subject: The Truth About Cash Flow for Investment Homes [print this page] Comparing the cash flow of investment properties is difficult, even for experienced real estate investors. You may have seen a version of these alluring marketing pitches: $3,000 Annual Cash Flow!
Get Positive Cash Flow With No Money Down! 31% Cash-on-Cash ROI! But common sense tells us that things that sound too good to be true often arent. How is an investor to know? A little basic knowledge and some due diligence up front will go a long way in answering this question. There are three primary ways that an investor makes money in real estate: from cash flow, property appreciation, and pay down of the mortgage (reduction of debt liability). Building equity through appreciation and mortgage pay down are generally well-understood; however, the idea of cashflow is much more ambiguous. Conceptually, it seems simple enough: cash flow is the difference between the checks you write each month and the checks you deposit. However, many sellers of investment property have a much looser definition of cash flow, or make very unrealistic assumptions about it, and therefore can easily mislead an unwary investor. Most commonly, the key elements of cash flow that are misstated are rents which are overestimated, or expenses which are understated or omitted entirely. Lets examine the elements which comprise cash flow with an example. Figure 1 shows the fundamentals required to calculate the true before-tax cash flow (BTCF). It assumes a single-family home that is purchased for $80,000 and is rented for $800 per month with a 5% vacancy rate. Property management is assumed to be 10% of the gross operating income (GOI) and the repair allowance is assumed to be 5% of GOI. Property taxes and insurance are assumed to be $800 each, with no landlord-paid utilities. The mortgage is assumed to be at an interest rate of 7.25% fixed for 30 years with a 10% down payment. Pro Forma Cash Flow Statement (rounded) Per Month Annual Income:
GSI: Gross Scheduled Income (Rents) $800 $9,600
Less Vacancy Allowance _ 40 480 GOI: Gross Operating Income 760 9,120 Operating Expenses:
Property Taxes67 800
Property Insurance 67 800
Property Management 76 912
Repair & Maintenance Allowance 38 456 Utilities Paid by Owner/Other 0 0 Total Operating Expenses 247 2,968 NOI: Net Operating Income 513 6,152 Debt Service Expenses:
Principal + Interest Payment 491 5,894
PMI: Private Mortgage Insurance 40 480
BTCF: Before-Tax Cash Flow (19) (222)
Figure 1 Cash Flow Statement
In this example, after including all of the expenses and allowance for vacancy and PMI, the true cash flow is actually a negative $222 per year! Yet sellers of investment properties will often claim that the cash flow is positive. This is because it is common for marketers of such properties omit many of the expense categories to make the cash flow sound larger than it actually is. Using the foregoing example, Figure 2 shows some common ways cash flow may be misrepresented from the example in Figure 1. Positive Cash Flow Sellers Measurement of Cash Flow (Annual) Gross rents (GSI) less principal & interest $3,706 GSI less principal, interest taxes, & insurance (PITI) $2,106 GSI less PITI and property management$1,194 GSI less vacancy & PITI $1,626 GSI less vacancy, PITI, and property management $ 714 Actual cash flow: GSI less and vacancy all expenses $ (222) About Author
