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An essential concept aspiring landlords and real estate investors need to grasp before diving into rental real estate is how to calculate rental property cash flow. After all, cash flow is the lifeline of a rental real estate business. Luckily, calculating cash flow is easier than you might think.
Learn the process of calculating cash flow for a rental property so you can focus on acquiring investment properties with good cash flow while avoiding the properties that eat into your net profits.
What is cash flow?
In real estate, cash flow is the difference between a property's income and expenses including debts. Cash flow is used in properties that produce income, like rental real estate such as an apartment complex, single-family rental, duplex, or commercial building.
A property can have positive cash flow, where there is more income than expenses and financing costs, or negative cash flow, where the expenses and financing costs exceed the income and the landlord loses money each month.
Most real estate investors aim at owning rental property with positive cash flow. The more cash flow a property has, the better the return and the more income the real estate investor earns. Having higher cash flow also provides the landlord with a safety net for when unexpected expenses arise like a burst pipe, roof replacement, or new A/C or furnace. The more cash flow you have, the more you are able to sustain your business expenses, especially in economically challenging times.
How to calculate cash flow
Calculating a rental property's cash flow is a relatively simple process:
- Determine the gross income from the property.
- Deduct all expenses relating to the property.
- Subtract any debt service relating to the property.
- The difference is the property's cash flow.
The gross rental income of a property is the total income from all sources before any expenses or mortgage payments are made. Some properties, like a single-family rental, will only have one source of income, the rental income. But certain rental properties, especially commercial property, may have additional income streams like on-site laundry, late fees, pet fees, or product sales like boxes or moving supplies.
Expenses relating to a property will differ by the property type. Commercial properties that have net leases may have fewer expenses than a residential rental property that uses a gross lease.
Calculate what the property's expenses will be to maintain that specific property. You can use the seller's expenses or you can estimate to get a rough idea of the cash flow for the property. Expenses can include the:
Subtracting the property expenses from the gross income provides you with a property net operating income (NOI) or the cash flow from operations. NOI is frequently used in commercial real estate and does not account for debt service, which is any payments made to pay a debt like a mortgage payment or preferred return paid to private investors. It's the cash flow the property produces if there are no financing expenses.
If there is debt service, this can be subtracted after the expenses to provide the property's cash flow after financing.
Cash flow calculation in numbers
Let's look at an example of how to calculate rental property cash flow using real numbers for a fully occupied fourplex with on-site laundry. The seller is asking $350,000 for the property. The numbers below are on a monthly basis:
|Income from Laundry||$375|
|Vacancy Rate (10%)||-$400|
|Repairs & Maintenance (saving 10% of gross income)||$400|
|Property Management (their fee is 10% of gross income)||$400|
|Trash & Sewer||$300|
|NOI (net operating income)||$2,476|
|Debt Service (mortgage assuming 20% down at 6.5% interest for 30 years)||$1,769.79|
|Net Monthly Cash Flow||$706.21|
|Net Annual Cash Flow||$8,474.52|
The 1% rule
There are times when a property's expenses aren't available upfront. If you want to quickly analyze the property to determine whether it is a worthwhile investment to pursue further due diligence on, you can use the 1% rule. The 1% rule is a formula used in rental real estate to determine whether a property is likely to have positive cash flow.
The rule states the property's rental rate should be, at a minimum, 1% of the purchase price. So if a property is for sale for $200,000 it should produce a rental income of $2,000 a month or more. If it only has a rental income of $1,500 it wouldn't satisfy the rule. The higher the rental income in relation to the purchase price, the better the return.
The 1% rule is a general rule of thumb. There are certain real estate markets where this rule simply does not apply. If the rental property is in a city where real estate is expensive, a state with high property taxes, or an area that requires additional insurance for flood or hurricanes or has deferred maintenance that will require additional ongoing repairs, 1% of the purchase price may or may not provide positive cash flow.
This rule is not the final cash flow analysis; it's simply a quick tool to use to see if you want to pursue a property further.
How much rental cash flow should you aim to earn?
Every investor has different financial goals. Some are happy with an 8% return on investment (ROI) while others seek an ROI of 15% or more. There is no magic number that is the perfect or right amount of cash flow to earn. It's common, after reviewing your financial goals, to establish a minimum cash flow per door or a minimum return requirement. When you're evaluating properties, this can help guide you in eliminating any that do not meet your standards for investing.
Just make sure you are taking into consideration the time commitment you will be putting forth in evaluating, funding, closing, and managing the property. You want to set your target cash flow high enough to make your investments worthwhile but not so high that you are unable to find properties to invest in.
According to a popular saying in real estate investing, cash flow is king. Having sufficient cash flow is essential in keeping your real estate business afloat. Investing in rental properties with positive cash flow should be the goal for every investor, and the more cash flow you earn from each property, the bigger safety net you'll have, and the more income you can earn.
Finding a positive cash-flowing property isn't always easy, but if you know how to accurately calculate rental property cash flow, you can have peace of mind knowing you're evaluating properties carefully and increasing the likelihood of buying a worthwhile investment.
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