Arguably, cash flow is the most important component when considering a potential real estate investment — or ANY investment for that matter. If it's importance makes you sweat, we got you covered. We are pulling back the curtain on all things cash flow from what it is, why it is, and how it is.
What is cash flow?
Think of real estate investment cash flow as the love child between a rental property's income and expenses. It is what's leftover after collecting rent and other income streams, paying operating and financing expenses, and feeding the cash reserve. In order to bring in more money than you spend each month, you need, pray, hope, and want that cash flow to be positive. More positive cash flow means more opportunity to reinvest in your property and other ventures, and the bigger the cushion to cover unexpected costs such as emergency property repair or sustaining the property during an economic crisis.
Gross vs. Net
Any and all income you generate from your rental property is considered gross cash flow. What is left at the end of the month after deducting those pesky expenses from the gross is your net. While investors primarily use the gross cash flow to determine if a property is worth investing in, the net cash flow is used to determine if you will actually be making any profit.
Related Reading: Flagship's Dictionary of Finance and Investment Terms
How to Calculate
Step One: Determine the gross income from a property.
Step Two: Deduct all expenses relating to the property.
Step Three: Difference = the property's cash flow.
As easy as 1-2-3. Maybe we'll call this the 3-D Method. (Not to be confused with popular Guy Fieri tv show or interactive cinema experience.)
The 1% Rule
If you are looking for a "rule of thumb" when it comes to understanding and maximizing your real estate investment cash flow, this is it. The one percent rule states that a cash-flowing property should rent for at least 1% of the original purchase price. Meaning: If you purchase a property for $200,000, it should rent for at least $2,000 per month. You can apply this rule when first analyzing whether a property would be a worthwhile investment or if you feel it is time to implement your exit strategy on a current purchase. But, preferably the former.
An important detail to keep in mind when applying the one percent rule is that it does not account for other property expenses including financing fees, repairs and renovations, taxes, etc. It also does not apply in areas where real estate is expensive or where additional insurance for flood or hurricanes is required.
The 50% Rule
If you want to give the previous rule of thumb the middle finger, then here is another, quicker guideline you can follow for estimating the cash flow of your rental property. The fifty percent rule states that property's expenses tend to be and should be about 50% of the total income, NOT including the mortgage principal and interest payment.
Calculating total income — a.k.a. gross cash flow — encompasses more than than just total rent. Most times, total income will include a rental property's application or late fees, and any additional tenant expenses like laundry, parking, etc. in addition to incoming rent. Being that these are estimations — hold the guess — it is wiser to err on the side of caution when listing potential incomes and assume you will get less than you hope to.
Both the fifty and the one percent rule should be used as an 'investment at a glance' and quick filter of potential properties. They should not substitute a thorough real estate analysis.
Factors that Hurt Your Cash Flow
Vacancies and Tenant Turnover
A vacant property = no income stream = a non-cash flowing property. Similarly with tenant turnover, you'll have to pay for cleaning and repairs that may go beyond what their security deposit covers and you'll lose money on the amount of time between tenant occupancy.
Repairs and Maintenance
Repairs and maintenance have the double whammy of draining your cash flow and taking a toll on your tenant's quality of life. Property upkeep alone requires time and money, but factor in any unpredicted expense of a burst pipe or mouse infestation and that required time and money runs thin. Which can result in an unhappy tenant and a future income stream loss.
Humans aren't perfect. Deadlines get missed and you're left standing there without a check or one not payed in full. Who do you think has to cover the leftover expenses — mortgage, insurance, taxes, repairs, etc. — out pocket?
Property Taxes and Insurance
A big cash flow hit, though out of your control, is the continuing rise of property taxes and insurance costs. If they go up faster than you can raise the rent, therein lies your deflating cash flow problem. Depending on the local market, you may be able to appeal your property taxes with the local government if you feel the increase was unwarranted, but don't hold your breath.
Ways to Increase Your Cash Flow
While implementing a rent increase seems like a simple solution to increase cash flow, it requires research, a reasonable reason, and a proper lease agreement. You should be charging comparable rates to similar properties in the area. If that isn't the case, then it is time to raise; however, try to avoid increasing rent during the holidays or special occasions. Your tenants will appreciate it AND it will help with tenant turnover.
Related Reading: When to Implement a Rent Increase
Replacing an existing mortgage with a new one of a larger amount allows for lower interest rates and longer loan terms. This results in smaller monthly loan payments, reducing your total cost, and you guessed it, more cash flow. Check with your lender if you notice interest rates falling. It may be time for a refinance.
Add Amenities and Upgrades
Adding value to your property will decrease your operating expenses and make it more appealing to potential renters. That value lies in your offered real estate features and amenities. Amenities are often what sell a prospective tenant on a lease because it is the biggest thing that can set physically comparable properties apart. As a landlord, you will spend more short-term by deciding to cover their water bill or invest in some gym equipment, but you will have grateful tenants that will choose your property over one that doesn't offer those same amenities. Creating more long-term cash flow.
As far as building upgrades, new windows can simultaneously save you on your heating bill while adding quality externally and internally to your property. Replacing a carpet between tenant turnover can save on cleaning expenses. Switching the stove from electric to gas will save on your utility bill. Just some proactive ideas. Not being proactive with upgrades can also lead to potential liabilities, creating potential problems and potential costs.
Furnish the Space
Since 2018, fully furnished apartments have grown as the preferred housing type. This is mostly due to business professionals frequently relocating and the growing costs of furniture. Offering even a partially furnished apartment expands your tenant base to short term renters and allows you to charge more for rent.
Create Additional Revenue Sources
As mentioned earlier, total income can encompass more then just tenant rent payments, especially for single-family rentals relying on one income stream. Those other income avenues could be adding coin-operated laundry, vending machines, pet fees and pet-friendly areas, or additional storage spaces for tenant bikes, cars, and other personal belongings. You could even create an accessory dwelling unit (ADU) available for short-term rental. An ADU is an additional structure on your property that — depending on its features — could be rented out as an office space, studio, or Airbnb. While an ADU will bring in higher additional revenue, it will require more investment planning and upkeep.
If you take away one thing from this blog, let it be this. Repeat after me: "Positive real estate investment cash flow is good. I like positive real estate investment cash flow. I need positive real estate investment cash flow." If you need help figuring out what your real estate investment cash flow should look and are looking for more insight in to how to maximize it, Download our Investment Real Estate Guide and Talk to a Lender.