Setting Up A Basic Budget

As an investor running a profitable rental business, budgeting is everything. Owning a successful investment property requires making intelligent and intentional spending decisions to keep your expenses aligned with your income. Using strategies to stay proactive about accounting and budgeting is critical for the long-term success of any rental business.

In this article, we’ll take you through the steps to create a very basic budget for your new rental business. From tracking income and expenses to saving reserves and allocating profits, this guide will hopefully help you take your first plunge into rental finances with confidence.

Why Is Budgeting Important for Your Rental Property?

It goes without saying that effective budgeting can make or break your real estate business. Starting a rental business requires a substantial initial investment. Purchasing properties, marketing, flipping, and maintenance are all steps that you have to take before you can start renting your properties and generating a return on your investment.

If you aren’t careful about how much money you’re dedicating to your real estate investments, you may not make enough to get a sufficient return on your investment. Budgeting involves thinking critically about every facet of both income and expenses and makes it much more likely that you’ll make informed and effective decisions about spending.

However, even once your rental business has been established and your properties are occupied by tenants who reliably pay rent, there are still unexpected costs. An unexpected maintenance issue, vacancy, or eviction, for instance, may require you to dip into your emergency fund or reserves. If you’ve been a responsible budgeter, an unexpected situation like this won’t break the bank – instead, you’ll be well-prepared for it.

Gathering Financial Information

Before you can start your budget, there is certain information you’ll need on hand. Having a clear picture of your financial situation is the backbone of effective budgeting. Gathering comprehensive financial information will provide you with the data needed to make informed decisions and set realistic financial goals.

Collect Past Financial Data on Your Rental Properties

Collecting past financial data on your rental properties is essential for creating a comprehensive financial picture of your business. This data will help you understand your income, expenses, and cash flow, and make informed decisions about your business.

If you’re starting from scratch, you’ll need any data related to your property acquisition and market research, including:

• The property purchase price
• Mortgage loan details
• Closing costs
• Any upfront costs (e.g., repairs, renovations)
• Approximate market rent
• Estimates of major recurring expenses (e.g., property taxes, HOA fees, property management, etc.)

If your properties are already rented and established, also include the following financial data:

• All financial statements, including income statements, balance sheets, and cash flow statements
• Data on rental income for the past 1-5 years
• Data on rental expenses for the past 1-5 years (e.g., property taxes, property management fees, maintenance costs, and other expenses)
• Data on prior vacancies, evictions, and general market trends in the past 5-10 years

You’ll want to review your past financial performance to identify trends and areas for improvement. You can use this data to create a baseline for your financial projections and new budget.

By collecting past financial data, you’ll be able to create a comprehensive financial picture of your rental property business and make informed decisions to drive growth and profitability.

Setting Up a Basic Budget for Your Rentals

We’ve mentioned two main parts of a basic budget previously in this article: income and expenses. These are important starting points to consider as you set up a budget and might be category headings on a balance sheet for rental property. Reserves constitute another line item you’ll want to allocate, set aside, and track. Let’s take a look at what each of these components entail and how you can go about calculating them for your business.

1. Calculate Your Expenses

The expenses included in your budget will depend largely on where you are in the stage of building your rental business. For instance, if you’re just getting started, it’s likely that you will have a lot of initial maintenance costs involved in preparing your properties for tenants, especially if you’re buying a fixer upper. However, no matter where you are in the process, some maintenance costs are to be expected. Worn down floors may need to be replaced, paint will need refreshed, and appliances may fail or break. A popular guideline is the 1% rule, which advocates setting aside at least 1% of the property’s value for regular maintenance costs.

Regular maintenance and upkeep costs are a type of operating expense, a specific IRS category for regular expenses required for normal business operations.

Other Operating Expenses

In addition to maintenance, other operating expenses include:

• Marketing
• Tenant screening
• Leasing fees
• HOA dues
• Property management fees (e.g., Wages or salaries paid to property managers or the premium for your property management software).
• Landscaping
• Pest control
• Utilities
• Insurance
• Property taxes

Experts recommend using the 50% rule when it comes to total regular operating expenses, meaning that the cost of these operational costs should total about 50% of gross rental income in a healthy budget.

Non-Operating Expenses

Your largest non-operating expense is undoubtedly any mortgage or loan payments related to the property. Unless you were able to put forward the entire cost of the property when you purchased it, your mortgage will be a regular and considerable payment that will take up the most room on your budget. However, because it is a regular and repeating payment, it can be anticipated and easily incorporated into any rental property budget template.

