Cash Flow Analysis – Smart Advice for Computing Operating Expenses

The cash flow of rental income property is what any investor engaged in real estate investing wants to determine. How much cash (both before taxes and after taxes) will remain after the property’s operating expenses and mortgage payment is deducted from the rental and other income generated by the property? In other words, will the property ultimately produce enough cash during any given year for me to pocket some of it (and perhaps invest it elsewhere) or have to feed into it (out of my personal funds) to keep the property running?

Arriving at an income property’s cash flow before taxes (CFBT) is straightforward: Simply calculate the property’s gross scheduled income (the total annual income that would be collected if all units are rented) then deduct some amount for vacancy and credit losses then add back in any other income that could be collected annually (i.e., from laundry facilities, garages, storage units, etc.) then deduct the property’s annual operating expenses and finally the annual mortgage payment you must make to own the property.

Arriving at the property’s cash flow after taxes (CFAT) is slightly more complex in that it either adds to or deducts from the annual (CFBT) depending upon whether the real estate investor has a tax liability or tax savings after the elements of tax shelter are applied (i.e., depreciation, mortgage interest, and amortized loan points) based upon the investor’s marginal income tax rate.

Okay, I understand that you if you are new at real estate investing you might be scratching your head about now. But stick with me. I just want you to understand the importance of cash flow plays in any investment real estate decision. It’s paramount.

Fair enough, now let me offer some suggestions about how you should enter the property’s annual operating expenses when you do your rental property analysis so you arrive at the correct bottom line.

Here’s the common tendency amongst many inexperienced agents and real estate investors.

They will use the current owner’s vacancy rate along with his repairs and maintenance costs to calculate their analysis. For example, if the owner is reporting a 2% (or perhaps even zero) vacancy rate and say a 2% repairs and maintenance cost, the tendency is to carry forward these figures into their own property analysis. In other words, they are content to assume that the same figures for vacancy rate and repairs that the current owner enjoyed will also apply to the buyer.

But this is a wrong real estate investing assumption because it’s not logical. Think about it.

The fact that the current owner has had a low vacancy rate can be attributable to any number of factors such as below-market rents, rent incentives, or sloppy rent collection policies that allow tenants (without penalty) to not pay on time. By the same token the repairs and maintenance costs might be the result of the owner doing the repairs himself or perhaps having a relative or friend do the work at a cost that’s next-to-nothing.

This is why all bank appraisers always use at least a 5% vacancy and credit loss rate and somewhere between a 6-8% repairs and maintenance rate for the property’s operating expenses when setting a fair market value for the property. So should you; it just makes smart real estate investing sense to arrive at the cash flow that you are most likely to collect if you purchase property (despite what the owner claims).

Real Estate Investing – Eliminating Risk

What would it be like to create business plans so clever that they are virtually infallible? A lofty goal, but an attainable one, for real estate investors willing to take the time to create a series of safety nets for their investments.

The premise works as follows: no matter how long term your investment goals are, investors are wise to consider and allow for contingencies forcing them to extend their ownership exposure for the property. In plain English, that means that you should invest with backup plans in place in case you have to hold onto the property.

From a practical perspective, how is this done?

If you flip real estate contracts, and your ownership exposure is (ideally) none, you probably are only concerned with how cheaply you can acquire a real estate purchase contract, and how expensively you can sell it. But what happens when your buyer bails out at the last minute? Or you can’t find a buyer? You’re stuck settling on the property yourself, which means the next fastest way to turn a profit is to sell the property. But of course, you now had to pay all those settlement expenses, and you’ll have even more expenses to sell the property. How do you recover that profit?

The answer is that you’ll have to create value in the property. The easiest way to create equity in the property is to improve it, so when you’re scouting for houses, even if only to flip the contract, look for fixer-uppers, because they’re easier to scrape a profit from if you’re forced to settle. As a bonus, you’ll be selling to a homeowner instead of a fellow investor, which means they’ll be buying retail instead of wholesale, improving your sales price further.

What’s the next safety net, if you can’t sell the property? You probably have a mortgage that you’re carrying every month, which means you’ll have to do something to cover that hefty expense, and fast. This means renting the property to a tenant, so that someone ELSE pays that monthly bill. So the trick here is minimizing your monthly costs (i.e. mortgage) and maximizing your monthly income (i.e. rent). Some neighborhoods lend themselves far better to rental properties than others, so consider the market rents when you buy a property (or put a contract on a property intending to flip it).

Neighborhoods that tend to make for good rental investments are college neighborhoods, immigrant neighborhoods, gentrifying yuppie neighborhoods, and stable blue-collar working neighborhoods. Each of these has their own pitfalls, but they make for a good place to start looking.

Once the property is rented out, you can sell to a fellow landlord or real estate investor at your leisure, if you so choose. If that fails to offer the profit your books need, what’s the next safety net?

The final safety net is to limit your exposure to neighborhoods that you feel are appreciating in value. Thus, if you can’t flip the contract, can’t renovate and resell, and can’t sell after renting out, you can always simply allow the property to appreciate on its own, after which you can refinance for cash out, or (finally!) sell the damn thing for a profit.

