Cash flow is a result of investing in real estate and leasing it to tenants for monthly rental revenue. Moreover, real estate investors seek rental properties that generate positive cash flow which means they invest in properties that generate positive cash flow. Furthermore, cash flow is the profit generated each month when all revenue is collected, all operational expenditures are paid, and cash reserves are put aside for future repairs. It is also a key tool utilized by real estate investors who acquire and keep real estate in order to enhance their revenue.
In this article, you will be able to know and understand what the cash flow is in real estate investment, why it is important for cash flow to be positive, the cash flow formula, cash flow calculations, factors that both help and hurt the cash flow, 1% rule, cash flow per unit as well as which areas are best for cash-flowing properties.
Why Do You Want Your Cash Flow to be Positive?
Positive cash flow is evidence of growing liquid assets which enables the company to meet its commitments, reinvest in the business, give back the money to shareholders and pay the expenditures while also providing a cushion against potential financial difficulties.
A greater opportunity arises because of an increase in cash flow. The best strategy to increase your net worth is to reinvest the proceeds from one investment into another. Cash flow provides security since it is constant. The additional money you earn each month may be used to build a bigger emergency fund to cover needs such as medical bills and automobile upkeep.
What is the Formula to Calculate Cash Flow?
This is the basic formula for free cash flow.
Free Cash Flow = Net Income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure
Below are the explanations of the elements in the Cash Flow Formula.
- Net income: It is the amount of profit remaining after subtracting the company’s expenses from the total revenue or sales. The information may be seen on the Income Statement.
- Depreciation/Amortization: Over time, a lot of your company assets such as equipment, may lose value. Depreciation is the process through which the value of an asset falls. On the other hand, amortization is a technique for amortizing the original cost of an item over its useful life. Depreciation and amortization are included as well on the income statement.
- Working Capital: The gap between your assets and liabilities indicates the capital utilized to operate your firm on a day-to-day basis. Working capital may be calculated with the use of the total assets and liabilities shown on the Balance Sheet.
- Capital Expenditure: Capital expenditures are the sum of money spent by the company on fixed assets such as land, real estate and equipment. Capital expenditures are shown on the Statement of Cash Flows.
How to Calculate Cash Flow?
The term “free cash flow” refers to a business’s disposable income or cash on hand. It is the money that remains after capital expenditures and other operational costs have been deducted. Also, it enables businesses to budget and prioritizes investments.
Add the net income with the depreciation/amortization less to the change in working capital less capital expenditure.
For instance, Sofia is a freelance graphic designer; she wants to determine her free cash flow in order to determine if employing a virtual assistant for around ten hours per month to handle client administration responsibilities is financially possible.
Sofia’s finances for the year look like the following:
- Net Income: $70,000
- Depreciation/Amortization: $0
- Working Capital: $8,000
- Capital Expenditure: $2,200 (Sofia bought a new desktop last year)
With that, Sofia’s free cash flow will be:
[$70,000] + [$0] – [$8,000] – [$2,200] = $59,800
That leaves Sofia with $59,800 in cash on hand to reinvest in her firm.
What are the Factors That Hurt Your Cash Flow?
Listed below are the factors that hurt Cash Flow.
1. Missed Rent
2. Vacancy
3. Property Taxes and Insurance
4. Tenant Turnover
5. Repairs and Maintenance
1. Missed Rent
Occasionally, your renter may fail to pay the rent on time or not pay at all. When a renter does not pay in full, cash flow is drastically decreased, and it is almost non-existent if a tenant skips a payment. Additionally, you might be obligated to reimburse all charges out of pocket such as a mortgage, that is if you have one, then insurance, taxes and a lot more.
2. Vacancy
A vacant property is synonymous with a property that does not generate income. There is no way to have cash flow flowing in if you do not have any sources of revenue.
3. Property Taxes and Insurance
When property taxes and insurance rates increase, you will see a little decrease in cash flow. You will be able to understand that these expenditures might increase each year. It just implies that you must seek a better offer and be prepared for any event that may occur.
4. Tenant Turnover
This has a negative impact on cash flow. When a renter vacates, there may be additional repairs or cleaning that you will be responsible for in addition to the amount covered by their security deposit.
5. Repairs and Maintenance
Nobody enjoys receiving an email from their property management informing them that a new furnace is required. Nobody enjoys the prospect of having to fix a roof leak. However, they are really possible and will mostly occur. Ideally, it is better for you to save a part of your monthly income in order to cover unforeseen expenditures. However, there are instances when your reserves are insufficient to pay certain costs which will result in digging into your own funds. If that occurs, cash flow will cease to exist.