Other non-operating expenses include investor income taxes, depreciation, and capital expenses, meaning any money set aside for major renovations or improvements outside of regular maintenance.

Note: While annual depreciation expense cannot be immediately deducted, it does reduce taxable income by allowing for yearly depreciation deductions. Depending on the method used, the taxable net income for a rental property will be reduced until the property is sold.

2. Calculate Your Income

The largest source of income for any landlord or property manager is regular rent payments. The amount that you end up charging for rent is entirely at your discretion, but we recommend closely considering your expenses and determining a rent price that will grant you an effective return on investment while staying competitive with the local rental market. Accurately determining your property value can help you set appropriate rent prices that reflect current market conditions as well.

As opposed to expenses, which can be much more variable and depend on circumstances outside of your control, income sources are generally more predictable and regular. This includes rent, but it also includes any additional fees you choose to charge for pets, parking, utilities, laundry, etc.

Your actual income may vary due to unexpected vacancies or evictions, which can sometimes occur due to irregular and unreliable rent payments. Budgets rely on being as predictable as possible, and to account for this, we recommend anticipating a 10% vacancy rate and adjusting your budget accordingly.

3. Calculate Reserves

Vacancies are just one example of unexpected expenses, which is why it is always a good practice to allocate some money in your budget to reserves. Tracking these reserves on your property balance sheet is crucial since they factor into your overall profit or loss.

A few types of reserve funds you will want to save in advance include:

1. Vacancy/tenant turnover reserves to cover the costs of turning over a unit.
2. Emergency reserves for unexpected expenses like evictions, legal fees, etc.
3. Replacement/CapEx reserves to replace capital assets over time and/or conduct large-scale renovations.

There are a few different strategies for determining how much of your money you should set aside for reserves. One strategy is to set aside six month’s rent per unit in your business, while another is to reserve a total of 10% of your monthly income (5% for vacancies and 5% for other capital improvements).

4. Calculate Your Net Operating Income and Cash Flow

Once expenses, income, and reserves have been estimated, real estate investors can estimate the profits they’re looking at for a given property or rental business.

Start by estimating your net operating income (NOI), which is your income after regular, monthly expenses are subtracted. This is your leftover cash available after the costs of maintaining your property are accounted for. For instance, let’s say you own a rental property and charge $1,700 rent to your tenant. if your annual income was $20,400 and your regular expenses totaled $8,000, you would calculate NOI like this:

Net Operating Income (NOI) = $20,400 – $8,000 = $12,400

Then, you’ll want to calculate your annual net cash flow by further subtracting your debt service. If your mortgage for the rental property above were $950 per month, your debt service for the whole year would total to $11,400. You would use that figure to calculate net cash flow:

Annual net cash flow = $12,400 – $11,400 = $1,000

Calculating an annual net cash flow will give you a larger picture of the likely sustainability of your business and will allow you to make necessary adjustments to ensure the success of your business. Using a net cash flow calculator will allow you to get these results quickly and easily. You can think of the result as an estimate of your gross profit, based on your rental income and accounting for direct expenses like property taxes, property management fees, and maintenance costs in addition to other factors that affect your rental property financial health, like debt and capital expenses.

Remember that these metrics exclude your reserves, so if you’re deducting monthly amounts of your income to build your reserves, be sure to incorporate that into your calculations.

5. Be A Proactive Budgeter

Once you’ve calculated your net cash flow, your budget is not quite complete. Instead, this calculation should help inform your decisions to adjust your spending and/or rent rates to make your budget more effective.

Where you have the flexibility to do so (every market is different), adjust your budget to allocate funds where you most need them and tighten them up in other areas. While there’s no true standard for a “good” cash flow, you can set your own goal to aim for.

Your individual situation will inform this process as well, of course. For example, you may be comfortable with a lower cash flow or profit margin if your property is located in a high appreciation area. Ultimately, your budget is a working document that should regularly be adjusted to fit your individual needs and context.

Remember also to keep good records of new expenses and incomes as they arrive, as diligent records will give you the clearest sense of the state of your business.

Conclusion

Making a good return on your investment is the bottom line of any real estate business, and for rental property owners, it has everything to do with effective budgeting. You can do this with pen and paper, in a spreadsheet, or using more advanced tools offered by rental accounting software like LedgRE.  Software can assist you in one of the most important jobs that you have as the owner of a real estate business.