Just as with each of our previous safety nets, our last one has certain indicators to bear in mind. Areas that are likely to appreciate must, first and foremost, have some sort of intrinsically valuable location. This could mean anything from an urban neighborhood close to a body of water, or close to the site of planned sports stadium, or an area with access to existing or planned transportation, or any number of other factors. Keep an eye on demographic patterns, and if you see a neighborhood that starts appealing to young professionals, it’s a strong sign, as they tend to be the first in the door of a gentrifying neighborhood.

The next time you consider buying an investment property (or contract), consider all of these safety nets, and look for fixer-uppers, areas with strong market rents relative to pricing, and neighborhoods likely to appreciate. Don’t assume your first plan will work, because it may be your last real estate investment if it fails.

Why Cash Flow is Paramount to a Real Estate Investment

The starting point for any investor making a real estate investment decision is a study of the overall market and supply and demand factors in specific cities and towns. Whether for speculative purposes or part of a long-term strategy, investors are never willing to engage in real estate investing unless the financial climate agrees.

As such, the bottom line for investors trying to decide whether to buy or hold boils down to their ability to analyze the health of a property’s cash flow, rental demand, and rent rates; because these will change over time for any income-producing property in any area and a prudent investor will want to stay on top of it.

The key element when analyzing rental property is the cash flow produced by the property (which simply stated is the difference between cash inflow and outflow). At all times any prudent investor engaged in real estate investing wants to know how well the investment is performing and subsequently whether it’s worth buying (or worth holding) based the climate of the property’s specific market.

Even if you accept the premise that rental property values will grow in value over time and will accumulate equity as you pay down the loan, you still need to be able to afford to hold onto the property. If the annual income you collect from the property, for example, does not cover the cash payments required running the property (i.e., mortgage payment and operating expenses) then you must decide whether you can afford to “feed” the property out of your personal budget as well as perhaps reduce your ability to invest capital in other markets.

Here are some questions you should ask and be convinced of when contending with negative cash flow. Is the situation temporary? Research the building trends, available financing, employment, demographic, and other economic trends in the area to determine whether they are positive or negative. How are market conditions going to change in the near future? Listen to the experts and try to quantify their predictions. Is market value growth exceeding negative cash flow? In other words, do you anticipate that the property value anticipated over time offsets having to feed the property and you can afford to wait it out?

When real estate investing, it always helps to find indicators that demonstrate a trend. If they are positive and appear promising (even in a slow market) then you might want to jump in, or in cases where you already are invested in a rental property you may wait out the market (if you can afford to); otherwise, don’t make the investment or (if you already own the property) it may be better to sell and cut your losses.

Here’s to your real estate investing success.

Useful Rental Property Valuation Calculations

Two calculations often made by appraisers using the income approach to valuate rental property involve the profit margin and break-even ratio. In this article I will explain and show the formulas for both.

Profit Margin

Profit margin is the result of dividing cash flow from comparative rental properties and the subject property by gross operating income. This is the gross income adjusted for likely vacancies. Since the profit margin is based on cash flow rather than tax-basis profit including depreciation is a good way for appraisers and real estate investors to determine whether one income property has better cash flow potential than either another income property or the average property in the current market.

Formula: Cash flow / Gross operating income = Profit margin

Breakeven Ratio

Break-even ratio is another analytical tool used by appraisers and investors that shows how well the gross operating income will cover cash requirements. When the ratio is below 1.00 it signifies that the property should be able to produce net positive cash flow. A ratio above 1.00 indicates a negative cash flow.

Formula: Operating expenses + Mortgage debt service / Gross operating income = Break-even ratio

This ratio can also be calculated to include the effect of tax reduction and provision for tax advantages. This is important to many real estate investors involved with income-producing properties because it is possible to report a tax-basis net loss but still produce a positive cash flow. When the tax benefits of the investment are substantial this formula should be given greater emphasis because for many individual investors tax benefits define the difference between positive and negative cash flow.

Formula: Operating expenses + Mortgage debt service – [(operating expenses + interest + depreciation) x effective tax rate] / Gross operating income = Break-even ratio net of taxes

ProAPOD Investor 4.0 Updated

ProAPOD Investor 4.0, our real estate investor software for novice investors, has been updated to include a photo page similar to the photo page included in ProAPOD Executive 10.0, our real estate investment software solution for agents and investors more engaged in real estate investing.

This will allow to add up to six more pictures of any property you might be analyzing into a new printable report called “Photo Page”. It’s very easy to use. Just open the form named “Photo Page” from our toolbar and select “Get photo” for each photo you want to include then follow the online instructions. You can also include a short description. ProAPOD will format and post the photo on the report automatically along with your description directly below the picture. The whole process takes less than 10 seconds.

Deleting or changing the photo is just as easy.

If you currently have the real estate investor software installed on your computer, simply login to your account from our website at http://www.proapod.com and click the download button under “Updates.”

Please report any problems you might incur immediately.

James R Kobzeff

ProAPOD