Before you start building your rental property empire, there are a number of crucial concepts you'll need to understand. One of these is cash flow, which is the lifeline of your real estate investing business.
Acquiring investment properties with good cash flow is essential for success. On the other hand, purchasing properties that lack sufficient cash flow could put a quick and painful end to your dreams of producing passive income.
What is cash flow, exactly, and why is it so important?
Let’s dive into the details to ensure that you make informed decisions when it comes to selecting rental properties.
Cash flow is the net balance of money that comes in and out of a business during a certain time period. You can have positive cash flow, which means that there’s more money going into the business than is leaving it. Negative cash flow, on the other hand, is when there is more money moving out of a business than there is moving into it.
As a rental property owner, you know all too well that money doesn’t only flow into your account. It costs money to make money, and every month you have expenses that likely include things like insurance, taxes, maintenance, and repairs. If you borrowed money to purchase the property, you’re also sending money out of your account in order to make loan repayments.
At the same time, money is flowing into your account in the form of rent and other potential forms of income from your rental property.
One of the most common reasons that small businesses fail is the lack of cash flow. In simple terms, this is when a business runs out of money and has to close its doors due to a lack of funds. When there’s more money going out than is coming in, the business model simply isn’t sustainable.
Your rental property investments aren’t all that different from a small business in this regard. That being said, cash flow isn’t the only important factor to consider when selecting a property to invest in. Appreciation, debt pay down, and tax benefits are all additional types of returns that you can receive from a real estate investment.
(Are you looking for other metrics to use when analyzing a rental property? Learn more about what a capitalization rate is here.)
It is fairly simple to calculate the cash flow of your rental property. In order to do so, follow these steps:
Your property’s gross rental income is the total amount of income that you receive from the property before you subtract mortgage payments or expenses. For some rental properties, there might be additional income streams beyond rent, such as late fees, on-site laundry, or pet fees, while other properties might have a single source of income in the form of rent.
The expenses that are related to your property will vary depending on the type of property and your circumstances. These might include:
When you complete step two, you will be left with the net operating income (NOI) of the property. This is also known as the cash flow from operations. In these figures, you aren’t taking into account debt services such as mortgage payments or other types of loan repayments.
Not all real estate investors will have debt services related to the property. However, if you are repaying debt for the property, you can then subtract this in order to find the cash flow after financing.
A cash flow statement (CFS), or the statement of cash flows, is a document that outlines the money coming in and out of your rental property business (or any other type of business, for that matter.)
By summarizing the amount of cash that is flowing in and out of the business, it can measure how well you’re managing your cash position.
It’s common for real estate investors to draw up cash flow statements annually. However, there’s no reason you can’t perform this task more often in order to better grasp your cash flow.
A cash flow statement can help you organize vital information that can be used to project future cash flow. This document can outline any changes in the balance sheet and allow you to make informed investment decisions. Providing insights into stability and liquidity, cash flow statements are an essential tool that allows you to understand the financial position of your rental property investments.
If you’re looking to estimate your cash flow quickly and simply, you can use what is known as the 50% rule. This is a formula that postulates that the expenses of any given property tend to be roughly half of the income, excluding mortgage interest payments you are making.
The basic formula looks like this:
(Total income x 0.5) - Mortgage principal and interest payment = estimated cash flow
It’s important to understand that this is just a way to roughly estimate cash flow. You shouldn’t replace a thorough analysis of the property with this formula. Instead, use it as one of the tools in your arsenal to quickly analyze dozens of properties in order to create a short list of properties to look at with more scrutiny later.
What makes cash flow “good” is ultimately subjective, and there is no set number or percentage that you can turn to in order to decide whether a property will offer good cash flow.
Some real estate investors prefer to have a minimum return on investment that they use while searching for property. Others analyze properties based on whether or not they will generate a net cash flow that will meet their cash-on-cash return targets.
