This is the first in a series of posts designed to give you the skinny on real estate investing terms. Real estate investing is rife with lingo and jargon–where do you turn? What is Cash Flow, CCR, ROI, Cap Rate, and the rest of the alphabet soup? We’re here to keep you in the know, and as you read through the many posts and learn about various topics, we’ll point you back to these definitions.
So without further adieu, let’s dive into our first, and perhaps most important, term: cash flow.
The Power of Cash Flow
Cash is King, as Pehr Gyllenhammar, former CEO of Volvo, is often credited with “coining” (see what I did there?) It was true in 1988 and it’s still true today with our shaken, albeit recovering, U.S. economy. In real estate investing, cash flow is known as the money that enters (or leaves) your pocket while you are operating an investment property. With that being said, cash flow can be positive…or negative.
Cash flow is the lifeblood of your investment. Cash flow can be calculated at the simplest levels by the following equation. Don’t worry, we won’t bog you down with complicated equations. This is all grade school math!
Cash Flow = Revenue – Expenses
Cash flow is how much cash enters or leaves your pocket every month. On the one hand, if you spend less money than you earn, you have a positive monthly cash flow. On the other hand, if you spend more money than you earn, you have a negative cash flow. This certainly applies to some people’s personal finances as well!
Simply put, in real estate investing, your goal is to pay the minimum amount for a property (expenses, i.e. mortgage) and receive the maximum amount in property value (revenue, i.e. rental income). Positive cash flow on a rental property can be difficult to find, which makes it important to run the necessary calculations to pinpoint these in your area.
[su_animate type=”rotateIn” duration=”1″][contentblock id=subscribe][/su_animate]
One rule of thumb we like to use when quickly evaluating properties is the “1% Rule.” A $100,000 property that rents for $1,000 a month has a monthly rent that is “1%” of the property’s total price. We’ve often found that this percentage of rent, and higher of course, has great positive cash flow potential.
Here is a common scenario. Remember that these are just generic figures for our expenses and you should work with your insurance agent, property manager, and county tax assessor to get the real costs nailed down.
– $285 ins/prop mgmt/tax
– $430 mortgage
= $285/month cash flow
This is a healthy amount of cash flow. To be more conservative and realistic, let’s look at some “risk adjusted” cash flow, which is the cash flow after repairs and vacancies are taken into account. Take the same cash flow that we calculated above:
$285/month cash flow
– $83/month repairs
– $83/month vacancy risk
= $119/month adjusted cash flow
Okay, now you might be more disappointed with the cash flow. Where did these repair and vacancy values come from? Well, the repair is using another “1% rule” which is to assume that repairs will cost 1% of the total property value per year. The vacancy cost is really just $1,000/year (your 1% rule at work again), or one month of vacancy on your property.
Remember that we are being conservative here. In the long run, you still have a property with positive cash flow. This should show you how important it is to find properties below market value or hunt down distressed properties and rehab them for maximum rent potential. The higher you can rent it for, the higher the cash flow. The cheaper you buy the property, the less money you have to pay out of your pocket for that amount of cash flow.
This all leads up to the CCR, or “Cash on Cash Return”, which is the percentage of that down payment you made that actually goes back to your pocket in cash flow. Tune in next week to hear more in our Investing Defined series!