When buying a rental property, the last thing investors want is to own an underperforming investment. According to Realty Management Associates, if the home does not generate enough income to cover maintenance and mortgage expenses, there is no way it can make a profit for its owner.
Since no one can predict the future, all investments will be attended by a level of uncertainty. But investors need to know that they should have as much control as possible over those factors that they can reasonably predict. One of those factors is the rental property’s cash flow.
What is “cash flow”?
It is the difference between how much a property generates in income and how much it costs to operate. Rental property income comes from the rent tenants pay. Rental property expenses include maintenance, taxes, insurance, legal fees, mortgage, and other costs.
A rental property is “cash flow positive” when income from the property exceeds the home’s expenses. It means that after the owner has settled all financial obligations, they still have some money left over.
That is what every property investor wants. The challenge is, how do investors determine how much a home will generate in income and cost in expenses when they have not bought it? That is why investors need to know a good way of calculating cash flow on a rental property before buying it.
How to calculate rental property cash flow
Before buying the home, let’s assume that the previous owner used it as a rental and kept records. These records form the basis for calculating future cash flow. If the home was not previously a rental property, there is another basis for calculating the projected cash flow.
Getting the basics
The information needed to calculate cash flow for a rental home includes the following:
1. Gross rental income
It is the total income from all sources before any expense is deducted. For single-family homes, the rent is often the only income source, although some landlords earn income from pet fees.
Commercial properties and multi-unit residential properties may have other income sources. The usual sources of additional income in a rental include laundry services, parking fees, late fees, and product sales.
2. Operational expenses
These are the costs associated with the ownership of the property and its use as a rental. Expenses differ according to the type of property and the number of services the owner offers. The expected expenses in a typical rental property will include all of the following:
- Property maintenance, repairs, and upgrades
- Spending on utilities; water, gas, electricity, and sewer
- Cost of business licenses
- Property taxes
- Property insurance
- Property management fees
- Marketing and advertising costs
- Payments on the mortgage, principal, and interest
- Vacancy rates (which are typically deducted from the gross income)
- Miscellaneous fees
3. Net cash flow after financing
After subtracting all expenses from the gross rental income, what is left is the property’s net operating income (NOI) or the cash flow from operations. That is if there are no mortgage deductions on the income. But if you subtract mortgage payments from the gross rental income, what is left will be the net cash flow after financing. This amount determines the owner’s profit on the property.
An example of cash flow calculation for a multi-unit rental property
Here is an example using a fourplex with onsite laundry and all of the units fully occupied. The owner of the property wants to sell it for $38,000. Below is how to calculate the cash flow on this property. The figures make use of monthly estimates:
- Rental income: $4,400
- Earnings from laundry: $412
- Vacancy rate (estimated at 10%): -$440
- Gross income (rental income + income from laundry, minus vacancy rate): $4372
- Property insurance: $201.30
- Property tax: $138.60
- Repairs and maintenance: $440
- Property management fee (charged at 10% of gross rental income): $440
- Trash and sewer services: $330
- Total expenses: $1648.90
- NOI (since there was no mortgage deduction): $2723.60
- Mortgage (assuming 20% down @ 6.5% interest rate for 30 years): $1946.77
- Net monthly cash flow on property: $776.83
- Net annual cash flow on property: $9321.97
- Return: 12%
Things to be aware of:
The 1% Rule: If a property’s rental income and expense records are unavailable upfront, the standard procedure is to use the 1% rule. It assumes that the monthly rent for a property should be at least 1% of its purchase price. But the effectiveness of the rule varies according to location.
Cash Flow is Variable: Because many factors determining a rental’s cash flow are changeable, the cash flow is also variable. Taxes, insurance premiums, and operating costs may change.
Finally, what level of cash flow should the investors aim for? There is no fixed amount, but investors should set the minimum cash flow, which justifies their investment of time and capital in the asset. If you’re new to this, it’s best to hire a professional to help you.
