What Everybody Ought to Know About Cash Flow
March 30, 2007 by David Cowgill
Calculating potential cash flow is a very important step to take as a real estate investor before you commit yourself to the long-term of owning rental properties. How much rental income will it receive for each month if the property is rented? This question relates not only to the immediate level of income but also to longer-term investment feasibility.
For example, if you expect the property to grow in value only modestly, and for very little income coming in each month, is it really worth the risk? If you believe that your income from owning rental property will not be substantial, there might be other alternatives for investing your money.
The amount of rental income you project to receive is a good indicator of whether or not the property is a valuable investment. In some areas with high demand for rental units, monthly income can be significant, perhaps even exceeding your mortgage payments and other monthly costs to produce a nice positive cash flow each month. In turn where the market is relatively soft, the viability of real estate investing makes this idea much less attractive.
So how do you calculate if a property is going to cash flow positive? It all comes down to simple math. First begin by calculating the known costs of owning a property such as insurance, property taxes, utilities, property management fees (8-12%), unforeseen maintenance costs (usually 10%), and your monthly mortgage payment. Once you have that number you basically have your monthly operating or debt expense calculated.
Next you want to calculate all the money coming in which is essentially your rental income from each unit. The best way to do this is to ask the seller’s for an APOD (Annual Property Operating Data) which is an operating statement that conforms to standard real estate practice. This should include the current rent roll for each unit and the total income coming in.
In more cases than not, the sellers I’ve dealt with usually say the tenants are paying below market value and the rents have room to increase.
If that’s the case, then why haven’t the owners already increased the rents to make more money each month? The answers I’ve heard have varied but to be honest there’s no substitute for good dependable tenants even if they’re paying $50 less each month in market value rent. A change in ownership is also a good time to adjust the rents moderately especially if you’re bringing in new tenants.
Now take this data and lay it out in an Excel spreadsheet or even on a pad of paper to begin your math. After you subtract the fixed expenses from your net income, you’ll have a good idea how much money you’ll be able to pocket each month before you even buy the property. Please note, this worksheet you are putting together is an example only. While it allows no provision for the unexpected expense or for any period of vacancy, it also excludes the potential growth in real estate property value during the year which cannot be known of course. In other words, make sure you consider all factors besides these rough numbers.
The one mistake I made from buying my first property was making sure that it would be cash flow positive each month. It wasn’t and I was paying $100 out of pocket (which didn’t seem bad at the time) but it’s still a property I was betting the farm would increase in value. That gamble did not pay off and my Las Vegas property ended up being a loss and I sold it after only two years of holding. It was an expensive lesson and one I don’t want you to make as well. Bottom-line — do not purchase an investment property unless it is break even or cash flow positive. Trust me, it’s not worth it.
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