When managing your own property, it can be easy to become a passive investor. The practice of collecting rents, paying the mortgage, and fixing property issues as they come up, all seem pretty straightforward. But, if you aren’t keeping score on your investment, you are setting yourself up for failure. Say for instance you would like to measure the return on your investment? Or perhaps you’d like to be able to articulate to a buyer of your property what type of return they may expect to receive when buying your property as an investment. This is when an operating budget becomes valuable.
What is an Operating Budget?
Much like the name suggests, it is a projection of the income and expense for the operation of a property. If your projections hold true, it can help you to anticipate how much profit you will earn in the course of a year. If you have managed a property for some time, it may be simple to estimate rents, mortgage payments and property maintenance costs based on past experience. If this is a new property, then some estimates will have to be made, but these are the basic components of an operating budget.
Rents: How much rent can you charge per month? If you are unsure, look on craigslist.org in your area for comparable properties. Depending on your market, this will help narrow down a range. If you still have a fairly wide range, drive to the properties, inspect the properties and rank them objectively against your property. On the operating budget, rents will always be annualized, so multiply the monthly rent amount by 12.
Mortgage Payments: If you are using leverage to finance your asset, include any monthly mortgage payments. You can choose to include taxes and insurance on this line, or you can itemize taxes and insurance separately. The benefit of itemizing the taxes and insurance separately, is that it provides further granularity on what impact taxes and insurance have on your profitability. Again, these are annual figures, so multiply monthly mortgage payments by 12.
Homeowners’ Association Fees: Provide an annualized figure for HOA fees, if you have any. Be sure to include any special assessments that you may have in the coming year.
Planned Maintenance: This is your opportunity to keep a schedule of items you would like to maintain. It also is an opportunity to ask some questions of your renters. Would you like for them to help you with caring for the yard? If not, you will have to either do your own landscaping, or hire someone to do so. Some people use this number as a plug for their operating budget, i.e. will only devote an acceptable amount of leftover funds to this line item. That can be short sighted for a long-term investment. Commit to budgeting 3.0% of the home’s value per year to planned maintenance if you have a single-family home, or 1.5% to a townhouse or condominium if a homeowner’s association is handling planned maintenance items on the home’s exterior. This has generally worked well for me, although, I would offer the caveat that each home is unique, and older homes seem to need more than these numbers, and newer homes seem to require less.
Unplanned Maintenance: How do you budget for something that by definition cannot be planned? If you are fortunate to have past records, you can estimate based on previous years. If you are not that fortunate, you will have to take an honest assessment of your home and ask, what items will likely break in the next year. A home inspection may be your best tool in this instance. There are a lot of variables to this estimate: Townhomes and Condominiums typically have fewer large ticket unplanned maintenance items, since the most expensive things, roof and sewage are typically covered by the HOA. Older properties will have more unplanned items just due to the overall number of outdated or outmoded features of the property. For a new home, townhouse or condominium 1.5% of the property value may make sense. For older properties, you can go as high as 3.0% of a property value in a given year.
Property Vacancy: This is an insurance item I put in any annual operating budget as renters by definition are temporary occupants. You may have a renter who has been faithfully paying rent for years decide to up and move. Then what will you do? Even in the best-case scenario, you will need a month to clean up, inspect and repair the property, not to mention secure a new renter. Also, your ability to secure a new renter is a product of the rental market you are dealing in. I usually put in one month because I can diligently prepare (or secure the resources to prepare) a property for rental within that time. I also operate property in a very hot rental market. You will have to do an honest assessment of your own market to see if this is feasible.
Your final operating budget might look something like this:
Show me the results: Once you’ve put together your operating budget for the year, you should hopefully be showing an anticipated profit. But in either case, you want to measure where you stand to determine if real estate investing was lucrative for you this year. To determine your capitalization rate, you will divide the net operating profit by the estimated property value. Since you have already based your budget items on an annual basis, this will be an annual rate.
Not quite the results you were hoping for?: Sometimes after looking at the initial operating budget, your return can look a little disappointing. If it does, you can take two approaches to this: If you are a short term investor, or risk averse, this investment may not be suitable for you. Real estate is not only illiquid, but subject to sweeping market fluctuations, and requires a lot of interaction. If you are fine with this property being a long term investment, keep in mind historically property values have increased over time, as have rents. Furthermore, assuming you are using leverage that amortizes normally, your debt service payments will remain constant. That can lead to slow and steady increases in performance over time.