Investing in real estate rental properties requires a great deal of research. One very important aspect of the process is understanding how a property is going to generate cash flow from rental operations. A simple cash flow calculation can illustrate the potential of rental real estate as an investment.
Here's how it works, using a fourplex as an example. We'll assume that all four units are destined for full-time rental and that the buyer did her research and made a good buy on the property.
The Basics
The purchase price is $325,000.
- The buyer put 20 percent down—$65,000—and financed $260,000.
- The mortgage is a 30-year loan at 6.5 percent with a principle/interest payment of $1,643 per month.
- Taxes and insurance at the time of purchase are $3,600 a year for a total payment of $1,943 per month.
Calculating Cash Flow
The buyer sees a steady rental demand for these units, all of which stay occupied most of the time. But, just to be prudent, we'll calculate a 6 percent vacancy and non-payment risk to anticipate real cash flow. The units are all identical and rent for $900 each per month.
The calculation would break down this way:
- Gross rental income is $900 x 4 units x 12 months: $43,200 per year.
- Payments are $1,943 x 12 months: $23,316 per year.
- The previous owner's repair expenses averaged $1,700 per year.
- Vacancy and credit loss is estimated at 6 percent of rents: $2,592 per year.
- The owner spends about $400 each year in miscellaneous and advertising costs, and she manages the property herself.
These are the basic operational items that go into cash flow calculations. Now let's look at our profits. Rent income less vacancy loss less payments less expenses equals cash flow.
- $43,200 - $2,592 - $23,316 - $2,100 = $15,192 or $1,266 per month over 12 months in positive cash flow
Cash on Cash Invested
Analyzing your return as "cash on cash invested," you would divide your actual cash investment of $65,000 down into the annual return of cash: $15,192. This is a yield of 23 percent on your cash invested! There are few investments out there that yield this kind of return.
Cash Flow Can Be Fluid
Cash flow is a function of a great many inputs, and any or several of them can change and damage or improve the scenario. Some are influenced by the market and the economy.
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If a major local employer closes or moves, the demand for rental property can plummet overnight. This is something you can't control, but hopefully, you can avoid disaster by doing your due diligence about the health and plans of local employers. You're probably in good shape if they're profitable with a long lease recently renewed.
Other factors that are out of your control are real estate taxes and property insurance. Taxes and premiums can increase, raising operating costs and lowering operating income and cash flow. These negative factors can be compensated for with other factors over which you do have some control.
For example, you might be able to find ways to reduce marketing, management, and maintenance costs. And, of course, you can raise rents if the rental market is strong. But this can be a delicate balance because it might increase vacancies. The loss of income from more vacant units can easily wipe out any gains from increased rents.
Other Calculations
This is by no means the only way to calculate cash flow for a rental property, although it might well be the easiest. You can include other calculations on the way to your bottom line.
Some methods include any tax savings you might realize thanks to property ownership, and others separately break down net operating income. But this simple formula should give you a clear-cut head start on what you need to know before investing. For More info Call or text A Level Up Realty 520-332-4114.
