The primary aim of investing in real estate is to acquire properties that will give you adequate rental property 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.
At the same time, it’s also essential for you to understand how to calculate cash flow for your rental property. Knowledge of this concept will help you make informed rental property decisions and improve your financial education.
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 (i.e., profit) remains for the investor after all the expenditures.
On the flip side, a negative cash flow signifies that rental expenses exceed rental income, while neutral cash flow occurs when rental income is the same amount as the expenditure. Investors, particularly those interested in wealth management and estate planning, often seek properties that have positive cash flow.
At the end of the day, different investors have different strategies and can stomach different levels of risk. Although it’s hard to definitively answer this question, a property that can generate at least 8 percent ROI is probably worth pursuing for real estate investors.
That said, some investors may be willing to invest in properties that generate less (e.g., if they’re buying a lot of units). On the other hand, some investors may be more selective and only interested in properties that can return 10 percent, 12 percent, or even 15 percent.
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 payments. In addition to the rental income, commercial properties may have other income sources including late fees, laundry fees, product sales, and pet fees, among other things. All of these make up the gross income.
Expenses involve all of the costs relating to the rental property. They also vary depending on whether the property is residential or commercial. Generally speaking, residential properties may have more expenses than commercial properties.
“For many investors, expense management is the cornerstone to good cash flow,” 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.”
Adding all of the following items up will give you a rough estimate of the expenses for the rental property:
In most cases, you may obtain the amount of these expenses from the seller. If not, you can do a rough estimate where you incorporate your own assumptions.
With so much on the line, it’s worth consulting a professional. After all, unrealistic assumptions may produce an inaccurate cash flow calculation. When you subtract total expenses from gross income, you get 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, and water heaters are all expenses that aren’t cheap.
Also, investors need to understand the way taxes affect cash flow. When factoring in depreciation, that paper expense may be able to provide a tax write-off. And, if there are losses on the property, you may equally be able to reduce your tax liability depending on your participation and whether you are above or below $150,000 in gross income. Unless you’re an accountant yourself, you will likely want to consult with your CPA to understand how this will affect your specific tax situation.
Keep in mind that NOI does not account for debt services, and it is common in commercial rental properties; NOI is only the same as cash flow when there are no financing expenses.
For investors that borrow money to finance rental properties, it’s necessary to calculate cash flow after financing. This will give you the exact cash flow—or income left over after all expenses are accounted for.
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: the 50 percent rule and the 1 percent rule.
The 50 percent rule states that a reasonable estimate is that your operating expenses will be 50 percent of your rental income. That is, if the rental income is $10,000, estimate that $5,000 will go toward operating expenses. Note that these operational expenses do not include mortgage payments. The 50 percent rule is only an assumption that awaits verification.
The 1 percent rule states that a rental property can only be profitable when monthly rental income is at least 1 percent of the purchase price. In other words, if the purchase price is $50,000, the total monthly rent should be at least $500.
With the 1 percent rule, you’ll know whether the monthly rent will be greater than the mortgage payment every month. It will also help you eliminate rental properties that might be money pits.
As you look to the future, be mindful of how rent prices might increase in local markets and the trends in vacancy rates. That may help you have a clearer estimate of your property’s value—and whether it makes sense to invest in the first place.
Smart real estate investors aim to acquire properties that will generate adequate cash flow. After all, a good cash flow signifies that the investment may be profitable.
At the end of the day, investors must understand the concept of cash flow before investing in any property. By understanding cash flow, you will make an informed decision when investing in properties. In the event you encounter issues while trying to determine the cash flow of a property, never forget that you can involve the services of professionals. The right financial advisor can help you determine a rental property’s likely cash flow, helping you make smarter investing decisions.
If you like stories like these, subscribe to our blog and get them sent directly to your inbox.
EP Wealth Advisors (“EPWA”) makes no representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented in this report. EPWA has used its best efforts to verify data included in this report. The information presented was obtained from sources deemed to be reliable. However, EPWA cannot guarantee the accuracy or completeness of the information offered. All expressions of opinion are subject to change without notice.
Information presented is general in nature and should not be viewed as a comprehensive analysis of the topics discussed. It is intended to serve as a tool containing general information that should assist you in the development of subsequent discussions with the appropriate professionals. Content does not involve the rendering of personalized investment advice nor is it intended to supplement professional individualized advice. Always consult a tax and legal professional prior to implementing any of the strategies referenced here.
Hiring or working with an investment advisor or financial planner and/or establishing a financial plan do not guarantee investment success, and do not ensure that a client or prospective client will experience a higher level of performance or results. All investment and financial planning strategies are subject to profit or loss. The risk of investment loss can never be eliminated.
The EP Wealth Advisors financial planning process starts with the relationship between you and your financial advisor. How do you value a financial coach? Developing a partnership that ensures we understand your goals lets us help you prioritize and organize your financial decisions—so you can achieve peace of mind and live your life.
Wealth management tips and news for all people