As a general rule, most real estate investors don’t buy properties that aren’t cash flow positive. However, cash flow can be different things to different people.
That’s why it’s important to pay close attention to net cash flow, and to understand how using the wrong net cash flow amount can affect other financial calculations used to value rental real estate.
What is net cash flow?
Net cash flow is the amount of cash left over after a transaction has been completed. Rental property investors normally measure net cash flow on a monthly and annual basis to monitor the inflows and outflows of money over a fixed period of time.
It’s important to remember that net cash flow does not include non-cash expense deductions such as depreciation and amortization. These expenses are used to reduce taxable net income, but not cash flow.
Why accurate net cash flow matters
By accurately calculating net cash flow a real estate investor can also accurately determine the potential returns on an investment rather than depending on the previous owner’s performance or a proforma statement.
Net cash flow can also be the same thing as net operating income (NOI) as long as non-cash expenses such as depreciation and amortization aren’t included in the NOI.
Common real estate investment formulas that use net cash flow include:
- Cap rate = NOI / Market value
- Cash on cash return = Net cash flow / Investment basis
- NPV = Net present value of discounted future cash flows
- IRR = Internal rate of return to calculate the ROI or return on investment
- DSCR = NOI (excluding mortgage payment) / Debt payment
- LTV = Loan to value ratio or Debt outstanding / Value of property when the cap rate formula uses projected NOI to calculate the market value of an investment – in other words –
- Property value = NOI (forecast) / Cap rate = $15,000 NOI (forecast) / 6% cap rate = $250,000 property value provided that the NOI is based on an accurate net cash flow calculation
When to use net cash flow
In addition to accurately calculating the above formulas that use cash flow, there are three other reasons why an accurate net cash flow analysis is critical before investing in real estate:
Pro forma analysis
Real estate investors compile a pro forma analysis to understand the potential cash flow an investment will generate. However, a surprising number of buyers rely on the seller’s pro forma statement when deciding whether or not to invest.
That’s a big mistake, because the seller wants to get the highest possible price for their property and may exaggerate the net cash flow by overstating income or understating expenses. Instead, a buyer should create their own cash flow analysis by accurately determining the property’s rental income and monthly expenses.
Inflated rental income
Many real estate investors like to ‘ballpark’ the value of a property using simple formulas such as the 1% rule or the 50% rule. The 1% rule states that the monthly rent should be at least equal to 1% of the property value, while the 50% rule says that half of the rental income will be spent on operating expenses.
While these calculations are easy to do in your head, they can also lead to a major headache once the property is purchased and the property isn’t performing as expected. Instead, investors who use a cash flow analysis can create a much more accurate forecast for property value and true net cash flow.
Budgeting for capital expenditures
Accurately forecasting net cash flow also gives an investor an idea of how much money is available for ‘CapEx’ or capital expenditures and non-recurring fees like leasing commissions and tenant improvements.
Over time, items such as appliances, heating and air conditioning systems, and roof wear out and need to be replaced. These expenses can lead to a cash flow catastrophe if there isn’t enough net cash flow left over to set money aside for CapEx, especially if high-priced items need to be replaced in multiple properties at the same time.
Examples of using net cash flow
One of the main reasons for investing in real estate is to have as much cash left over at the end of the day. That’s why it’s critical to understand how to calculate cash flow and to do it right.
Here are three examples of using net cash flow in real life:
Calculate net cash flow for any property type
Let’s begin with an example of the steps to follow to calculate net cash flow for any property.
We’ll use a property with a rent of $1,000 per month, a vacancy rate of 3%, a monthly mortgage payment of $700, and annual operating expenses of $2,500.
Remember the formula: Net cash flow = Net operating income (NOI) – Debt Service
Step 1 Calculate gross annual rental income: $1,000 x 12 = $12,000
Step 2 Calculate annual vacancy and credit loss: 3% x $12,000 = $360
Step 3 Calculate gross operating income: $12,000 – $360 = $11,640
Step 4 Calculate net operating income: $11,640 – $2,500 annual operating expenses = $9,140
Step 5 Calculate annual mortgage payment: $700 x 12 = $8,400
Step 6 Calculate annual net cash flow: $9,140 NOI – $8,400 annual mortgage = $740
Now let’s calculate the net cash flow for a single-family home and a small 4-unit multifamily rental property.
Single-family rental property
Vacancy rate estimate at 5% =<$900>
Annual mortgage payment (PITI) =<$12,000>
Annual operating expenses & repairs =<$4,000>
Total projected net cash flow =$1,100
Monthly rent $1,000 x 4 units x 12 months =$48,000
Vacancy/credit loss 6% of total rents = <$2,880>
Management fee 10% of total rents = <$4,800>
Property taxes per year = <$3,000>
Property insurance per year = <$1,500>
Maintenance/repairs $60 x 4 units x 12 months =<$2,880>
Mortgage payment $2,159 x 12 months = <$25,908>
Total net cash flow = $6,960
Net cash flow can mean different things to different investors, but at the end of the day net cash flow is the amount of money left in the bank after all of the bills have been paid.
Cash flow can also be fluid.
For example, a key employer in a market could relocate which in turn reduces the demand for rental property. Or, a landlord may be lucky enough to find a ‘golden tenant’ who renews their lease year after year, creating a property with no vacancy or credit loss.
Real estate investors should always keep these things in mind when thinking about net cash flow:
- Net cash flow is what’s left over after a transaction has been completed
- Real estate investors measure net cash flow on a monthly and annual basis
- Financial real estate formulas that use net cash flow in their calculations include cap rate, cash on cash return, and IRR
- Sellers may attempt to artificially increase a pro forma net cash flow by overstating potential income and understating expenses