What is Real Estate Cash Flow?
In Real Estate investing there is a name for the difference between rental property income (rent) and liabilities (mortgage, vacancies, taxes, etc.) and that is Cash Flow. Cash flow is what almost all real estate investors strive for and will make up what money you can expect to receive at the end of each month from your rentals.
A property can have positive cash flow, where income exceeds expenses or negative cash flow, where income is less than expenses.
Ideally your real estate properties produce positive cash flow as it increases your monthly income and can help fund any unexpected expenses like burst pipes, torn up carpets, etc.
Real Estate cash flow is only one of the four ways investors make money with real estate alongside appreciation, mortgage pay down and depreciation. Calculating these 4 things can help answer the question, is real estate a good investment?
How to Calculate Rental Property Cash Flow
Calculating a rental property’s cash flow is as easy as 1,2,3,4.
- Determine the gross income from the property.
- Deduct all expenses relating to the property.
- Deduct debt services.
- The difference is the property’s cash flow.
Gross Rental Income
Gross rental income of a rental property involves adding up all the income sources of your real estate investment.
Some properties will only have one source of income, rent.
While others might also generate income from laundry fees, pet fees, late fees, etc. Adding all of these up will give you your gross rental income.
Real Estate Expenses
Expenses vary greatly from property to property but being as accurate as you can when adding them all up will add to your overall confidence level for the cash flow total.
You can either use the seller’s expenses or your own estimates to figure this out.
Some of the most common rental property expenses include:
- Vacancy rate (A good rule of thumb is 5% of monthly rent)
- Property taxes
- Property management
- Private Mortgage Insurance (If down payment was less than 20%)
- Utility expenses (water, electric, gas, trash, and sewer)
- Maintenance Reserve(repairs and upgrades over time)
- Other miscellaneous fees
Subtracting the property expenses from the gross income provides you with a property net operating income (NOI) or the cash flow from operations. NOI does not account for any debt payment you might have to make like a mortgage for example.
If you do have a loan payment, which you most likely do be sure to subtract that as well from the gross rental income to get your final cash flow number.
Gross Income – Expenses – Debt Payments = Cash Flow
*If you’re interested in starting real estate investing but have little capital to work with, I have a guide on how to invest in real estate with no money and bad credit.
Cash Flow Calculation Example
Here’s a great example of a duplex I found that I was going to owner occupy. Owner Occupying means you get a normal 30 year fixed rate mortgage and live in one of the units while still renting out the other. This is great for people getting started in real estate investing. If you don’t have any capital to get started you might want to consider investing in real estate with no money, it even works if you have bed credit as well.
Here is the fair market value for the home. You can see the purchase price, down payment, and the loan terms.
Here is the rental income. Unit A rents for $750 and unit B rents for $625 but since I would be owner occupying, I would live in that unit and therefore collect no rent from it.
Here are all the expenses including property taxes, insurance, PMI and a maintenance reserve for any unexpected repairs.
After calculating all my expenses the monthly cash flow comes out to be -$103.25. Why is this good? Well for the same down payment I could’ve used to buy a single family property I now could own a duplex, rent one unit out and live there for only $103 a month. Not too shabby for my first year.
*This means next year, when I would’ve moved out and rented both units I’d have a cash flow somewhere around $500/mo.
Now comes down to the 3 main ways to make money with real estate. And now you’ll see why cashflow isn’t everything. Thanks to my tenant living there he paid $1,578 of my mortgage principal that year.
Thanks to leverage and being able to own a property with only a 15% down payment, I got to benefit from the sweet 3% appreciation, not on my investment but the VALUE of the home which is $130,000. This means by owning the place I made $3,660 in appreciation. And even with the -$1,239 in cash flow that year I made $3,999 on my $21,300 investment which is a 18.77% ROI. (And I lived for almost free)
Oh.. and if I purchases the duplex as an investment and didn’t owner occupy.. here are the numbers. $10,822 return on a $21,300 investment equaling a 50.81% ROI. Basically doubling my money every 2 years!
The 1% Rule
With so many real estate investments to analyze how can you cut through the crap and bad rentals? You use the 1% rule.
A good baseline to determine if a rental property has god cash flow is if the monthly gross income is at least 1% of the value of the property.
This means, if a duplex is worth $200,000 you would hope for the total gross income to be at least $2,000 a month.
Some people think that’s still too low and opt for the 2% rule! Same concept but gross income is 2% of the price.
The rule of thumb however is just that…. a rule of thumb. In some real estate markets following this rule just simply won’t be possible. This is why you can’t just focus on cash flow. Remember there are 4 things that help an investor build wealth with real estate.
This is why some investors instead use Cap rate to determine a rental properties potential.
What Is Capitalization Rate? (Cap rate)
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.
Capitalization Rate Formula
Capitalization Rate = Net Operating Income / Current Market Value
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