Calculating Cash Flow for Real Estate Deals – It’s Not Complicatedcalculated that cash flow based upon pre-Depression rental rates.
While we are not in that same situation now, the recession that began with the housing crash of 2008 brought a lot of would-be entrepreneurs out of their closets. They saw great potential, not in flipping houses but, rather, in buying up foreclosures and then renting them out to new tenants. Some have realized a great ROI over these last several years; others flopped miserably and lost a lot of investment cash. Some of those flops could have been avoided if individuals new to real estate investing had performed some simple math calculations to determine cash flow from the houses they were buying. There are two ways to do this, and both will work pretty well.
Actual Cash Flow Calculation
Defining cash flow is the first step. It is the amount of cash left over after all expenses have been paid – sort of like net income. For real estate rentals, this should be calculated on a monthly basis, because rent and bills tend to be monthly. The simple formula is this: Income from the property – Total expenses = Cash Flow
The devil is in the details, as they say. While the formula is simple, figuring all possible income and expenses might be a bit tricky.
Income: Obviously, income is the amount of rent you will be receiving. There might be little tidbits of extra income, such as application fees, interest on security deposits, and a projection of late fees, but when you balance these against the cost of running credit checks and other minor expenses, they will be a wash. It’s safe to count income only as the monthly rental.
Vacancy rate must be considered in income. Plan on one month a year of vacancy. So to figure your monthly income, multiply the rent amount times 11 then divide that by 12.
Expenses: This becomes a bit more complex, and it may differ from house to house and from rental agreement to rental agreement. For example, you may cover trash and water on some properties but not on others. The important thing is that you calculate your expenses as accurately as possible. Here are typical expenses:
- Property Insurance – based on annual premium divided by 12
- Property Taxes – based on assessments divided by 12
- Mortgage if you have borrowed to buy the property. This is your monthly P & I, plus mortgage insurance if required. If you roll taxes and insurance into your mortgage payment, then you have these first 3 items covered
- General Upkeep/Repairs – difficult to calculate. Many use a general rule of thumb of 15% of the monthly rent set aside in a separate account for these purposes. If you own several rental properties, and you set aside this amount from all of them, you are usually covered if a major expense occurs for one property. If you only own one property, then you will need a higher percentage at least in the beginning, until the account builds.
- Homeowner Association Dues – total annual amount divided by 12
There are some expenses that will not be recurring – office supplies/equipment and accounting software, for example. These you do not need to break out for individual houses, but if you own several or multi-family units, you may want to add a bit more to the amount you are setting aside in your maintenance/repair account.
Is It Worth It?
Now you can calculate your cash flow and see if it is really worth the investment to purchase the property.
If you plan to pay cash for the property up front, you will need to take that monthly cash flow and figure out the per cent return on your investment. Is it a decent return based upon average rates of return with other investments? The other factor here is appreciation of value. If you believe that the home will increase in value over time, then you should factor in that increase as well.
The 50% Calculation (Estimate)
This method is a good one if you are considering a property and just want to get a general idea before you actually get more serious.
Basically, this “rule” is that you subtract 50% of the rental income to get your estimated cash flow amount. There is an extra caveat here, however. That 50% subtraction should happen after you take out the mortgage payment. So if you will be taking out a mortgage on the property, here is what the 50% rule looks like:
½ of total rental income – mortgage payment = cash flow
If you pay cash for the home up front, then ½ of the total rental income becomes your cash flow. Then, you can calculate the per cent return on your investment as well.
Using the 50% rule as an initial tool is a good idea, but once you get serious, do the full calculation.
There you have it. It’s really not rocket science, but it is surprising how many fail to just do the math ahead of time.
By Jonathan Emmen