Most homeowners consider real estate to be a lifestyle choice that comes with maintenance and taxes. However, for real estate investors, real estate can be a money making machine that keeps on adding value with each passing year. This is where cash flow for real estate comes into play. In layman terms, cash flow for real estate is the net profit or loss generated after renting out real estate post the deduction of the liabilities. If positive cash flow can be obtained, the higher the cash flow is, the better the profits are and therefore cash flow potential should not be ignored.
Here is a guide to everything you need to know about real estate cash flow.
What is Positive Cash Flow? And Why Do You Want Positive Cash Flow?
In the simplest terms, cash flow is the difference between the revenue generated from rental properties and the expenses incurred by it. However, positive cash flow is a rare but ideal situation in which the income exceeds expenses and thus generates profits for the owner.
Acquiring positive cash flow real estate is a popular strategy among investors but positive cash flow is extremely difficult to obtain, particularly at present. This is essentially a passive source of income that can be consistent but real estate investment is not without significant risk. While it may appear that a property is cash-flowing, a bad tenant could cause substantial damage to a property, such as by turning it into a meth house, or a tenant could stop paying rent. Since March, there has been an eviction moratorium in Washington State. Without the possibility of evicting a tenant, if a tenant stops paying rent, even if they have the ability to pay, there is not much that a landlord can do until the prohibition ends. When the prohibition ends, it may be possible to obtain a judgement against a tenant for back-rent, but they will probably be uncollectable. The prohibition on evictions keeps getting extended and at present expires at the end of the year. There is a concurrent federal prohibition on evictions due to Covid-19 but the tenant must make some allegations about having difficulties due to Covid-19.
Rental income property provides returns to investors in multiple forms. Most investors hope for leveraged appreciation. But another form is rents, which hopefully covers all if not most expenses (neutral or positive cash flow). It is also possible to purchase at a discount, particularly if the property is distressed and the investor knows how to estimate the costs of repairs.
Appreciation, coupled with low cost leverage, has helped a lot of investors in the long run even if their properties generated negative cash flow. In no other business is it possible to obtain a bank loan with an interest rate that is fixed for 30 years. Leverage can turn a small amount of appreciation into a large return on the actual cash (down payment) that was invested. But a positive cash flow property allows the investor to sleep better at night, without having to dedicate income from elsewhere to support that investment.
Why Else Do You Want Positive Cash Flow?
In most locations at present, investors are purchasing properties that generate negative cash flow. They are gambling–assuming that there will be appreciation. But properties that generate negative cash flow are alligators. They can eat you alive, particularly when times are tough. While there are multiple ways to profit from rental income real estate, positive cash flow properties should be favored for a plurality of reasons. Here are some of them:
- Capital seeks out yield. If you are able to purchase a property that generates positive cash flow when most everyone else is generating negative cash flow, there is a good chance that you will see appreciation. For example, if you can find a cash-flowing property generating a 9% cap rate, investors who are only earning a 1% rate of return from a bank CD, or a 3% cap rate in their California city, may well prefer to own your property or a property in the same area as yours. At some point, your city will be discovered and values will go up. Beware, however, of cities with declining populations, such as in the rustbelt or, currently, New York City and densely populated coastal cities in the Northeast and California, as well as cities experiencing riots such as Portland and Seattle.
- Cash flow creates more opportunities. Banks are more likely to offer you a second loan if your first investment property generates positive cash flow. If your first property generates negative cash flow, you would need to offset that amount with your salary or other business income. Positive cash flow can help you grow your portfolio to a larger size than if your properties generate negative cash flow. It is still possible to grow a portfolio with negative cash flow properties, of course, such as by occasionally selling an appreciated property or by refinancing an appreciated property. But be aware that cash-out refis can be difficult to obtain for investors, such as those who have more than 4 financed properties or at certain times when there are additional audit factors as there are at present due to Covid-19. A portfolio of positive cash flow properties is more likely to help an investor obtain loans to acquire more properties than a portfolio of negative cash flow properties.
- Cash flow creates a safety cushion. Properties occasionally need expensive maintenance such as new roofs, new furnaces, new air conditioners, etc. However, with the positive cash flow, it becomes easier to put away money for a rainy day so that maintenance is not deferred and the properties are well maintained. Well maintained properties attract better tenants and, of course, are worth more than poorly maintained properties.
- Cash flow creates financial freedom. A consistent positive cash flow can be used for things other than real estate if a substantial portfolio is built up or if loans are paid off. For example, 30 years after purchasing properties, you will own them free and clear. That’s when the magic happens. At this point you can have real financial freedom, and quit your 9 to 5 job. If you don’t want to wait 30 years, you can re-leverage by occasionally selling properties and using the profits as down payments for more or larger properties. Refinancing to take cash out is sometimes a possibility as well, particularly when you have four or fewer financed properties. The rules are changing constantly so as a mortgage broker about the rules for cash-out refinances. Just be sure that the new payment is manageable based on current rents.
How Do You Calculate Cash Flow?