The return on investment (ROI) is a percentage that indicates how much profit is made in relation to the cost of the investment. You’ll often hear 8% as a general rule of thumb when it comes to an acceptable ROI for rental properties. However, some investors might have a minimum return of 6% while others might look for properties with 12% ROI or higher.
You can find the ROI of a rental property by taking the net cash flow and dividing it by the cost of the property.
A Cash-on-cash return is a measurement of an investor’s annual return in relation to the mortgage payments paid during a specific year. This is a metric that is typically used for one-year periods rather than for the life of the project.
You can determine the cash-on-cash return of a property by taking the annual pre-tax cash flow and dividing it by the total cash invested during the time period in question.
If you already have a rental property and you aren’t satisfied with the cash flow it’s providing, there are a number of strategies you can use. Put simply, there are two ways to improve your cash flow: you can either increase the amount of money coming in or decrease the amount of money going out of your rental.
Let’s take a look at what options are available to you to help you obtain the positive cash flow you desire.
Even a small reduction in your monthly costs can mean a lot when you’re looking to improve your cash flow. If you’re hoping to lower your overhead, you’ll want to take a look at your expenses for the previous three to six months. Highlight any spots where you think you could be saving a bit more money.
This might mean deciding to use an online tax service instead of a CPA, switching utility companies, or looking for a more affordable insurance policy. By switching providers, negotiating, or shopping around, you can potentially reduce your monthly costs by a noticeable amount in aggregate.
One of the worst things that can happen to your rental property’s cash flow is having a vacancy (or several.) When your rental units are empty, you’re still on the hook for loan repayments, utilities, maintenance, repairs, and more. On top of that, finding new tenants can be costly and time-consuming.
Similar to the way that it’s way more expensive to hire a new employee than to keep an existing one, it’s a lot more affordable to keep an existing tenant than it is to search for a new renter. Of course, there are definitely circumstances where a tenant causes so much trouble that finding new renters is the more affordable option.
If you’ve already got reliable tenants, make an effort to reach out to them as their lease nears expiration. You might consider waiving fees or offering incentives to help keep your units rented out to high-quality tenants.
Another consideration for boosting your rental property cash flow is allowing pets if you don’t already. Many landlords charge a pet fee per month of somewhere between $50 and $100. This is an easy way to increase your cash flow with very little in the way of work on your end.
If you do go this route, it’s advised that you ask for a decent-sized pet deposit. This can help you deal with any necessary repairs if the pets cause any damage. You also might consider putting restrictions on the type of pet or the breed in order to avoid any issues.
Raising the rent on your existing tenants is a very impactful way to improve your cash flow. Even a small amount can add up to make a sizable difference over time. This is particularly true if you own several rental properties.
That being said, you will want to justify the increase to your tenants and give them plenty of notice. You’ll also want to stay tuned in to any local regulations that relate to rent increases.
It’s also important to keep in mind that you could potentially lose your tenants this way. If you raise the rent by too much or to an amount that’s above the market rate, your tenants might leave to find a more affordable option. It’s best to be very considerate of making rental increases and take into account the possibility that it could leave you searching for new tenants again.
Setting the proper price for rent is a balancing act. If you set your rent prices too low, you’re obviously leaving money on the table. On the other hand, though, setting your rent prices too high can turn off potential tenants and leave you with vacancies.
If you bought your rental property with the help of financing, refinancing might help to increase your monthly cash flow. It’s a good idea to keep your eye on mortgage interest rates and consider whether or not refinancing could lower your monthly mortgage payments.
There are costs to refinancing that need to be taken into account, however. When you refinance, you will be responsible for paying closing costs similar to when you originally took out the loan. While closing costs can vary, they generally amount to 2% of the total loan amount.
It’s also worth noting that refinancing will reset your payment schedule. Mortgages are amortized loans, meaning that at the beginning of the loan repayment schedule you are primarily paying interest rather than the principal. You’ll want to run the numbers to ensure that it actually makes sense financially for your rental property business.
