How To Do An Accurate Rental Property Cash Flow Analysis
Accurately calculating cash flow is the key to success for rental property investors.
Doing an accurate rental property cash flow analysis lets you focus your time and energy on deals that generate solid cash flow while avoiding money-losing property that could end up being cash flow negative.
What is Cash Flow?
Cash flow is a description of the way money flows through a rental property, similar to the way water flows over a waterfall.
Gross cash flow begins with rents and other income collected from a rental, is reduced by deducting normal operating expenses and debt service, and ends up as net cash flow that is subject to tax.
Higher levels of cash flow also help to reduce investment risk. That’s because there’s more money being generated from rental income to pay normal expenses, and also for unexpected repairs such as a broken water pipe in the middle of winter, or a major capital expense such as having to replace the HVAC.
How to Calculate Rental Property Cash Flow
There are four steps real estate investors follow to accurately predict rental property cash flow:
Step #1: Estimate gross cash flow/income
Your gross cash flow includes all money that comes in throughout the year:
- Gross rental income = $12,000 annual rent
- Additional income = $1,000 from sources such as pet rent, appliance rent, and application fees
- Vacancy (assuming a 6.5% vacancy rate) = – $780 from tenant turnover
- Gross Cash Flow = $12,220
Step #2: Forecast gross operating expenses
Gross operating expenses are money that goes out each year as a cost of owning and operating a rental property. Some of the most common expenses include:
- Leasing fees = $500
- Property management fees = $1,040
- Maintenance costs = $360
- CapEx (capital expenditures) reserve contributions = $600
- Insurance = $1,200
- Property tax = $1,500
- Gross Operating Expenses = $5,200
Step #3: Calculate NOI before financing
Next, calculate your net operating income (NOI) by subtracting your gross income from your gross operating expenses:
- NOI = Gross cash flow/income – Gross operating expenses
- $12,220 Gross cash flow/income – $5,200 Gross operating expenses = $7,020 NOI
Step #4: Calculate net cash flow after debt service
Let’s assume a $100,000 purchase price on a rental property using a conservative down payment of $25,000 and financing the remaining $75,000.
With a conventional 30-year mortgage at a fixed interest rate of 4%, the monthly mortgage payment is $358 (P&I). You annual net cash flow after debt service is:
- Net cash flow = NOI – Debt service
- $7,020 NOI – $4,296 Debt service ($358 monthly mortgage payment x 12 months) = $2,724 positive cash flow (or $238 in monthly cash flow)
Another good way to look at rental property cash flow is to compare it to a waterfall, such as Niagara Falls. Four of the Great Lakes provide the water that flows over Niagara Falls. Then, once the water falls over the Falls it travels to the St. Lawrence River, and eventually the Atlantic Ocean.
Your rental property is similar to the Great Lakes. The gross income provides the cash that flows, while you wait on a pristine beach in Florida for your personal share of the cash flow. Before your cash reaches you, much of it is used to “water” your rental property so that you’re not left high and dry:
- Collect rent and other income
- Pay normal operating expenses such as management, repairs, and insurance
- Pay the monthly mortgage
- Pay income taxes
- Pay yourself
As a real estate investor, your goal is to have as much liquid cash as possible at the bottom of your cash flow waterfall. Believe it or not, the IRS helps you to do just that, as we’ll see next.
How to Calculate Taxable Cash Flow
To understand the tax benefits that real estate investors receive, we’ll need to go back and calculate our net cash flow. That’s because two of the expenses we used to determine our net cash flow – CapEx contributions and the principal part of the mortgage payment – aren’t treated as expenses by the IRS.
Adjust your net cash flow
Begin by making the following adjustments to make to calculate pre-tax cash flow:
- Start with net cash flow = $2,724
- Add back CapEx deduction (because you’re setting aside the money, not spending it) = +$600
- Add back the principal part of your mortgage payment (because only the interest is deductible) = +$1,296
- Pre-tax cash flow = $4,620 ($2,724 net cash flow + $600 CapEx + $1,296 principal part of mortgage payment)
Deduct for depreciation
The next step in determining the taxable income from the rental property is to calculate your depreciation deduction.
