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Whether you are considering your first single-family rental investment or you already have a large portfolio, it is standard practice to prepare a pro forma budget when analyzing a deal. A pro forma is used to project income and expenses, and while it includes most of the elements of an operating budget, the two function differently.
Pro formas are critical to analyzing a deal and are used to develop exit strategies and help establish the price a buyer will be willing to pay. Lenders also use pro formas to help determine their lending parameters. Since there is a tendency for buyers to be optimistic about the operational improvements they can make once they are in control of the property, pro formas are often tilted toward the best-case scenario.
Pro formas are usually prepared once during the property acquisition and then quickly forgotten or ignored. In contrast, operating budgets are financial plans that both guide your ongoing activities and give you a benchmark to assess your performance.
It’s important to remember that buying single-family rental (SFR) homes, along with all other types of investment real estate, is much more involved than buying other asset classes. If you buy stock, collectibles, art or commodities, you decide when to buy and when to sell, and the market determines your return without any further action from you.
An SFR, however, is an active business enterprise (even though the IRS considers it to be a passive investment for tax purposes). The business owner (investor) has a great degree of control over the revenues, expenses and return on investment (ROI), and that’s where the operating budget will help.
When preparing the revenue budget for an SFR, it’s important to know what the current market is and to plan for some lost revenue due to future vacancy and marketing costs. Lucky is the SFR owner who has long-term renters who stay for years and happily pay annual increases in rent. It is safer to plan on at least one week of vacancy each year as the property is turned from old resident to new, but in reality, that week could turn into several weeks of a vacant home with no rental revenue.
Just as manufacturers and retailers have “costs of goods sold” that reduce revenue available to pay for operating costs, landlords have the equivalent on rental properties. These costs include marketing costs to find prospective renters, and if you’re working with a property management company, there might be an increased cost or commission for them to fill the vacancy.
There are several areas of expense to take into consideration on your budget: normal operations, turnover costs, minor repairs and capital expenditures. Normal operations should be relatively easy to accurately budget. You should be able to determine what your management fees, gardening, utilities, etc. will cost you with little variance. You might be able to save a few dollars by switching vendors, and you can build that plan into your budget. But have you considered potential costs such as increased usage charges from the water company (in addition to repair costs) if your pool or irrigation springs a leak?
There are almost always costs associated with turnover from one renter to the next. If the previous renter caused damage, you might be able to recoup some or all the cost from their security deposit (you do collect a security deposit, don’t you?), but you cannot recoup the costs for normal wear and tear. Every few years you might need to pay for items such as painting and flooring, and you should plan for that in your budgets as turnover cost.
The two areas that trip up many SFR owners involve not planning (and budgeting) for the unexpected. Minor repairs are things that are unexpected and unwanted, but can be absorbed out of cash flow. Minor electrical or plumbing repairs not caused by tenant negligence would also fall into this category. Everybody has their own threshold, but typically this category would be for things costing less than $1,000.
The budget area often neglected, especially by new investors, is capital expenditures, frequently referred to as CapEx. Some CapEx can be planned for, such as making improvements to upgrade a property so you can collect more rent and increase the value, or replacing a roof after it exceeds its useful life. Other CapEx are surprises that cannot easily be anticipated.
If you have plenty of income or cash flow from other sources, while it is still is a good idea to budget for it, you might not be as concerned about funding a major repair costing several thousand dollars. Many new investors are living rent check to rent check, though, and budgeting and actually setting aside some money each month for the CapEx repairs can make the difference between a successful investment and a money pit.
One strategy is to develop a separate CapEx budget outlining the lifespan and costs of items you can identify, such as roof, HVAC, cabinets, driveway, water heater, etc. For example, if the HVAC unit for the property costs $4,000 to replace and has an expected life of 20 years, the cost would be $200 per year or $16.67 per month. Do that for each item, and you can build your CapEx budget, but it’s also important to consider the remaining lifespan. In the HVAC example above, if you’re already 10 years into the 20-year lifespan, you’d need to double your annual CapEx budget allocation in order to have the full amount available when it’s time to replace it in 10 years.
You can use a CapEx budget to be aware of what you might need to spend down the road, or you can use it to create a separate bank account and physically deposit the CAPeX budget amount each month.
A good budget that includes a CapEx budget can help you better run your properties, plan for the future and determine profitable exit strategies.