While you might be tempted to raise the rent as a simple way to increase your cash flow, there are some other considerations that can be more impactful in the long run. You can take steps to minimize both your risk and your vacancies, including:
While you might be strapped for cash right now, properly maintaining your property and abiding by landlord-tenant law is overall more important than bringing in a little extra money every month.
If you’re having a hard time justifying raising the rent on a vacant apartment or home, but you’re looking to increase cash flow, you might consider furnishing your rental. Before heading to the thrift store to outfit your apartment on a budget, though, you’ll want to do some market research to ensure that there is demand for furnished rentals in your property’s location.
Do you own an apartment complex? You might be able to add some additional revenue sources on your property that help you generate more income. Consider adding vending machines, coin-operated laundry, or additional storage space for tenants.
Another potential option when it comes to boosting your cash flow is adding an accessory dwelling unit (ADU). This is a free-standing structure on the same property that has its own kitchen, bathroom, living space, and private entrance. This type of additional unit can be ideal for long-term rentals, short-term rentals, or as a studio or office space.
Adding an ADU is a big upfront investment, but if all the numbers add up it can do a lot for your bottom line. However, make sure you thoroughly research local zoning ordinances in addition to possible tax consequences, maintenance costs, up-front costs, and market demands before diving in. It’s not worth building an ADU that is unlawful, as this can result in code enforcement actions as well as issues if you chose to refinance the property down the road.
You’ll also want to think about how an ADU could affect the quality of life of the tenants in your primary property. Would building an ADU take away outdoor space in a way that makes the unit less appealing? If building an ADU would lower the amount you could charge for rent or make it difficult to maintain tenants, it’s possible that the attempt to improve your cash flow could backfire.
When you are analyzing potential properties to invest in, cash flow is one of the important metrics you will want to take into account. While there are a number of factors that can impact your success as a real estate investor, it’s worth understanding how the type of property you choose to invest in can impact your ability to generate positive cash flow.
As far as cash flow goes, multi-family properties can be a very appealing option. While they are typically more expensive than single-family homes, multi-family properties can produce legitimate income while consolidating maintenance and management needs in one property. Owning one building with several units also distributes the cost of vacancy, meaning that the more units you have the less one vacant unit negatively impacts your bottom line.
Purchasing a single-family home can be a great first-buy for new real estate investors. If you’re looking for a property that is affordable and allows you to learn the ropes without getting in over your head, a single-family property is a good place to start.
Assuming that you’ve done your research into the local rental market and all other aspects of due diligence, this can be an accessible way to start building your rental empire. Financing for single-family homes typically requires a good credit score and a 20% downpayment, in addition to meeting several other lending requirements, but you’ll find it’s a lot more attainable than a loan for a larger, more expensive property.
Owning one single-family home can ultimately be a bit riskier and more time-consuming than owning multiple units. Many landlords of this size will deal with property management on their own, as hiring it out can really impact their cash flow. You’ll also want to take into account the fact that owning one property means that vacancies aren’t distributed in the same way that they are when you own many units.
Of course, cash flow isn’t the only metric that matters when it comes to making smart investments. Some investors might be more interested in having rental income build equity and the potential for appreciation over time.
Another option for types of rental properties to generate cash flow is a townhouse. Townhouses are multiple units that stand side by side. You’ll also hear them referred to as row houses.
These properties can offer more to tenants than standard apartments or condos. Each unit might have appealing features that allow you to rent the units at higher prices, such as driveways, yards, and porches.
Whether you buy a row of townhouses or a single unit, you might find this to be an investment strategy that produces the cash flow you are looking for.
Buying an apartment building can be an ideal way to produce positive cash flow and a source of passive income. With more units, the amount of money coming in can be significantly higher than with a single-family home. Many apartment building owners opt to hire property management rather than dealing with management themselves, as it’s much more affordable when you have a company managing many units in one location. If you choose to deal with maintenance and repairs on your own, however, you’ve likely bought yourself another full-time job.
