The term “cash flow” is thrown around rather generously in the real estate industry, but it usually comes with no definition or explanation. Everybody just expects you to know what it means. While you are undoubtedly smart enough to use context clues to figure out some semblance of meaning, it is better to learn the specifics of what cash flow is, how to calculate it, what impacts it, and why it matters for your business. I figured I would make it easy for NREIA members to learn by creating a guide to understanding real estate cash flow for beginners; by the time you finish reading this article, you no longer need to nod along and pretend you know what somebody means when they say “cash flow”—now you can nod along because you do know what they mean.
WHAT IS CASH FLOW?
In simple terms, your cash flow is the money that you bring in after collecting all your income, paying all your expenses, and subtracting any other payments, savings, or deductions—so basically the amount of money you have left over after paying everything you owe.
Because these concepts are more easily understood when they are illustrated, picture this scenario with easy numbers: you purchase a multi-family property with five units. The rent you charge each unit is $1,200 a month. The mortgage costs you $1,500 a month; maintenance and repairs for the year average $150 a month; miscellaneous operating costs, such as advertising, insurance, and taxes, run you about $50 a month; finally, you decide to put $300 a month into an emergency reserve for the property. Where does that leave you? Let’s break it down.
Your annual income from each unit is $1200 a month times 12 months, so $14,400 from each unit.
You have five units, so that is 5 times $14,400. Your total annual income from the property is $72,000.
The annual mortgage is $1,500 a month times 12 months. $18,000.
Maintenance averages at $150 a month, which is $1,800 a year.
Miscellaneous costs total $600 for the year ($50 times 12 months).
Each year you put about $3,600 into your contingency fund.
So, what is your annual cash flow? Well, if you calculated $48,000, that is correct! You get that number by subtracting all the expenses from your income:
CASH FLOW = $72,000 – 18,000 – 1,800 – 600 – 3,600 = $48,000
Once you write it out and see it in action, it becomes very easy to calculate cash flow for your own properties. However, keep in mind that cash flow is fluid, and these inputs can change at any given time. You may need to increase or decrease rent, or perhaps maintenance costs more this year, or maybe miscellaneous costs skyrocket due to a sudden increase in taxes. Having a contingency fund for circumstances like these is extremely important, hence why I added it to the scenario above.
WHAT CAN HARM YOUR CASH FLOW?
There are a number of factors that can impact your cash flow. Some things, like increasing rent, long-term tenants, or preventative maintenance, can give you a little boost. However, I want to focus on the things that would do the opposite so you can remain aware and avoid these issues to keep your cash flowing.
- Repairs and maintenance. While you should be calculating this into your original project cash flow, sometimes you discover extreme or unexpected repairs for which you do not have the budget. To avoid situations like these, have the property thoroughly inspected when you purchase it and keep up with preventative maintenance to avoid any repair build-up.
- Tenant turnover or vacancy. When tenants move out, you have a vacant property. What that means is you have a property with no cash flowing in, but the cash is still flowing out. On top of that, you might have to expend some resources for cleaning or maintenance between tenants. Try to ensure your tenants stay for as long as possible by doing what you can to keep them happy; respond to requests in a timely manner, don’t substantially increase rents after their lease expires, etc.
- Missed rent. This is an obvious cash flow killer. If a tenant fails to pay rent for a month, that is a chunk of your income missing. While you might be able to take a delay or two, if tenants are consistently missing rent or paying extremely late, it can create trouble on the back end. Stipulate a late rent policy in your lease and encourage your tenants to pay on time.
- Unexpected expense increases. Nobody likes paying more money, so it always comes as an unwelcome surprise when property taxes or insurance prices increase. While there is unfortunately no avoiding these increases, you can analyze the previous changes in rates and factor that into your rental costs and the rest of your budget. You can make tracking and analyzing your expenses easy, though, when you use a program like HammerZen, an app that automatically uploads your purchases into QuickBooks.
WHY DOES CASH FLOW MATTER?
To sum it up nicely, cash flow is important because it helps you understand which properties to purchase and which properties to avoid. While you may not be able to get the exact numbers when estimating cash flow, you usually have access to all the necessary information to get a pretty good idea—and by doing that, you can easily project which properties are going to be money-makers versus money-takers. Of course, you want properties that produce a positive cash flow, but in some circumstances, you can buy a property that cash flows negatively if you have enough reserves to run at a deficit and if you think the payoff will be worth it in the end. Essentially, cash flow in real estate is a tool you can use to judge the viability of a property.
Ask yourself if you should invest for Equity or Cash Flow?
Ask yourself if you want money right now when you retire or acquire properties to build wealth?
The above example is a simple cash flow, but there are other ways to calculate your ROI and Cash Flow of your business.
If you have any questions about cash flow or real estate accounting in general, do not hesitate to reach out to our team at HammerZen!
Gita Faust is the founder & CEO of HammerZen, which helps businesses save time & money by keeping track of The Home Depot purchases and efficiently importing receipts and statements into QuickBooks. National REIA members receive discounts on QuickBooks services and software. Learn more by visiting www.hammerzen.com/nreia.