How to Create a Budget for Your Rental Property
Budgeting is an important part of any business, but many rental property owners struggle when it comes to the budget. One of the most-asked questions from new landlords is “How do I create an accurate budget for my rental property?” Even experienced rental property investors will struggle if they don’t account for expenditures accurately.
After all, budgets aren’t just back-office busywork. Real estate investors use budgets to determine whether a property is worth acquiring and what the potential profits will be. And property owners need budgets to evaluate their businesses’ performance. Knowing how to budget and plan for costs will save you money and stress in the long run. So, we’ve created an eight-step process to help you create, maintain, and use a budget effectively for your rental property business.
Eight-Step Budget Process
1. Pick Your Budgeting Tools.
A budget is a projection of your income and expenses. Sure, you can jot a few notes down on a napkin or notepad when you’re reviewing a property. But to build a budget that helps your business in the long run, you’ll need some tools.
Excel spreadsheets allow you to use or create templates so you can compare your statements. Some accounting software platforms have built-in budgeting features or will allow you to export reports to work on your budget elsewhere. If you prefer to use an app to keep yourself organized, free or paid options like YNAB, EveryDollar, and Empower offer account syncing, expense tracking, and goal setting.
The important thing is to find the tool that works best for you. If you don’t have time to learn how to use a new app or template, you’re less likely to keep up with your budget. A budget is a living document, though, and to get the most out of it, you’ll need to work with it often. So choose the platform you’re most comfortable with.
2. Calculate Your Expected Monthly Rent.
Projecting your revenue is a critical step that can trip up both newcomers and experienced investors. Maybe you’re expanding your portfolio in a new market. Or perhaps you’re a first-time landlord. Either way, get some advice before you set your revenue projections.
Some real estate agents specialize in working with rental property investors. These agents have a better grasp of what investors are looking for in a property—including the metrics you’re interested in. A local agent will have a handle on past operating expenses for potential properties and can advise you on potential rents.
Local property management and investment groups are also great resources for advice on local market conditions and rent rates.
With a previously rented property, look at the last few profit and loss reports. If the rent amount is still appropriate for the property and market, use it for your projections.
3. Estimate the Costs.
To make your budget as helpful as possible, think about all of your spending—not just the property-related outlays but your business expenditures as well. List the type of costs and the estimated price tags.
Estimating expenditures can be daunting, especially for maintenance or operating costs. Fannie Mae suggests allocating up to 4% of the property’s annual rent as your maintenance budget, although some experts advise 10%–15%. If you need help establishing a baseline for your estimates, try one of these methods.
The 1% Formula
With this approach, owners expect annual maintenance costs to equal 1% of the property’s purchase price.
property purchase price × 1% = annual maintenance baseline
The Square-Footage Formula
To help estimate your annual maintenance costs, budget a minimum of $1.00 per square foot annually.
square footage × $1.00 = minimum maintenance budget
The 50% Rule
This method proposes that the property’s normal operating costs should be about 50% of the gross rental income.
gross rental income × 50% = normal operating costs
Note that these methods don’t account for the age of the buildings or the current conditions of the property’s critical systems (plumbing, electrical, HVAC, etc.). It’s best to use these approaches as a starting point, then make modifications based on a property’s details.
4. Categorize Your Costs.
Real estate investments come with a lot of costs—just look at the list you compiled in step 3. Categorizing your expenditures helps reduce overwhelm and ensures that your list is complete. Divide your business’s costs into four major categories, then add subcategories to help you account for as many outlays as possible.
Acquisition Costs
When you’re considering a new property, make sure your budget projections include these fees:
• Appraisal fees
• Home inspection fees
• Loan and closing costs
• Real estate taxes
• Seller costs, such as back property taxes, sales commissions, or outstanding repair bills, assumed by the buyer
• Survey costs
• Title insurance
• Transfer taxes
• Utility installation fees
Leasing Costs
Advertising, screening potential tenants, and evicting bad tenants all add up. Make sure your budget accounts for leasing costs, like these:
• Marketing
You may pay for yard signs, professional photography, enticing listing copy, or website and social media ads.
• Eviction fees
These include charges for serving and filing notices, fees for the lawyers and sheriff, and court costs.
• Screening costs
Landlords screen an average of two tenants per vacancy. Credit checks run from $30 to $50 per check. However, most online screening services have the option to require the applicant to pay for the application or screening fees, background checks, credit reports, and eviction history.
If you work with a broker to find your tenants, remember to account for their fees as well.
• Renewal fees
When tenants renew their leases for your units, real estate agents or property managers charge a fee. If it’s a percentage-based cost, you’ll usually pay between 25% and 75% of the total rent. Flat rates range from $250 to $500.
Operating Costs
Divide your operating expenditures into two subcategories: fixed and variable.