Apartment buildings are one of the best investments you can make in real estate for cash flow. However, obtaining financing isn’t quite as accessible for new investors.
An increasingly popular type of rental property is short-term rentals that are rented out through services like Airbnb. There are a number of vital components that you will need to run a successful short-term rental, including demand for short-term rentals in the location where you’re buying the property.
If you can have an Airbnb rental rented out most of the month, you might be able to make quite a bit more per month than you would with a long-term tenant. However, it’s important to not overlook the out-flow of cash that this will entail, including furnishing the place, marketing the property, paying fees to the listing service, and cleaning costs.
Doing your research before purchasing a rental property is absolutely key if you want the investment to be a success. There are a lot of landmines that can pop up that destroy your returns if you aren’t careful, so it’s important to avoid making flippant decisions when it comes to picking the right property.
Let’s take a look at some of the factors you should take into account when selecting a property to be rented out.
Your vacancy rate and the quality of tenants you attract will have a lot to do with the neighborhood the property is in. For example, purchasing a rental near a university will increase the likelihood that your tenants will be students. While this isn’t necessarily a bad thing, you might find that you are left holding vacancies through the summer months.
It’s also worth noting that some towns actively try to discourage rental conversions. Through the imposition of red tape and outrageous permit fees, some properties that would otherwise be ideal might not be as successful at generating cash flow as they might appear from face value.
If you are planning on investing in homes that are best suited for families, you’ll want to be attentive to the local schools. This will have a big impact on the quality of tenants you attract and the rent you can reasonably charge. It’s also an important consideration when you take into account the overall value of your rental value when you sell it down the road.
One thing that can eat into your bottom line is property taxes. It’s important to understand how much you will need to put towards property taxes, as there's a good chance they vary greatly within your target market.
Paying high property taxes might be worth it when you take into account all other factors. For example, a great neighborhood that attracts long-term, high-quality tenants might mean that your cash flow isn’t problematically impacted by high property taxes.
There’s more to what makes a neighborhood appealing than nice housing stock and good schools. You’ll also want to look into local restaurants, parks, public transportation links, movie theaters, and any other perks of the area.
You’ll have an easier time finding new tenants in places with a growing job market. Keep an eye out for major companies moving to the area and check out the U.S. Bureau of Labor Statistics to find out the local rates for job availability.
When you’re buying a rental property, it’s important to understand the potential changes that could occur in your chosen target area in the future. New construction indicates that the area is growing, but some types of development can be harmful to the value of nearby properties.
Your rental income is likely going to be the bulk of your inward cash flow, so you’ll want to understand how much you can reasonably charge for rent in your target market. It’s important that your rental income covers loan repayments, insurance, property taxes, and other expenses.
You’ll also want to try and understand the potential growth or decline of the area where you’re rental property is located. The important thing is to ensure that possible changes (such as a property tax increase) could make what was once an affordable property a major loss.
Another important factor to ensure that you can rely on a certain amount of incoming cash every month is how many listings for rentals there are in the area. Having a high number of listings could simply indicate a seasonal turnover cycle, but it could also point to a neighborhood that is heading in the wrong direction.
Some areas are obviously more prone to natural disasters than others. It’s important to research the likelihood that your property will be damaged by an earthquake, flood, hurricane, or other extreme weather events. You’ll also want to get intimately familiar with the terms of your insurance policy to make sure that you’ll be covered for any and all potential hazards.
Understanding cash flow is essential for success as a rental property investor. Sure, you might get lucky with a property, but is that really the type of thing you want to leave up to chance? It doesn’t matter whether you’re looking at a single-family home in the country or an apartment complex in the urban core– either way you need to make sure the numbers are leaning in your favor.
That’s why we’ve created the ultimate rental property calculator. Rather than breaking out a pen and paper, you can use our calculator to see all of the most vital metrics in one organized place. Determine a property’s cash flow, cash on cash return, ROI, and much more using our rental property calculator.
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