The Truth about Cash Flow
We all have seen extravagant claims of thousands of dollars in cash flow advertised by various Get Rich Quick real estate investment schemes. Positive cash flow is always an attractive advertisement but if you look closely, many of these claims are false.
To better understand cash flow of an investment property, it is important to identify the three primary ways that real estate investments provide a return; through appreciation, cash flow, and the reduction of principal (pay down of debt). Each investment will generally capitalize on one, or more of these elements. Building equity through appreciation and paying down the mortgage are generally well-understood by most investors. Cash flow is much more ambiguous.
On the surface calculating cash flow is fairly straightforward. Cash flow is simply the difference between the checks you receive every month, and the checks you write. Where most people run into trouble, is when they deal with sellers of real estate investments that have a much looser definition of cash flow, or make unrealistic assumptions relating to rental income or expenses. The most common elements of cash flow that are misstated are rental income, which are overstated, or expenses which are understated, or omitted entirely.
Using an example of a $100k home, let’s calculate the true before-tax cash flow (BCTF) assuming the home is rented at $1000/month with a 5% vacancy rate. Property management is 10% of the gross operating income (GOI) and the repair allowance is 5% of GOl. Property taxes and insurance are each determined to cost $1000/yr. The mortgage is at 7%, amortized over 30 years with a 10% down payment resulting in an annual payment of $7995.
In this example, the home has a Gross Scheduled Income of $12,000/yr less $600 in vacancy costs resulting in an annual GOI of $11,400. After subtracting the remaining property management, taxes, insurance, maintenance, and debt service costs totaling $11,795, this home winds up with a negative cash flow of $395 a year.
Yet sellers of investment properties will often claim that the cash flow is positive. This is because it is common for marketers of such properties omit many of the expense categories to make the cash flow sound larger than it actually is. It is incumbent upon you, the investor, to perform your own due diligence. Study the seller’s numbers. Most of the components of the cash flow calculations are precise numbers which can be identified or estimated very accurately such as rents, property taxes & insurance, management expenses and the mortgage payment. The vacancy rate, repair allowance and utilities (if paid by the landlord) must be reasonably estimated. After factoring in appreciation and pay down of the loan, an investor can make an informed, lower risk decision when purchasing investment property that will deliver exceptional returns.
Jeffrey King, a real estate investor for over 20 years, co-founded Meridian Pacific Properties and helps clients acquire positive cash flow properties for their personal real estate investment portfolios.
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