What are the factors that help your cash flow?
Listed below are the factors that help Cash Flow.
1. Long-term Tenants
2. Increasing Rent
3. Appealing Property Taxes
4. Preventative Maintenance
5. Refinancing
1. Long-term tenants
As mentioned above, turnover and vacancy are major drains on cash flow, so you must aim for long-term tenants. Satisfied renters are more likely to become long-term tenants. What will happen if you respond swiftly and properly to their maintenance requests. This also means that you should not be greedy when it comes to boosting rents after their contract expires.
2. Increasing Rent
The most effective strategy to boost cash flow is to raise your property’s rent. This may be achieved by acquiring a property that is underperforming and renegotiating the lease to reflect market rent. You may also modify the property to enhance rent by installing contemporary features like central air conditioning and more.
3. Appealing Property Taxes
Property taxes might increase every year. If they continue to rise faster than you can increase the rent, it may result in a cash flow crisis. Depending on the market in which you invest, appealing your property taxes to the local government may make sense if you believe the rise was unreasonable.
4. Preventative Maintenance
Monthly cash flow may be drained by significant repair and maintenance charges and in the long run, preventative maintenance may save you money. Clear and clean gutters before winter, trim trees near your house and check your HVAC systems more frequently. Large expenditures do not happen frequently, but when they do, it is better to prepare beforehand.
5. Refinancing
It is important to check in along with the lender in order to monitor the mortgage interest rates on a regular basis. If interest rates decrease, you might well be able to refinance mortgage, lowering your monthly mortgage payment while increasing your cash flow. Now, do your due diligence and account for the lender and closing costs, however, keep this technique in mind.
How does the 1% Rule Help You Determine if a Property Can Generate Positive Cash Flow?
The 1% rule is a method used in renting real estate to estimate if a property will generate positive cash flow. If you wish to do a rapid analysis of a property to evaluate if it is worth pursuing more due diligence on, you may apply the 1% rule. In rental real estate, the 1% rule is used in order to evaluate if a property is likely to generate positive cash flow.
The rental price should be at least 1% of the purchase price. If a property is offered for $200,000, it should rent for at least $2,000 per month. If it is around $1,500 it will not fit into the criteria. The higher the rate of return, the bigger the rental revenue.
How Much Cash Flow Should You Have per Unit?
Strive for a cash flow of $100–$200 per unit purchased. A duplex should bring in at least $200 each month. If it’s a fourplex, the minimum is $400. Cash flow is highly influenced by the market in which you invest. Local rental prices and property valuations can have a significant impact on cash flow.
Assume that an individual has properties in the South that only generate between $150 and $200 per unit in cash flow. While the cash flow is clearly lower, in part due to lower rentals, the cash-on-cash return is theoretically better due to the fact that an individual did not have to spend nearly as much money to buy the property.
However, rather than focusing just on cash flow figures, you must also consider the return on your investment, which is just as critical. So then it comes down to your investment goals, risk tolerance, and the market in which you choose to invest.
What Areas are best for Cash Flowing Property?
Upon analyzing such data and trends throughout the United States compile the following list of the top 5 best areas to invest in real estate this year, 2021. The following are the greatest locations for real estate investment and rental property acquisition.
- Dallas, Texas: It is best to consider investing in Dallas real estate since the city’s economy caters to all income levels. Dallas seems to have the nation’s lowest homeownership rate, with renting inexpensive rather than acquiring. Rental apartment demand increased by 14% sometime last year, which makes it a good time to invest in Dallas real estate.
- Houston, Texas: What makes Houston such an attractive investment location is the city’s thriving real estate industry. Trade volumes are substantial, and housing stock moves quickly. This implies that it is rather simple to liquidate assets and sell your property.
- Boise, Idaho: Consistently low inventory levels across the entire Boise Metro Area housing market, along with exceptionally low fixed mortgage rates, maintain a strong demand, driving property prices upward in this area.
- Las Vegas, Nevada: The Las Vegas real estate market is fully bursting with new firms. The new enterprises are coming up at a far higher pace than the state average.
- Atlanta, Georgia: Atlanta is the capital and economic hub of Georgia. It is regarded as one of the ten most productive states in terms of yearly GDP contribution to the United States. As the city continues to see economic growth, property values in Atlanta are expected to climb as well in the coming years.