The IRS allows you to depreciate the cost of a residential rental property (excluding the land value) over a period of 27.5 years. We’ll assume that the value of the lot on our $100,000 rental property is $15,000, which leaves a building value of $85,000 that is subject to depreciation:
- Depreciation expense = $85,000 / 27.5 years = $3,091
- Taxable cash flow = $4,620 (pre-tax cash flow) – $3,091 depreciation expense = $1,529
If you’re in the 22% tax bracket, you would pay $336 in federal taxes ($1,529 x 22%).
So, even though you really have a net cash flow of $2,724 going into your bank account (after making the full mortgage payment and CapEx contributions), according to the IRS your taxable income is only $1,529, thanks to the power of depreciation expense.
Now, let’s like at some additional rental property and business expenses you may be able to take to help reduce your taxable cash flow even more.
Typical Rental Property Expenses That Reduce Cash Flow
One of the most exciting things about owning a rental property is adding up the cash flow that’s coming in. However, where many investors make mistakes is by overlooking all of the costs of owning and operating a rental property.
Here’s a detailed look at typical rental property expenses that your property could have, depending on the type of property you own and how you run your real estate investing business:
- Vacancy expense (due to tenant turnover)
- Credit/bad debt expense (due to eviction)
- Leasing fees
- Property management fee
- Routine maintenance
- Utilities (water, sewer, trash, gas, etc.)
- Appliance replacement
- CapEx (capital expense) account funding
- Capital repairs such as new HVAC or roof
- HOA monthly dues
- HOA special assessment
- Property insurance
- Landlord insurance (additional liability coverage for rental property)
- Rental tax
- Business license
- Office expenses
- Payroll expense (for W-2 employees)
- Continuing education (books, seminars, investor groups, etc.)
- Travel expenses
What is Considered “Good Cash Flow”?
Nearly all real estate investors own rental property for the recurring cash flow the investment provides. Unless you’re playing the high-risk game of fixing-and-flipping or wholesaling, as a real estate investor the more cash flow a property generates the better.
That’s because the more gross cash flow you have coming in from rents and additional services such as additional pet rent or appliance rental, the more money you’ll have to pay the operating expenses and mortgage. At the end of the day, you’ll also have more cash profit to add to your bank account.
However, one important thing to note is that you can typically see higher cash flowing properties in lower-income areas with higher risk, higher reward potential. So also keep that in mind as you’re analyzing properties.
Investors seeking to build a real estate portfolio of rental properties with high cash flow often look for Class C houses and multifamily properties in neighborhoods with average ratings of 2 or 3 stars. Also known as “cash cow” property, these investments may not appreciate that much over time, but the gross yields are in the double digits.
If you go to the Roofstock marketplace, then filter your search by “gross yield”, you’ll find rental property in working-class areas with yields of 16%, 17%, even 18%, or more. Tenant demand can be consistently strong, and renters tend to renew their leases year after year, which can keep vacancy loss low and minimize unnecessary expenses due to tenant turnover.
As you research different markets for rental property with good cash flow, keep in mind that cash flow can be either positive or negative. A cash flow positive property is one that generates more income than expenses. On the other hand, negative cash flow can occur when operating expenses and debt services exceed the amount of money coming in.
While there are a number of reasons for negative cash flow, the two biggest causes are lack of due diligence when you’re buying a property and using too much leverage:
Roofstock Certification and Guarantee
For investors who want an added safety net when looking to buy a rental property, the Roofstock Certification Process helps to reduce the risk when buying rental real estate.
Before a property is listed on the Roofstock marketplace, the property goes through an in-depth vetting and review process, including things like a professional property inspection, valuation and rental market analysis, review of tenant payment history, and home disclosure reports.