Fixed Operating Costs
This category is for the stable monthly costs related directly to operating your investment property. Make sure your budget accounts for these fees:
• HOA dues or condo fees
• Homeowners’, landlords’, and other insurance payments
• Mortgage or loan payments
• Property management fees
• Property taxes
Variable Operating Costs
Variable costs change from month to month. The amount may fluctuate, or the payment frequency might be irregular. Use this category to capture inconsistent or seasonal expenses that are easy to overlook.
• Service contracts for pest control, HVAC inspections, etc.
• Lawn service and equipment maintenance, like mower tune-ups and fuel
• Seasonal maintenance, like tree trimming, gutter cleaning, and snow removal
• Utilities, like trash, recycling, electricity, water, sewer, heating oil, or gas
• Pool cleaning, chemicals, and maintenance
• Supplies, such as smoke detector batteries, light bulbs, HVAC filters, and janitorial items
Your budget for variable costs should also account for vacancies, emergencies, and capital expenditures. Building these into your budget now can save you stress and headaches later.
Owner Costs
This category is where you account for the costs of running your real estate investment business.
• Continuing education expenses, like conference or membership fees
• Dues and subscriptions for real estate publications or reports
• Annual registration fees for your LLC
• Office supplies
• Professional fees, such as legal or accountant costs
• Business phone plans
• Travel costs to work on the property or acquire new properties
• Philanthropy, like charitable contributions from the business or gifts for tenants, contractors, or employees
5. Determine the Gross Profit.
Once the bones of your budget are in place, you need to figure out if you’re operating at a profit or loss. The gross profit calculation gives you a quick estimate.
gross revenue − cost of goods sold = gross profit
In this formula, only include costs directly related to the rental unit. Leave out the mortgage, acquisition, and leasing costs for now. Remember, this is just a rough indicator of your property’s profitability.
But when you need a more detailed estimate, use a pro forma budget.
Pro Forma Budget
This budget calculation helps buyers and sellers project the potential internal rate of return (IRR) of a rental property and get the best possible purchase price. To create a proforma budget, you need to use some of your estimates.
Use this example as a template for your pro forma budget.
Property price = $200,000
Projected monthly gross rental income = $2,000
Vacancy loss (5%) = $100
Effective gross income = $1,900
Repairs (5%) = $100
Property management (7%) = $140
Other operating expenses (utilities, property tax, etc.) = $400
Projected monthly cash flow or net operating income = $1,260
Several metrics depend on the pro forma net operating income and cash flow, so they need to be as accurate as possible. Your cap rate, cash on cash return, and return on investment formulas all start with this calculation.
6. Determine Your Net Profit
To see what funds your business will have left at the end of the month, you need to calculate the net profit. Use the last figure from your pro forma budget and your mortgage for this formula.
net operating income − mortgage expense = net profit
That’s your before-tax cash flow. Use this measurement as an indicator of whether your income property is operating successfully. If you’re left with a profit at the end of the month, that’s great!
But it’s normal to have a loss for the first few months with a new rental property. The leasing fees, capital investments, and repairs can strain your budget, but those expenditures should decrease during the first year.
However, if the estimated expenses consistently overshoot the projected revenue, it may be time to make significant changes or sell the property.
7. Allocate the Net Profit
After you calculate your net profit, it’s time to divide up the funds. Many property owners split their profits between four categories.
• Taxes
Consider setting up a separate savings account for taxes to make sure you don’t spend those funds. Your tax preparer can help you estimate your taxes so you know how much to set aside.
• Emergency Fund
If you chose not to include a savings line in your budget, this is another chance to build your cash reserve. Many small business owners set aside three to six months’ operating expenses in an emergency fund. See our full discussion on cash reserves for rental properties to learn more.
• Planned Spending
This is a savings fund with a specific purpose. Maybe your property will need a new roof, appliance, renovation, or upgrade soon. Setting money aside for that expenditure each month will help you cover the cost later without going into debt.
• Owner Paycheck
The remaining funds are your paycheck!
8. Review Your Budget Regularly
Finally, review your budget each month, at minimum. Make this part of your regular accounting workflow, so you can monitor your expenditures and make adjustments in real time. If you’re over one budget line this month, see how you can offset the overage next month. Knowing your numbers and cash flow situation can help reduce stress. Plus, by actively monitoring your budget, you’ll have a better understanding of your business and more control over your spending.
Takeaways
Budgets help real estate investors at each stage. Buyers use budgets to determine the potential profitability of a property. Property owners need budgets to evaluate the performance of their current units. And budgets also act as indicators so investors know when it’s time to sell a property. Knowing how to budget and plan for expenditures gives you more control over your finances and a better understanding of your business. Get started today with REI Hub’s eight-step budget process for your rental property business!
