financial planning?
This is where a calculator and a spreadsheet are needed.
The process of calculating the finances for your real estate property should all look similar to this:
The main metric for valuating your real estate property is Cash Flow.
Cash Flow = Income – Expenses – Mortgage Payment
In the case of rental properties, income refers to the monthly rent on your property.
In this case, we’ll assume that your monthly rent is $2,300.
For the sake of simplifying the example, we will only include some of the expenses as a demonstration.
- Vacancy rate: 10% OR $2,760/year
- Electricity: $50/month OR $600/year
- Water: $75/month OR $900/year
- Repairs costs: $600/year
- Taxes: $300/year
Based on this, the total annual expenses for your property in this example would be: $5,160
Let’s also suppose that you bought the property for $300,000, for which you acquired a mortgage loan of $250,000, and you made a down payment of $50,000.
Let’s also suppose that your mortgage loan was a 30-year mortgage with an interest rate of 3.5% and that your annual loan payment is $13,500.
Taking all of that into account, your ANNUAL cash flow should look something like this:
Cash Flow = Income – Expenses – Mortgage Payments
Cash Flow = $27,600 – $5,160 – $13,500
Cash Flow = $8,940
This is good because it’s a positive cash flow.
Now, in order to calculate what this means for your investment, it’s time to do a simple calculation in order to determine your Cash on Cash Return.
CoC = Cash Flow/Cash Invested
In this case, the Cash Invested refers to the amount of cash that you’ve paid as down payment:
CoC = $8,940/$50,000
CoC = 0.17 OR 17%.
Since CoC refers to the rate at which your investment will have paid for itself, this means that for our example, each year you will have gain a profit which amounts to 17% of the initial amount that you’ve paid for your investment, not including the money you’ve borrowed through your mortgage loan.
Financial Planning: Conclusion
While real estate financial planning might seem like a challenge or an undesired task that is crucial for your investment, in reality, it is not as difficult or as complicated as it may seem. And while practice makes perfection when it comes to financial planning, there exist a number of tools that can help you plan your finances, and even do investment property analysis and calculations for you in order to determine your best investment opportunity.
Mashvisor has that and more. So, before you get started on your investment venture, give Mashvisor a look and you won’t be disappointed with what you find there including our investment property calculator.