Rules of thumb to help calculate an investment home's potential cash flow

By Tom Kelly
Saturday, August 28, 2010

Let's assume home values are down in the area where you like to vacation. Truth be told, you wouldn't mind retiring there one day.

If you bought an investment home now and rented it out, is there any way of knowing if it will appreciate? And is there a break-even formula to use when considering annual cash flow?

One of the better second-home rental formulas now used was developed by Christine Karpinski, author of "How to Rent Vacation Properties by Owner." Karpinski's definition of the break-even point is when all of the income (rent) from your vacation rental property is enough to pay all of the bills associated with ownership of the property. In other words, your vacation home should not cost you another dime after your down payment.

According to Karpinski, if your monthly mortgage payment is equal to -- or less than -- one peak-season week rental rate, and if you rent for 17 weeks, then you should be able to achieve positive cash flow.

Consider a property that rents "by owner" (without a real estate management company) for $2,000 a week during the peak season with a monthly mortgage payment of $2,000. There are 12 peak weeks, most or all of which are usually occupied. So 12 weeks rented equal one year's mortgage payments.

In addition, you'll need to rent it for five other weeks to pay for incidentals such as power, phone, association dues, minor maintenance, etc. If you handle the rental yourself and have 17 weeks booked (33 percent occupancy), you will have a break-even cash flow. Rent more, and you have positive cash flow, according to Karpinski, who serves as the director of the owner community at HomeAway.com.

When analysts look at stocks, they often focus on the price-earnings ratio as a measure of whether the stock is overvalued or undervalued. The higher the number (especially relative to the market as a whole or to historical averages), the more likely the stock is to decline in price over time.

Professor Edward Leamer at the University of California at Los Angeles proposed that real estate be considered in a similar light. In this case, though, the ratio is the price of the investment property to the annual rent it will earn. This calculation will give you a standard by which you can judge the relative potential for appreciation of different properties in different neighborhoods and even in different cities. In other words, it helps you make sound investment decisions by giving you a tool to measure alternative investments against each other. Here's how it works.

Suppose you're looking at a $255,000 property that will rent for $1,500 a month, or $18,000 a year. (We can assume there will be no vacancy, but you can figure in whatever you deem to be reasonable.)

You are also looking at a $120,000 property that will rent for $850 a month, or $10,200 annually.

The price-earning ratio for the first property is approximately 14 (255 divided by 18), and the second is approximately 12 (120 divided by 10.2). The second property appears to be a better candidate for appreciation because it has the lower price-earnings ratio.

For a truly effective comparison of the two properties, you need to make a second calculation. You need to look at the price-earning ratio average for both properties relative to those properties in the same neighborhood.


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