The ability to accurately calculate cash flow is the key to success for rental property investors.
A cash flow analysis will help you focus your time and energy on buying rental properties that generate solid monthly income while avoiding deals that could end up being a financial burden.
Regardless of if you are doing a traditional rental or an Airbnb investment, we recommend looking at the traditional rental rates as a baseline and a backup plan. Airbnb is a riskier investment than a traditional rental but can be much more profitable. However, situations like Covid or other unforeseen circumstances may require your to switch from Airbnb to a traditional rental, so if you would like to protect your investment as best as possible, understanding all of your exit strategies would be an advantage.
Defining cash flow.
As you might expect, cash flow it’s where the money goes in and out of your investment properties on an ongoing basis. Like most things that happen with real estate investing, different experts have their own opinion on how much rent to income ratio should be considered “good.”
Gross cash flow begins with the money earned from renting out a property, is reduced by deducting all of the operating expenses and debt obligations on that property, and ends up as net cash flow. This final figure may or may not be subject to taxes depending if it falls within tax brackets.
Higher cash flow levels help reduce investment risk because there is more money coming in from rental income that can be used for normal running costs and unforeseen expenses. A great example would be a broken water pipe during the winter, or if you had to replace your HVAC system unexpectedly.
What is Considered “Good Cash Flow”?
Nearly all real estate investors own rental property for the recurring cash flow it provides. However, not every investor is looking to make a quick profit on investment – they are simply interested in owning and managing their investments for long-term success. The more gross monthly income generated from rent payments or additional services such as pet rent or appliance rentals, the better off you’ll be because this means that your operating expenses will have less of an impact on bottom line profits at the end of each month.
With higher risk comes the chance for greater reward and it’s important to keep that in mind. As you’re analyzing properties, make sure you take into account areas with lower-income areas which can have higher cash flow potential well above average.
The best properties to buy are those that generate more income than expenses. This is called positive cash flow, and it’s one of the main things you should look for when considering your options. Negative cash flow means there isn’t enough money coming in to make up for all of the costs associated with running a property.
When deciding what type of rental market to invest in, consider how much revenue each potential investment generates versus its operating expense ratio down below as well as debt service coverage ratios on top.
How to Calculate Rental Property Cash Flow
To make your real estate investment pay off, you must accurately predict the cash flow of a property. This includes factors like income and expenses that come with owning rental properties. There are four steps to doing this:
- Estimate gross cash flow/income
- Forecast gross operating expenses
- Calculate NOI before financing
- Calculate net cash flow after debt service
Step #1: Estimate gross cash flow/income
Your gross cash flow includes all money that comes in throughout the year:
- Gross rental income = $12,000 annual rent
- Additional income = $1,000 from sources such as pet rent, appliance rent, and application fees
- Vacancy (assuming a 6.5% vacancy rate) = – $780 from tenant turnover
- Gross Cash Flow = $12,220
Cash flow can be found with the click of a button, just type in an address at Dynamic.RE and it will tell you what rental rates as well as the short-term rental annual revenue.
Step #2: Forecast gross operating expenses
Gross operating expenses are money that goes out each year as a cost of owning and operating a rental property. Some of the most common expenses include:
- Leasing fees = $500
- Property management fees = $1,040
- Maintenance costs = $360
- CapEx (capital expenditures) reserve contributions = $600
- Insurance = $1,200
- Property tax = $1,500
- Gross Operating Expenses = $5,200
Step #3: Calculate NOI before financing
Next, calculate your net operating income (NOI) by subtracting your gross income from your gross operating expenses:
NOI = Gross cash flow/income – Gross operating expenses
$12,220 Gross cash flow/income – $5,200 Gross operating expenses = $7,020 NOI
Step #4: Calculate net cash flow after debt service
Let’s assume a $100,000 purchase price on a rental property using a conservative down payment of $25,000 and financing the remaining $75,000.
With a conventional 30-year mortgage at a fixed interest rate of 4%, the monthly mortgage payment is $358 (P&I). Your annual net cash flow after debt service is:
$7,020 NOI – $4,296 Debt service ($358 monthly mortgage payment x 12 months) = $2,724 positive cash flow (or $238 in monthly cash flow)
Expenses to consider
You’re probably not alone if you can’t help but feel a sense of accomplishment when your first rental property starts to generate income. With all the costs that come with owning and operating an investment, it’s important to be aware of these before making any big decisions so you don’t get caught out by surprise later on down the line!
There are many exciting moments in real estate investing such as seeing cash flow pile up for months ahead – but one thing people often overlook is how much running and owning a rental adds up too. Whether there was an impulse buy or just jumping into things without thinking about possible complications, we want everyone else who owns rentals now knows what they missed before moving forward: every time money leaves due to maintenance work needed, or you have to put more cash into it for repair costs, etc. there is always a chance you could take out even more money than what the lease says because of unforeseen circumstances… so, if any repairs need to be done, factor in those numbers and include them in your overall budget!
While buying a rental will give results regardless, there are many ways to maximize its potential profit by reducing downtime and maintenance costs and managing the property to pay for itself with a little bit of money put up every month!
When adding up all expenditures, you may find out that your actual cash flow is lower than you thought. Here are is a list of potential expenses to consider:
- Vacancy expense (due to tenant turnover)
- Credit/bad debt expense (due to eviction)
- Leasing fees
- Property management fee
- Routine maintenance
- Utilities (water, sewer, trash, gas, etc.)
- Appliance replacement
- CapEx (capital expense) account funding
- Capital repairs such as new HVAC or roof
- HOA monthly dues
- HOA special assessment
- Property insurance
- Landlord insurance (additional liability coverage for rental property)
- Rental tax
- Business license
- Office expenses
- Payroll expense (for W-2 employees)
- Continuing education (books, seminars, investor groups, etc.)
- Travel expenses
Helpful Cash Calculations to Know
Three other common cash calculations used for a rental property are the 1% Rule, the 50% Rule, and Cash-on-Cash return. We’ll use our rental property to explain how each one works:
Gross monthly rent / Property value = 1% or more
The 1% Rule states that the monthly payments on an income property should be at least 1%. of the property’s value:
$1,000 gross monthly rent / $100,000 property value = .01 or 1%
Net cash flow = (Gross rent x 50%) – Mortgage P&I
The “50% Rule” states that a rental property’s net income should make up at least 50% of its gross profit, minus the monthly mortgage payment:
($12,000 gross annual rent x 50%) – $4,296 mortgage P&I = $1,704 per year
Cash-on-cash return = Net cash flow / Cash invested
The cash-on-cash return formula is a valuable way to measure the yield of an investment property. It compares your initial investment and all future income from that same amount back into what you are actually receiving in profit, or net cash flow.
The key thing about this equation is how it can be used for any type of real estate transaction: if you’re buying a rental house with money on loan; investing in shares through stocks investments; purchasing stock options as part of your portfolio strategy.
$2,724 net cash flow / $25,000 down payment = .109 or 10.9%
In order to generate passive income, it’s important for those who are looking for success in the long term that they invest wisely. There is a lot of potential available when choosing rental properties and there may be more than one type worth considering which will give you an idea as to what kind of real estate market you would like your investment property in.
Rental properties provide an excellent opportunity for generating passive incomes through lucrative areas with lower-income communities where cash flow rates can produce high returns on investments well above average at times too. It’s also wise before making any decisions about how much revenue each property generates or its operating expense ratio, debt service coverage ratios down below just so no chances are missed out by investing into something less profitable or not even feasible for the time being.
Stay tuned for more details about real estate investment properties and how you can start making money right away with the proven techniques from expert investors.