Fundamentals play a big role in investing, whether you’re analyzing a company’s core financials or evaluating the essential driver of returns on an investment. Cash flow in real estate is the fundamental factor determining whether your real estate business stays healthy and grows or turns its assets over to a lender.
Understanding cash flow in real estate is crucial to keeping your real estate business afloat and scaling. Here’s what you need to know.
How Does Cash Flow in Real Estate Work?
Cash flow in real estate describes the movement of money in and out of a property. It includes the revenue the property generates, mostly from rent, and the expenses incurred while running it. Analyzing cash flow can show you the potential profitability of your property.
Generally, calculating cash flow is as simple as subtracting the expenses for operating a property from the revenue you earn from the property. If the difference shows that you generated more income than expenses, you have a positive cash flow; if your expenses are higher than your income, you have a negative cash flow.
Beyond rent, your income could come from parking, charging tenants to keep pets and other amenities. Your expenses may include property taxes, insurance, maintenance, utilities or other operational costs.
How to Calculate Cash Flow in Real Estate
You need positive cash flow to continue to run your business, so it’s important to know how to calculate cash flow in real estate. Here are the steps to calculate the annual cash flow from your rental property investment:
- Project your gross income
- Identify your gross expenses
- Calculate the net operating income (NOI)
- Calculate the cash flow after debt
Your gross income includes projected rents and other sources of money, such as income from miscellaneous charges, reimbursements for utilities and application fees.
Your operating expenses will likely include property taxes, insurance, maintenance and repairs, property management fees, homeowners association fees, utilities, and vacancy costs. You might also set aside some amount for capital expenditures (e.g., a new roof, new air conditioning systems, etc.) in your gross expenses.
Subtracting your gross expenses from your gross income gives you the NOI, offering a glimpse of the potential profitability of the property before you consider your debt service (cost of financing).
Subtracting debt service from NOI gives you cash flow. If you have positive cash flow, the property is likely profitable. However, if you have negative cash flow, it may not be a good investment.
Cash flow analysis is essential before buying a property to determine whether it might be a good investment, and regular cash flow analysis later on can capture changes in expenses, income and market conditions.
Importance of Cash Flow in Real Estate
Cash flow shows the money moving in and out of your property over time. It can also be used to calculate other important metrics, such as:
- Cash on Cash Return: The money you earn on your cash investment.
- Internal Rate of Return: Measures profitability by rate of return at break-even.
- Equity Multiple: Compares cash flow to initial equity investment.
Investigating these metrics reveals an investment’s potential profitability and can help you make informed investment decisions.
A solid rule of thumb many real estate investors use is the 1% rule, which says you should multiply the price you paid for your property by 1% to get the monthly rent you’d need to charge to maintain a cash-flow positive.
This can be a helpful guideline to avoid the time, effort and research needed to evaluate cash flow metrics. However, it doesn’t include other important factors, such as the rental market, cost of living and average incomes in the area around your property.
What Is a Good Cash Flow in Real Estate?
Getting a positive number after subtracting your operating expenses and debt service from your total revenue means you have good cash flow in real estate. It all starts with choosing a sensible location for cash-flow-positive properties, selecting the right type of investment for that area, and employing a long-term strategy.
A positive cash flow of $100 —$200 per monthly unit can be considered good.
Factors That Can Help and Hurt Cash Flow in Real Estate
Vacancies, tenant churn, taxes, maintenance and repairs can all eat into your rental income, giving you negative cash flow in real estate. Fortunately, you can use several strategies and tactics to boost your cash flow.
Consider purchasing a property at the lowest price possible. Then, you can put the money you save into upgrades to help attract and retain tenants.
You can also spend more time (and even money) to find and keep good tenants. Such an investment can pay dividends later with tenants who stay longer and don’t require costly repairs. You can raise the rent annually by building it into a lease agreement or offer a lower rent with a longer term.
Additional strategies and tactics could include creating other revenue streams, such as charging extra for pets or parking, charging an application fee, providing vending or retail on-site (such as a coffee shop) and reducing your operating costs.
What Is the 1% Rule?
As mentioned, real estate investors use the 1% rule when considering whether to invest in a property. Simply multiply the purchase price of a property by 1% (or move the decimal point two places to the left) — the result is the minimum income you need for a positive cash flow.
For example, if your rental property investment costs you $200,000, you’d need $2,000 per month to see positive cash flow. When deciding whether to charge tenants $2,000 a month, it’s important to consider various market factors, including the property’s location, comparable rents, average incomes and cost of living.
When applying the 1% rule, be aware that the suggested monthly rent doesn’t reflect your expenses for operating the property or other factors, such as the local market.
Analyzing Cash Flow in Real Estate Is Your Key to Maximum Property Potential
Cash flow and the metrics used to track it can help you determine whether a particular investment is a good one before you purchase a property. Continue examining your cash flow for metrics such as cash-on-cash return, internal rate of return, and equity multiples to get the most out of your property.
Frequently Asked Questions
What type of real estate has the most cash flow?
Commercial real estate (office buildings, hotels, shopping centers, multifamily apartments, industrial sites, etc.) generally has the most potential for high cash flow.
What is a cash flow analysis in real esstate?
Cash flow analysis is a financial tool for evaluating the risk and profitability of a real estate investment. Using all sources of income and expenses, you calculate the potential net cash a property might generate.
What is a good cash flow ratio in real estate?
Some investors consider an annual cash flow of 10% of the property’s purchase price to be a good cash flow ratio. While not a ratio or percentage, others say $100 —$200 per monthly unit is a solid general figure.