If you follow this blog for a while, you know that last month we have closed down the deal on our first rental property. Having an extra investment real estate is always exciting. However, you should always stay with two feet on the ground, especially when deciding to make such a big investment. There are many ways to calculate how good a rental property investment is. Unfortunately each method have their own strength and weaknesses. In this article I’m going to explain how to calculate cash on cash return based on our specific example.
In order to calculate your cash on cash return you need two figures:
- the actual cash you invested in buying the property
- the annual cash flow you can get out of the property
First of all, you should not underestimate the amount that you need to put into buying a rental property. In a previous article I have already described what kind of costs can you expect when you buy an investment real estate in the Netherlands. In our specific example the final costs were EUR 146,972.21 so this is the amount we are going to use. Now we only need to get the other amount.
Annual Cash Flow
In order to calculate the annual cash flow, you need to have your annual income and deduct from this amount the annual expenses.
Calculating the annual income is the easy part. Your typical income would be the rental fee you charge. Fortunately we were able to find a tenant pretty fast. They have already moved in and we are charging them EUR 850 per month. So we’re going to multiply this amount with 12 months and we get EUR 10,200 gross rental income per year.
As always, calculating the expenses is the hardest part. Not only because it can be easy to forget about certain expenses, but others are simply unknown for certain and you need to estimate these. Let’s see the possible expenses in our specific example:
In the Netherlands you can calculate with property tax, water tax and sewage tax. For our rental property these are currently adding up to EUR 234.46 per year.
2. HOA Fees
If you buy an apartment, you must calculate with home owners association (HOA, or in the Netherlands VVE) fees. This will represent a great part of your annual expenses, so you need to be careful here during the selection. We pay EUR 100 per month, or EUR 1,200 per year as HOA fees for our rental apartment.
3. Maintenance Costs
HOA fees would cover any outside maintenance, but not inside ones. If something breaks within the property, you would like to redecorate certain things after a tenant moves out etc., you would need to pay for such costs as a landlord. In most of the months you would not have such fees, but every once in a while these might ad up to a significant amount. You would really need to kind of guesstimate the annual maintenance costs. I personally add EUR 1,000 per year for ourselves as maintenance fees. Let’s see in a year or two how optimistic or pessimistic this amount was…
4. Property Management
In order to be able to get your rental property taxed as an investment (which is more tax advantageous in the Netherlands), you would need to hire a property management company. These guys also take a lot of administrative burden off your shoulders for the price you pay. They would typically provide you with a rental agreement, be a first point of contact with the tenant in case of any issues, make sure that the rental fees are paid on time etc. Their typical monthly fee is 5% of the monthly rental fee plus VAT (at least this is how much we pay). In our case we are talking about EUR 617.16 (EUR 850*5%*1.21VAT*12) per year.
In addition, they charge a one off fee for assisting during the tenant selection process (advertising, background check etc.). The cost for this is typically one month rental fee plus VAT. As (hopefully) we won’t need to find a new tenant every year, I calculate with a 2 year turnover. This translates to a yearly cost of EUR 850/2*1.21 = EUR 514.25.
Based on the above, the total annual property management fees would be EUR 1,131.41.
In a perfect world our apartment would be rented out continuously. However, I am pretty sure it won’t be the case. We need to calculate with vacancy in order to get to a more reasonable end result. The problem is that you need to estimate this amount as you can never know the vacancy rate in advance. My assumption is there will be a two years tenant turnover and in each case it will take 1 month to do some basic renovation and find a new tenant. This means a yearly cost of EUR 425.
This can be a big expense. In our case, we have increased the mortgage on our primary residence. This did not only mean that we have an extra mortgage, but as our home equity line of credit got over 85%, our monthly mortgage payment has increased by EUR 5,457 per year.
This amount includes both interest and principal. Now you might argue that the principal amount is not a real expense, but since we are talking about cash on cash return, I rather include it.
Total Annual Expenses
Summarizing the above, the total annual expenses are adding up to EUR 9,447.87.
If we deduct the above amount from the annual income, we end up with EUR 752.13. This will be our annual cash flow.
Cash on Cash Return
In order to calculate the cash on cash return, you need to divide the annual cash flow by the actual cash invested (without the mortgage). In our case, we have invested EUR 49,972.21. Therefore, our annual cash on cash return is 1.51%.
This is a pretty low return, so the question must be raised: Can we do something about it?
Absolutely! Once our outstanding mortgage falls below 85% of the house value again, the interest rate will decrease. This is why in the beginning we want to put as many extra payments against the mortgage as possible. Based on my estimation, adding EUR 30,000 extra payment in total, in combination with some property price increase would do the trick.
Then, the yearly mortgage payments would decrease to EUR 2,928, which would increase the annual cash flow to EUR 3,281.13. The cash invested would increase to EU 79,972.21, which would give us a cash on cash return of 4.1%, which is a more reasonable number.
Readers, if you are also having an investment property, what is your cash on cash return?
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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on financial independence and early retirement