The primary aim of investing in real estate is to acquire properties that will give you adequate cash flow. A good cash flow typically signifies that your investment is profitable. For this reason, you need to know how the rental property can generate cash flow.
It is also essential for you to understand how to calculate cash flow for your rental property. Good knowledge of this concept will help you make informed rental property decisions.
Cash flow is the difference between the property's income and expenses. For rental properties, cash flow projection is the same as Pro Forma Cash Flow. It gives investors an overview of the cash flow for a specific duration in the future.
The result of this calculation can be positive, negative, or neutral. When there is positive cash flow, it means that the rental income is more than the expenses on the property. In this situation, money remains for the investor after all the expenditure.
A negative cash flow signifies that the rental expenses exceed the rental income, while neutral cash flow is one where the rental income is the same amount as the expenditure. Investors often seek properties that have positive cash flow.
Remember that cash flow is the difference between rental income and expenses.
Cash flow = Total income – Total expenses
So, to calculate cash flow, you need to:
Gross income – is the total amount of rent from all the rental units before any expenses or mortgage payment. In addition to the rental income, commercial properties may have other incomes such as late fees, laundry fees, product sales, pet fees, etc. All these make up the gross income.
Expenses – involves all the cost relating to the rental property. It also varies depending on whether the property is residential or commercial. Residential properties may have more expenses than commercial properties.
“For many investors, expense management is the cornerstone to good cashflow,” explains Bob Preston, President of North County Property Group. “Too often they see the income but forget that it means nothing unless the expenses stay lower.”
Expenses may include the vacancy rate (5% depending on the area), property taxes, advertising, property insurance, business licenses, property maintenance, utility expenses, property management, and other miscellaneous fees. A total of these will give you the expenses for the rental property.
You can obtain the amount for most of these expenses from the seller, or you do a rough estimate where you can incorporate your own assumptions. It is worth consulting a professional because unrealistic assumptions may produce an inaccurate cash flow calculation. When you subtract the total expenses from the gross income, what is left is the Net Operating Income (NOI) or Cash Flow from operations. Thinking ahead on the property, be sure to budget for regularly scheduled maintenance. New roofs, appliances, water heaters are all expenses and can be costly.
Also, investors should understand the way taxes affects cash flow. When factoring in depreciation, that paper expense may be able to provide a tax write-offs. And if there are losses on the property you may equally be able to affect your tax liability depending on your participation and if you are above or below $150k in gross income. You will want to consult with your CPA to understand how this will affect your specific tax situation.
The NOI does not account for debt services, and it is common in commercial rental properties. The NOI can only be the same as Cash Flow if there are no financing expenses.
For investors that borrow money to finance rental properties, it is necessary to calculate the Cash Flow after financing. This will give you the exact Cash Flow or income left after all expenses.
Cash Flow after financing = Cash Flow from operations/NOI – Financing Costs/Mortgage
There are two usual rules that you can use when you want to estimate the Cash Flow of a rental property before acquiring it. These are the 50% rule and the 1% rule.
The 50% rule states that you should estimate that your operating expenses will be 50% of your rental income. That is, if the rental income is $10,000, you should estimate that $5,000 will go for operating expenses. Note that these operational expenses do not include mortgage payments. The 50% rule is only an assumption that awaits verification.
The 1% rule states that for a rental property to be profitable, it must have at least 1% of the purchase price as it's monthly rental income. That is, if the purchase price is $50,000, the total monthly rent should be $500 or more.
With the 1% rule, you will be able to know whether the monthly rent will be greater than the mortgage payment every month. It will also help to narrow down on the properties that investors can choose.
As you look to the future, another thing to factor is the appreciation in rents in the local market and the trends in vacancy rates. That may help you have a clearer estimate of your property value.
Real estate investors aim at acquiring properties that will generate adequate cash flow. A good cash flow signifies that the investment may be profitable.
It is essential to understand the concept of cash flow before investing in any property. It will help you make informed decisions when investing in properties. If you encounter issues while trying to determine the cash flow of a property, you can involve the services of professionals.
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