Anyone engaged in real estate investing – whether as a broker listing and marketing or real estate investor buying and selling – already know what importance that a rental property’s cash flow plays in any investment decision.
Often referred to as the “bottom line” that investors really pay for when they make their investment, cash flow alone has been known to make or break rental property deals by its favorable abundance (immediate or potential) or by the lack thereof.
Those less acquainted with investment real estate on the other hand aren’t expected to have had that experience, so it seemed like a good idea to help them understand the basic cash flow process. Namely, the necessary financial data to derive it, and the formulations required to compute it.
We’ll start with the basic concept of cash flow first and then walk you through the steps commonly used to make the computation. And for the record, we’ll be speaking primarily about cash flow before taxes.
What It Means
Cash flow is all of the cash inflows less all of the cash outflows generated by a rental income property during a given period of time. The money a landlord collects from rents is the inflow, and the money a landlord spends to keep the property in service is the outflow. The difference between these two amounts is our cash flow.
1. Gross Scheduled Income
This is the total amount of rental income that the property would generate were it totally occupied and contained no vacant units. In cases where there are vacant units, you would apply either a market rent or perhaps one of the property’s established rents. Just bear in mind that you’re computing the rental property’s gross “scheduled” (or potential) income so be sure that this amount reflects 100% occupancy.
2. Vacancy and Credit Loss
This is where we adjust for losses due to unoccupied space or nonpayment of rent by the tenants. Typically shown as a percentage of the gross scheduled income, it may be what the actual vacancy rate is at the time of your real estate analysis or perhaps an average percentage of what the property has encountered over the past several years. To be on the safe side, though, always include some percentage for vacancy even when there are none at the time you’re evaluating the property.
3. Other Income
This is rent the landlord might be collecting in addition to the dwelling units such as a coin-operated laundry facility, storage units, or garages.
4. Gross Operating Income
Unlike the potential income illustrated above, this represents the actual amount that the landlord can expect to collect.
Gross Scheduled Income less Vacancy and Credit Loss plus Other Income equals Gross Operating Income.
1. Operating Expenses
These are the expenses incurred to maintain and keep an investment property operational and in service. In other words, these are the costs that are necessary to keep the revenue stream flowing.
This would include costs such as real estate property taxes, insurance, water/sewer, trash, electric, maintenance and repair, landscaping, property management, pest control, snow removal, legal fees and so forth.
Operating expenses do not include federal or state income taxes, mortgage payments, depreciation or capital improvements (e.g., a new roof or siding). These only become a factor when the owner’s tax liability is taken into account and you want to compute cash flow after taxes.
2. Debt Service
As it sounds, this is the amount paid to service the debt (i.e., the mortgage payment). In this case, it includes the entire amount of a mortgage payment even though the interest portion is deductible.
Gross Scheduled Income
less Vacancy and Credit Loss
plus Other income
equals Gross Operating Income
less Operating Expenses
less Debt Service
equals Cash Flow
Rule of Thumb
When doing a real estate analysis on any rental income property, don’t be tempted to over-inflate the numbers simply because you like the property, or to under-inflate the numbers because you don’t. Use realistic numbers to make your forecast and let the bottom line speak for itself. It’s the only proven way you can make prudent real estate investment decisions.
Here’s to your real estate investing success.