Calculating cash flow is fairly straightforward if you know the rents and vacancy rates for your city and know they expenses for your property. Here’s an example:
Let say that you have four units in a property. The rent for each unit per month is $1,000.
So adding the total income from the entire building, the total revenue from the property is $1000 per month x 4 units = $4000.
On the other hand, let us assume that you spend $3500 per month on the mortgage, taxes, insurance, maintenance, utilities and other expenses. This is your liability for the property.
So the gross profit or the cash flow for your property would be
$4000 – $3500 = $500 per month.
Of course, before buying a property, you will only know the amounts to expect for taxes, insurance, and mortgage. You will not know what to expect for repairs. One way to be reasonably confident about the cost of repairs is to make your first purchase a multi-family building and demand that the seller provide you three years of income and expenses statements as reported to the IRS. These are called “Schedule Es” Real estate agents tend to overstate income and understate expense in their listings. However, owners will not overstate income or understate expenses to the IRS. By obtaining the Schedule Es, you can see the exact income (after vacancies) and expenses that an owner faced. This is how to rate cash flow is calculated for any given rental property. Here is a breakdown of the various components of the cash flow formulae.
- Gross Income: Gross income (also known as gross rental income or GRI) is the total income generated as rent from your units. In larger apartment buildings, there may be creative ways to charge for additional things if the previous owner has not already done so and you are able to handle the extra management hassle (time) required. . One can sometimes additionally charge for parking spaces, laundry, late fees, storage, and vending, or can add units in the basement if zoning laws allow (make sure you have sufficient parking to meet city requirements). This grand total sum is termed as gross income.
- Operating Expenses: Operating expenses represent the total expenditure that an investor must incur to keep the property up and running. Expenses include vacancy loss, taxes, insurance, principal, interest, maintenance, sewer (if multifamily), water (if multifamily and not separately metered), power (if multifamily and not separately metered), grounds maintenance (if multifamily), garbage (if multifamily), maintenance and repairs, interior common area cleaning (if multifamily), and property management if you don’t plan to manage the property yourself. Depreciation is a loss for tax purposes, and will appear on the Schedule Es, but is not an actual operating expense.
- Net Operating Income: The next figure in the process is the net operating income. The figure is obtained by subtracting operating expenses from the gross rental income. This figure can be calculated on a monthly or annual basis.
How Do I Find Positive Cash Flow Properties?
While investors in California rarely, if ever, see positive cash flow investment properties (when using 20% down conventional financing), such properties can often be found in many areas after a real estate bust, such as what happened in 2007. Since then, values have gone up faster than rents and positive cash flow is currently very elusive. A rule of thumb is to look for properties that will sell for less than 100x one month’s rent. Currently, interest rates are so low, you can go up to about 120x for single family homes. With single family homes, the tenant pays for water, sewer, garbage, power (all utilities), plus lawn maintenance and snow removal. For that reason, you can generally use a higher multiple for single family investments than multi-family even without low interest rates. This is a rough rule of thumb and different locations will have different property tax rates, utilities, types of insurance required or recommended (e.g., flood, earthquake, windstorm) in addition to the normal fire and liability, etc. If you look at the gross rental yield map at numbeo.com, you can find a few cities left that are bright green. Those are the ones with decent rental yields. Housingalerts.com is also a good source of information on where to obtain the highest rental yields. Be careful to avoid declining cities or areas (in terms of population or crime). At present, look at Clayton County (far southern suburbs of Atlanta), smaller cities in Texas, Tucson, Oklahoma, Indiana, parts of Tennessee, parts of Mississippi and Alabama, and parts of New Mexico. Now you can ask a local real estate agent what sized units are in demand and what areas are in demand. Usually, areas in the best school districts are in demand with tenants, as they are for owners. Using Trulia, you can search for homes for sale in certain school districts. You can get an idea of the rental values of those properties using rentometer.com or Zillow or can ask a property manager. Compare the rents to prices to make an estimate of whether you will obtain positive cash flow.
Concluding Remarks
While most investors purchase negative cash flow properties and gamble on appreciation, appreciation is not a sure thing. There have been times when values have gone down. It could happen again. Values have gone up rapidly recently in low density areas (Wyoming, Idaho, South Dakota, North Dakota, Montana, Nebraska), including Cheney, Spokane, and North Idaho as people flee high density cities due to Covid-19 and because they are allowed to work from anywhere, at least for now. Low interest rates are pulling in sales from the future. People who would normally sell are not willing to list at present because that could mean inviting the virus into their homes. But unemployment is high and there is currently a prohibition on foreclosures. When that prohibition on foreclosures ends, and when interest rates rise, we will see more inventory and that will put downward pressure on values. Do not assume that there will always be appreciation. Positive cash flow lets you ride out the bad times and wait for the good times. In the long run, values go up as the cost of building material goes up and the supply of currency goes up (inflation). Positive cash flow lets you keep the property, without dipping into your pocket, when there is an unexpected crisis.