Roofstock even goes one step further by offering a 30-day money-back guarantee and a lease-up guarantee if you buy a vacant home.
Leverage is a powerful tool real estate investors use to finance rental property without tying up too much of their own money as a down payment. However, just like eating too much of your favorite food and gaining weight, using too much leverage can inflate your expenses and leave you with very little net cash flow.
As a rule of thumb, a conservative loan-to-value (LTV) ratio is 75%. So, if you’re investing in a rental property priced at $100,000, you should plan on putting $25,000 down plus your normal closing costs. A conservative LTV keeps your monthly mortgage payment affordable, and your property cash flow positive, generating a steady profit each and every month.
A Rental Property Cash Flow Example
How to calculate cash flow from a rental property investment
Investing in real estate rental property requires a great deal of research, and understanding how a property is going to generate cash flow from rental operations is an important aspect of that process.
A simple cash flow calculation can illustrate the potential of rental real estate as an investment. Let’s use a fourplex as an example and assume that all four units are destined for full-time rental. You’ve done your research and you made a good buy on the property.
Here’s what you can expect in cash flow from a rental.
Start With the Basics
The purchase price of the property was $325,000. You put 20% down—$65,000—and financed $260,000. The mortgage is a 30-year loan at 6.5% with a principle/interest payment of $1,643 a month.
Taxes and insurance at the time of purchase are $3,600 a year, or $300 a month, for a total payment of $1,943 a month.
Calculating Cash Flow
You’re seeing a steady rental demand for these units, all of which stay occupied most of the time, but we’ll calculate a 6% vacancy and non-payment risk to anticipate real cash flow just to be prudent.
The units are all identical. They each rent for $900 a month.
The calculation would break down this way:
- Gross rental income is $900 x 4 units x 12 months = $43,200 per year.
- Your payments are $1,943 x 12 months = $23,316 per year.
- The previous owner’s repair expenses averaged $1,700 per year.
- Vacancy and credit loss is estimated at 6% of rents, or $2,592 per year.
- You spend about $400 each year in miscellaneous and advertising costs, and you manage the property yourself.
These are the basic operational items that go into cash flow calculation. Rent income less vacancy loss less payments less expenses equals your cash flow:
$43,200 (gross rental income) less $2,592 (vacancy factor) less $23,316 (mortgage, taxes, and insurance) less $2,100 (repairs and costs) equals $15,192. This works out to $1,266 per month in positive cash flow over 12 months.
Costs can be tricky, however, because some don’t happen every month. Stay on the safe side by treating them the same way as vacancies at a realistic percentage.
Cash on Cash Invested
Divide your actual cash investment of $65,000 down into the annual return of cash—which is $15,192—to analyze your return as “cash on cash invested.” This is a yield of 23% on your cash invested. There are few investments out there that yield this kind of return.
Cash Flow Can Be Fluid
Cash flow is a function of a great many inputs, and any or several of them can change and damage or improve the scenario. Some are influenced by the market and the economy.
For example, a major local employer might close or move, so the demand for rental property plummets overnight. This is something you can’t control, but you can potentially avoid disaster by doing your due diligence about the health and plans of local employers.
You’re probably in good shape if the major employers are profitable with long leases that have recently been renewed.
Other factors that are out of your control include real estate taxes and property insurance. Taxes and premiums can increase, raising operating costs and lowering operating income and, by extension, cash flow. But 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, or maintenance costs. You can raise rents if the rental market is strong, but this can be a delicate balance because it might increase vacancies. The loss of income from more vacant units can easily wipe out any gains from increased rents.
This is by no means the only way to calculate cash flow for a rental property, although it might well be the easiest. You can include additional calculations on the way to your bottom line.
Some other methods include tax savings you might realize thanks to property ownership, and still others separately break down net operating income. But this simple formula should give you a clear-cut head start on what you need to know before investing.