Real Estate Investing and Cash Flow
How to Calculate Cash Flow

If you are going to make money in Real Estate Investing, you must understand Cash Flow. Take this free course from real estate guru, Carleton Sheets.

Make Sure Every Prospective Property Makes Sense Financially

The property you want to buy will bring in $9,600 per year in rent. With annual mortgage payments totaling $4,700 and taxes and insurance running $1,600, how much income should you expect to receive each year? Easy, you say. Just add $4,700 and $1,600. Subtract that from $9,600 and figure on pocketing $3,300 a year. Right?

Wrong. "You've got to look at more than rent and mortgage payments," says income property investor and manager Russell Lester. Lester, a Coldwell Banker broker, recommends doing a thorough cash-flow analysis before buying any property. "Otherwise you could end up with an alligator you have to feed every month. This is not as much of a problem as it was in the eighties, but you still need to do your homework."

So Here's Your Math Assignment:

Determine the "Effective Annual Income"
Add the rent you expect to charge and any other income the property might produce from things like coin-operated laundry equipment or other extras. From this sum, subtract a little for vacancies and collection losses. For most single-family properties in healthy rental markets, 5 percent of gross income is considered a safe allowance. (That translates into 18 vacancy days a year.) In the example above, subtracting 5 percent from the gross income would mean an effective annual income of $9,120.

Calculate Operating Expenses
Include property taxes; insurance; and any legal, accounting, or management fees associated with the house or apartment building. Even if you manage the property yourself, you should include a management fee that reflects what is being charged locally. Count on some utility costs, too. While tenants can usually be trusted to pay their own gas and electric bills, landlords often prefer to pick up the tab for water, sewer, and garbage.

These expenses are fairly straightforward. More difficult to figure are maintenance costs, like snow removal and lawn care, fixing a leaky faucet, patching and painting walls, or replacing a broken appliance. Setting aside $50 per month per unit is probably prudent. To avoid more costly repairs, Lester again advises doing your homework. "Know what the problems are before you buy. Check out plumbing, electrical, and heating systems, and be sure the building is structurally sound."

Now back to our example: To cover additional operating expenses and to have a little extra for surprises, let's add $1,200 ($100 each month) to the $1,600 for taxes and insurance. That brings total operating expenses to $2,800.

Add Total Debt Service
Multiply your monthly mortgage payments by 12 to arrive at an annual figure. Add to this any other debts attached to the property. If you use a credit card, use a line of credit, or borrow from a relative to make the purchase, be sure to include this in your debt service calculations.

Compute Net Operating Income
Does our example have a positive cash flow? To find out, add $2,800 (total expenses) to $4,700 (total debt service). Subtract that from $9,120 (effective gross income). You should come up with $1,620 per year. That's positive cash flow.

And while no down payment would really make the deal sweet, let's say you put up $5,000 of your own money. Even then, you would receive a return of more than 32 percent per year. It sure pays to do the math before you buy.

Copyright © 2002 -2006 by Carlton Sheets, All Rights Reserved.

This Real Estate Investing course to understanding Cash Flow was brought to you by real estate guru, Carlton Sheets.