As water flows over a waterfall, cash flow describes how money moves through a rental property.
When typical operational costs and debt payments are subtracted from gross cash flow, which starts with rentals and other revenue received from a rental property, net cash flow that is taxable is left over.
Additionally, increased cash flow lowers the risk associated with investments. This is because more money is created through rental revenue, which may be used to cover regular bills, unforeseen repairs like a broken water pipe amid winter, or significant capital costs like replacing the HVAC.
What Qualifies as a “Good Cash Flow”?
Almost all real estate investors hold rental property because of the consistent income flow it generates. The more cash flow a property creates for you as a real estate investor, unless you’re playing the high-risk game of fixing and flipping or wholesaling, the better.
This is so that you can pay your running costs and mortgage from the increased gross cash flow you’ll have from rentals and other services like additional pet rent or item rental. You’ll also have extra cash earnings at the end of the day to put in your bank account.
However, it’s important to keep in mind that properties with higher cash flows and higher risk tend to be found in lower-income neighborhoods. So bear that in mind as well when evaluating properties.
Class C homes and multifamily buildings are frequently sought after by investors looking to develop a portfolio of rental properties with significant cash flow in areas with average star ratings of 2 or 3. These assets, sometimes known as “cash cow” properties, may not increase in value over time, but the gross returns are in the double digits.
How to Determine the Cash Flow of a Rental Property
Real estate investors use four processes to forecast the income flow from rental properties precisely:
Step 1: Calculate the gross income/cash flow
Your annual gross cash flow is made up of all incoming funds:
- Rent x gross rental revenue = $12,000 per year
- Income from sources including pet rent, appliance rent, and application fees totals an additional $1,000.
- Vacancy (based on a 6.5% vacancy rate): $780 lost due to tenant churn
- $12,220 is the gross cash flow.
Step 2: Forecast gross operating expenditures
Gross operational expenditures are sums of money spent annually on maintaining and owning a rental property. Among the most typical costs are:
- Rent costs equal $500.
- $1,040 in property management costs
- $360 is the maintenance expense.
- Capital expenses (CapEx) $600.00 in reserve contributions
- $1,200 insurance
- $1,500 in property taxes
- $5,200 is the total operating expense.
Step 3: Before financing, determine your NOI.
Subtract your gross income from your gross operating expenditures to arrive at your net operating income (NOI):
- Gross cash flow or income minus gross operating expenditures, or NOI, is $12,220. $5,200 in gross cash flow or income $7,020 NOI x gross operating expenses
Step 4: Determine the net cash flow after debt repayment.
Let’s imagine that a rental property costs $100,000 to buy, with a prudent down payment of $25,000 and finance for the rest $75,000 needed.
The monthly mortgage payment for a typical 30-year loan with a fixed interest rate of 4% is $358 (P&I). After paying your debts, your annual net cash flow is:
- NOI minus debt service equals net cash flow.
- $7,020 NOI – $4,296 Mortgage debt payments ($358 per month x 12 months) equals $2,724 in positive cash flow (or $238 per month in cash flow).
Comparing rental property cash flow to a waterfall, like Niagara Falls, is another useful technique to analyze it. The water cascading over Niagara Falls comes from the four Great Lakes. After the Falls, the water flows into the St. Lawrence River before finally reaching the Atlantic Ocean.
The Great Lakes are comparable to your rental property. While you wait on a beautiful Florida beach for your individual share of the cash flow, the gross income provides the money that is flowing. In order to prevent you from being left high and dry, a large portion of your income is utilized to “water” your rental property before it reaches you:
- Gather rent and additional income.
- Pay for standard operational costs including administration, maintenance, and insurance.
- Pay the mortgage each month.
- Spend money on taxes
- Expense yourself
The bottom of your cash flow waterfall should include as much liquid capital as you can as a real estate investor. As we’ll see in the following section, the IRS actually assists you in doing just that.
How to Calculate Cash Flow That Is Taxable
We need to go back and determine our net cash flow before we can comprehend the tax advantages that real estate investors enjoy. This is so because the IRS doesn’t consider CapEx contributions and the main portion of the mortgage payment to be expenses, which are two of the costs we utilized to calculate our net cash flow.
Net cash flow adjustments
To determine pre-tax cash flow, start by making the following modifications:
- start with $2,724 in net cash flow.
- Recover CapEx deduction (as you’re saving the money rather than spending it) = +$600
- Since only interest is tax deductible, subtract the principal portion of your mortgage payment, which comes to $1,296.
- Pre-tax cash flow is $4,620 ($2,724 net cash flow plus $600 in capital expenditures and $1,296 in principle from a mortgage).
Take into account depreciation
Calculating your depreciation deduction is the next step in figuring the taxable income from the rental property. The cost of a residential rental property (excluding the land value) may be written off by the IRS over a period of 27.5 years. Our $100,000 rental property’s lot is valued at $15,000, thus the remaining $85,000 represents the building’s worth, which is subject to depreciation:
- The depreciation cost is $85,000 divided by 27.5 years, or $3,091.
- (Pre-tax Cash Flow) Taxable Cash Flow = $4,620 Depreciation costs of $3,091 less $1,529
You would pay $336 in federal taxes ($1,529 multiplied by 22%) if you fall into the 22% tax rate. Therefore, even though you actually have $2,724 in net cash flow (after paying the full mortgage balance and making CapEx contributions), the IRS calculates that your taxable income is only $1,529 because of the influence of depreciation expense.
Costs Associated With Rental Properties That Reduce Cash Flow
Calculating the cash flow that is coming in from a rental property is one of the most exciting aspects of ownership. But where many investors go wrong is by failing to consider all of the expenses associated with owning and managing a rental property.
Depending on the sort of property you own and how you conduct your real estate investment company, the following is a thorough look into common rental property expenditures that your property could have:
- Vacancy costs (resulting from tenant turnover)
- Credit/bad debt costs associated with the eviction
- Lease charges
- Fee for property management
- weekly maintenance
- Repairs
- Landscaping
- utilities (such as water, sewage, garbage, and gas)
- Replaced appliances
- Capital expenditures fund an account
- major renovations, including a new HVAC system or roof
- monthly HOA fees
- HOA special evaluation
- Homeowners’ insurance
- (Additional liability protection for rental property) Landlord insurance
- Rental fees
- License for Business Marketing
- Office costs
- Payroll costs (for W-2 workers)
- Education that never ends (books, seminars, investor clubs, etc.)
- traveling costs
CONCLUSION
There is a proverb that goes, “Cash is king.” You can see how accurate those statements are now that you know how to perform a cash flow study on a rental property. For every investor in rental properties, a reliable and regular cash flow is essential. High levels of cash flow can help you lower your investment risk by ensuring you have enough money to cover operating costs and loan payments.
As informed investors, we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.
