Wednesday, November 13, 2019 / by Zifan Gao
Cash Flow 101 — A Guide to the Basics of Cash Flow
Investing in a rental property often means doing a great deal of research and one very important aspect of the process is understanding how property is going to generate cash flow from rental operations. You can perform a simple cash flow calculation to illustrate the potential of rental Real Estate as an investment.
Here’s how it works: using a residential fourplex as an example, let’s assume that all four units are expected to be rented. Let’s also assume that the buyer did their research and the property was a decent deal - not exactly a steal but they also didn’t overpay.
Let’s start with the basic property and deal information:
Purchase price: $325,000
20% down payment: $65,000
Financed balance: $260,000.
Mortgage: 25 years at a 5-year fixed rate of 3.34 percent
Combined principal and interest payments: $1,276/month
Taxes and insurance (at the time of the purchase): $3600 a year
Total payment (mortgage payments + property taxes and insurance): $1,576/month
Now that we have the basics laid out, let’s look at the gross income. In our example, the buyer expects a strong rental demand for these units in the coming years. They should all be occupied most of the time but, just to be prudent, and I hope most of you do this, we’ll budget a 5 percent vacancy and non-payment rate to model a conservative real cash flow.
The units are all identical and they rent for $900 each per month so the calculation breaks down this way:
$900 x 4 units x 12 months = $43,200/year
The total payment (as listed above) is $1,576/month. So per year, that number comes to
The previous owner’s repair expenses averaged about $1,700 per year so for this simple calculation that’s what we’re going to use. Vacancy and bad debts are estimated at 5 percent of rents so $2,160 per year. Also, the owner spends about $400 each year on various things like advertising costs and manages the property themselves. These are the basic operational items that go into cash flow calculations. Now let’s look at our profits. The cash flow formula is:
Rental Income – Vacancy/Bad Debts – Payments – Expenses = Cash Flow
So what are the numbers?
$43,200 - $2,160 - $18,912 - $2,100 = $20,028 per year
or $1,669 per month in positive cash flow
Now, as a disclaimer, I used really simple numbers to get the calculation across in an easy to digest way. If we were doing this for real there are other numbers we might throw into the mix such as closing costs when the investor bought the property, realtor’s fees if they ever thought they would rent some units through realtors, etc.
Now, let’s talk about cash on cash return. To analyze your cash on cash return, you divide your annual return of cash, which in this example is $20,028 by your actual cash investment, which is equivalent to the down payment.
$20,028 / $65,000 = 0.308
or 31% return on your cash invested
There are few investments out there that yield this kind of return which is why so many people love investing in Real Estate. If we were to take into account Principal Repayment and Property Appreciation, your return would go up even more.
Now, keep in mind that cash flow can be fluid. Cash flow is really a function of many inputs and a change in any of them can damage or improve the cash flow scenario. Some of the functions are influenced by the Real Estate markets and some by the general economy. For example, if a major local employer closes or moves, the demand for residential rental property can plummet overnight because the employment isn’t there.
The factors involved in cash flow
You obviously can’t control this but hopefully, you can avoid disaster by doing your due diligence about the health and plans of local employers, especially large ones. You’re probably in good shape if they’re profitable, with a long lease recently renewed or just signed.
Other factors that are mostly out of your control are Real Estate taxes and property insurance rates. An increase in taxes and insurance premiums can raise operating costs and lower operating income and cash flow. However, the good news is that these negative factors can be compensated for with other factors over which you do have some control. For example, you might be able to find ways to reduce marketing, management, and maintenance costs and, of course, if the rental market is strong, you can raise rents.
A word of caution though. For people who, like me, are in Ontario this is really dependent on what rent control regulations allow. And even if you have the right to raise rents at your discretion, this can be a delicate balance because it might increase vacancies. You want to keep in mind that lost income from vacant units can easily wipe out any gains from increased rents.
This is definitely not the only way to calculate cash flow for rental property but it’s likely the simplest way. You can also slot in other calculations as you run numbers to see if returns from a property will meet your expectations. Other ways to calculate returns include any tax savings you might realize thanks to a specific property ownership structure, etc.
At the end of the day, I find this is the simplest formula that can give you a basic starting point to see the big picture when you’re considering a specific rental property purchase.
As always, I’m open to answering any questions you might have about Real Estate Investing so feel free to message me here or email me at email@example.com.
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