For most investors, cash flow is the most important consideration when it comes to an investment property. In fact, usually it’s the most important factor.
So how much cash flow should you be looking for in an investment? That depends! While many investors look for properties that will generate at least 1-2% of the purchase price each month, the right amount of cash flow for you will depend on your investing goals and criteria. It also depends on other factors, such as appreciation; how much the investment is expected to appreciate in value over time.
In this article, we’ll take a look at what exactly cash flow is, how it’s calculated, and what you should look for when assessing a potential investment property.
What is Cash Flow?
Cash flow is how much income a property is generating, after expenses. The more cash flow, the better the returns. Cash flow represents the profit an investor is able to walk away with.
Now, let’s take a look at the difference between net cash flow and gross cash flow: two very different calculations.
Gross Cash Flow
Gross cash flow is the gross income you collect through rent and other various fees you might charge your tenant. This can include things such as late fees and application fees as well. Any income that you generate off of your rental is considered gross cash flow.
Net Cash Flow
Net cash flow, on the other hand, is the money that is left at the end of the month after you deduct all the expenses and bills associated with the property or unit. Net cash flow is gross cash flow minus expenses. Ideally, your net cash flow will be positive, but there may be some cases where the net cash flow shows a negative balance. This can happen when unexpected repairs arise, your tenants are late on the rent, or you have a vacancy.
For the most part, investors are concerned about the net cash flow. While calculating the gross cash flow can be a fast and easy way to determine if a property is worth considering further, the net cash flow will help determine whether you will actually be making a profit.
Expenses to Consider
When you are calculating your net cash flow, it is important that you are realistic about your expenses. Be as specific as possible to help give yourself the most accurate estimate possible.
Some common expenses might include:
Property management fees
Utilities - If you are paying them
Mortgage insurance and interest - Don’t count the portion of the loan that’s paid toward the principal
While it can be difficult to accurately estimate the costs of all expenses, a little bit of research can get you fairly close to what you can expect to pay each month. You can also consider talking to local property managers or other investors in the area to get a better idea on costs.
Factors That Impact Your Cash Flow
A property’s cash flow is influenced by a number of different factors. In order to determine what is or isn’t a good cash flow on a rental property, it is important to understand the variables that could impact it as well.
A property’s location is one thing that will have a significant impact on its cash flow. The amount of rent that you can charge and the income you receive is greatly reliant upon the housing market that it’s in. The local housing market will impact your property’s appreciation rates as well.
Every location has its pros and cons, but it is important to be vigilant when it comes to studying the location. Be sure to consider property taxes, interest rates, and in some cases, homeowner association fees that are applicable. You should also be aware of any rent control laws for the area that could impact your rent as well. Finally, consider the long-term stability of your investment by assessing the local housing market. This will give you a good idea about whether a property is expected to appreciate in value, and if so, how much.
Investors: Take a look at the Renters Warehouse Research Center to find housing data on markets across the country. See housing appreciation, employment information, job diversity, and more.
Type of Rental
You should also consider how the property will be used. Will you be living in a multi-family unit, renting out one side while living in the other? Are you going to rent the property as a vacation rental or a long-term rental? These are all factors that will impact the cash flow.
Finally, the financing you obtain for your investment property can play an important part in your cash flow as well. The interest rate that you’re able to qualify for, as well as mortgage insurance (PMI) will also take a bite out of your cash flow. You’ll want to work to get yourself into the best position possible to borrow by looking to boost your credit score and increasing your down payment. A higher down payment (20%) means that you’ll be able to eliminate PMI, saving you between .5 and 1% of the mortgage payment annually.
Wondering if you should invest in a property? Read: How to Determine If a Property Is Worth Investing In.
Other Important Calculations
Understanding a property’s cash flow can be a great first step, but once you have this figure, you can use it to run some additional numbers on your property. These important calculations include a property’s cash-on-cash returns and the property’s cap rate.
Once you know your projected cash flow, you’ll be able to calculate the cash-on-cash return of a rental property. This calculation takes into account the returns that you’ll get on the money that you’ve personally invested. If you’re paying all-cash, this figure will be the same as your Cap Rate. Annual Income / Money Invested = Cash-on-Cash Return
The cap rate is an equation that looks at the Net Operating Income (NOI) divided by the purchase price: Cap rate = NOI/Purchase price. The cap rate calculation considers cash elements and not loans. It looks at the property itself, irrespective of how it was financed, making it handy for assessing the returns on all-cash properties or for comparing the returns on different properties, regardless of how they were financed.
The 1% Rule
The 1% rule (or in some cases, the 2% rule) is a quick way to calculate if a property in question is worth considering further. Since not all properties have their expenses readily available, you can use the 1% rule to help quickly determine if you will have a positive cash flow on the property you are interested in.
The 1% rule says you should be able to rent a property at a minimum of 1% of the purchase price. If the current rental income is anything less than that, you will know that the property most likely isn’t worth further consideration.
Of course, there are variables that can impact this rule, such as adding value to a home, or increasing the rent if possible. This is just a simple way to do some easy math on the go to help you decide if this property is worth your continued research.
It is important to note that the 1% rule isn’t a quick easy-out for research and careful analysis. Rather, it is a formula used to help you in the decision-making process.
Increasing Your Cash Flow
In some cases, you can boost your cash flow. Here are a few ways that you can do that:
Vacancies can impact your cash flow in a big way. Reducing vacancies can help boost your cash flow and keep your property cash flow positive. Reducing vacancies can be done in a number of different ways, but one of the best ways is to reduce tenant turnover and keep your current tenants happy. This is especially true if the tenants that are currently there are a good fit for your property. Keeping a tenant happy can cost less than trying to find a new tenant to fill an empty property.
Looking for ways to reduce tenant turnover rates? Read A Landlord's Guide to Reducing Vacancy Rates, for some helpful tips.
Adding value to your property is another great way to improve cash flow. While it may seem counterproductive by spending money to increase your profit, strategic improvements can help keep your tenants happy and reduce tenant turnover rates, attract tenants who are willing to pay more in rent, as well as help to increase your overall home value.
The key is making strategic improvements that are guaranteed to lead to positive results. Here are a few suggestions:
A fresh coat of paint
Hardwood or laminate floors
It is important to do your research to ensure you are making the right improvements and that these improvements will actually increase the amount of rent that you’ll be able to charge.