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).