Cash flow definition for real estate investors [2019 edition + scenarios]

Cash flow definition for real estate investors [2019 edition + scenarios]
by Brad Cartier, posted in Finances

When it comes to rental property investing, your “cash flow” is the net amount of money that piles up in or disappears from your bank account each month. Real estate cash flow can be positive…or negative. For example, if you’re pulling in $1500/mo in rent and your mortgage, taxes, insurance, and property management fees are running $1000/mo, your net cash flow is around $500/mo.

Let’s ask a simple question: Would you rather have money in the bank today or entertain the promise of seeing money in the bank at some future point in time?

Cash flow definition for real estate investors [2019 edition + scenarios]

If you chose the former, then welcome to the real estate cash flow investing club! Near term cash flow is something that a certain kind of investor tends to prefer over uncertain (but potentially lucrative) long-term appreciation. You can put cash flow to use in other projects and ventures right away. Other types of investors are often more focused on whether their property has the potential to appreciate and what that will mean for their equity position. These investors are generally willing to wait and get the bulk of their expected financial return upon sale.

And while real estate markets have historically gone up at about double the rate of inflation, there are pronounced down cycles too, which are difficult to predict. Investing for future appreciation alone can be tricky, unless you are a committed and strategic long-term buy and hold investor. This is where the cash flow approach to real estate investing comes in, which prioritizes money in your bank account now, ready to be redeployed for other investments or simply spent on things you value in life.

Exactly what is cash flow real estate investing?

One way to think about cash flow investing is to compare it to investing in dividend-paying stocks. At regular intervals you receive cash distributions from the investment while doing very little – if anything – with the asset you’ve purchased.

Here’s a quick example:

    • Bob owns three rental properties that each rent for $1,000 per month
    • His expense ratio (the percentage of gross rental income used for normal operating expenses like maintenance, property taxes, and property management fees) is 40%
    • Bob also sets aside 5% each month in a capital reserve account
  • Bob’s monthly cash flow is: $3,000 ($1,000 x 3 homes) – $1,200 (40% x $3,000) – $150 (5% x $3,000) = $1,650 per month

How to create positive cash flow: 3 winning examples

Sounds pretty good, doesn’t it? But there are ways that cash flow investors may be able to further increase their income every month:

1. Raise current rents to market rents

Every year Bob pulls market rent comparables to make sure the rent he’s charging his tenants is at least on par with the market. He learns that rents for properties comparable to his are going for $1,050 per month. So, when he renews the leases, he also raises the rent at all three properties to market. His income goes up, and assuming his expenses stay the same, the result is as follows:

New cash flow: $1,650 + $150 = $1,800 per month.

Typically, expenses are more static than rents, so as you raise rents your mortgage, taxes, and insurance costs often decline as a % of gross rental income. There are nuances to this, but as a general rule this is often the case.

2. Reduce operating expenses

After brining his rents to market, Bob also takes advantage of Stessa’s free rental property software. With access to world-class management tools and reporting at zero cost, Bob reduces the monthly operating expenses on his rental property portfolio by $70 when he drops his other expensive software subscription.

New cash flow: $1,800 + $70 = $1,870 per month.

3. Add value to rental property

So far Bob has increased his cash flow by $220 per month. But he’s not stopping there. Bob decides to convert the spare room above one of his rental homes’ garages into a studio apartment that he quickly rents out for $300 per month.

New cash flow: $1,870 + $300 = $2,170 per month

By bringing his rents to market, using Stessa to track and manage his rental portfolio, and adding value to a rental home he increased his monthly cash flow by: 32% ($2,170 / $1,650)!

The risk of negative cash flow: 3 cautionary examples

In the real estate investment business, when more cash flows out than in during a given month, that’s what’s known as negative cash flow. Here are three costly cash flow mistakes that some real estate investors make:

1. Paying (or borrowing) too much for the purchase

This is a common mistake that real estate investors who focus on appreciation are susceptible to making. Overpaying for an income property results in extra-large mortgage payments that can go on for years. If market rents don’t increase steadily, investors can find themselves barely able to cover the property expenses. For example:

  • Monthly rental income $1,000 – 40% expense ratio – 5% capital reserve ratio – 50% mortgage payment = $1,000 – $400 expenses – $50 reserves – $500 mortgage = $50 monthly cash flow

Now, what happens if a tenant leaves and it takes one month to find a new one?

  • $0 rental income – $950 expenses = $950 negative cash flow. When the property is re-rented it will take 19 months ($950 negative cash flow / $50 monthly cash flow) to recoup what was lost during only a single month of downtime!

2. Choosing the wrong tenants

Having the wrong rental strategy is a guaranteed recipe for negative cash flow, even when the property is purchased at a below market price. Some investors are so anxious to get a vacancy filled that they overlook the necessity of running a tenant credit report and background check. Let’s assume for this example, the following scenario:

  • Monthly rental income $1,000 – $750 (40% expense ratio + 5% reserve ratio + 30% mortgage payment) = $250 cash flow

Now let’s say the tenancy goes bad. The tenant disappears in the middle of the night without paying the current month’s rent, takes all of the appliances with them, and leaves behind $2,000 worth of damage. It takes one month to make repairs and re-rent the property:

  • $0 rental income – $750 normal expenses – $3,000 repairs & new appliances = $3,750 negative cash flow

While situations like these are by no means entirely avoidable, you can indeed minimize your exposure by doing your homework and checking references before signing a new tenant. If cash flow is important to you, then minimizing downtime that results from non-paying tenants should be a priority.

3. Spending too much on expenses

Some real estate investors spend too much on items like landscaping, business operations, and fancy renovations. While this approach may produce the best-looking property on the block, very few tenants will pay an above-market rent in return. Most tenants just want a nice enough place to live in and call home.

It’s basic math. When landlords spend more on expenses than the rental income will cover, the result is negative cash flow. Expenses you could be overpaying for include:

  • Insurance (be sure to shop around annually)
  • Advertising (of vacancies)
  • Management software (Stessa is free)
  • Landscaping (shop around and minimize frequency)
  • Property management (self-manage or negotiate lower rates over time)
  • Utilities (use energy efficient appliances, give tenants incentives to reduce use)

Frequently asked questions about cash flow investment real estate

Q: Why invest in cash flow real estate?

A: Cash flow real estate is like getting a monthly paycheck, plus over time your property may appreciate in value, which can be a nice bonus.

Q: How is cash flow calculated?

A: Gross rental income – outgoing expenses (including debt service) = net cash flow

Q: What areas are best for cash flowing property?

A: All markets are different, but in general, working-class neighborhoods with strong job growth often have the most reliable rental demand.

Q: Can I have a loan on cash flow property?

A: Yes, in fact OPM (other people’s money—i.e. the banks’) can be one of the best strategies used to invest in rental real estate – just be sure not to over-leverage!

Important things to know about cash flow

  • Cash flow is what you have left over at the end of each month
  • Cash flow is what you have today, appreciation is what you hope to have tomorrow
  • Cash flow investing focuses on creating regular monthly income streams
  • Positive cash flow can be created by buying wisely, bringing current rents to market, and reducing your operating expenses as much as possible
  • Negative cash flow occurs when investors spend more money each month than the property generates via rent and other income sources like laundry and parking

As with any real estate investment, due diligence can make or break your business so always do your research upfront and make realistic projections for both rental income and operating expenses. . Once complete, do the simple math to get a better idea of the cash flow you can expect. The math won’t lie, and you’ll have a much better idea if the rental property might prove to be a worthwhile addition to your portfolio.