Cash flow is why most real estate investors invest in rental property. Whether to get a steady stream of it on a monthly basis or a lump sum of it when the property appreciates in value and gets sold (or both); the proverbial real estate investing adage is true: real estate investors buy the revenue investment real estate generates.
In this article we will look at rental property cash flows.
About Cash Flows
Cash flows essentially represent all of a property’s cash inflows less all of its cash outflows during a given period of time. They are always regarded in one of two ways:
- Those collected before taxes without any regard for the investor’s federal income taxes (CFBT)
- Those that are collected after Uncle Sam takes his share (CFAT)
This is why you regularly will see cash flows labeled as (CFBT) and (CFAT) in real estate analysis reports. The designation simply indicates whether or not it is revenue collected by the investor before or after his or her income tax liability.
Both constitute a rental property’s income stream and therefore should be understood when real estate investing.
It should be noted, however, that real estate investors are commonly more interested in (CFAT) because it presents a more concise picture on the profitability of an investment property opportunity directly applicable to the investor.
Cash flow before taxes is revenue that does not consider the property’s impact on the owner’s tax liability.
It is the property’s net operating income (gross income collected less operating expenses) less debt service and capital additions (i.e., cost for a new roof) plus loan proceeds (i.e., funds obtained from a second mortgage to pay for the new roof) plus interest earned (i.e., interest earned by the owner on revenues collected).
Net Operating Income
– Debt Service
– Capital Additions
+ Loan Proceeds
+ Interest Earned
= Cash Flow Before Taxes
Say a rental property generates a net operating income of $120,000, requires the investor to make an annual mortgage payment of $100,000 (the debt service), and that there are no capital additions, additional loan proceeds, or interest earned.
Cash flow after taxes is revenue less any tax liability that arises from the operation of the rental property.
This is a bit more complex because it requires a calculation for taxable income followed by a computation for income tax liability (or loss) which in turn is subtracted from CFBT. We’ll start with the formulation then look at the two other components required to make the calculation. For this discussion, however, we will keep it simple because we are just trying to give you an idea of how it works. There are other articles here on the subject with more detail if you wish.
Cash Flow Before Taxes
– Tax Liability
= Cash Flow After Taxes
Okay, so we have to see how the tax liability is computed in order to make the calculation. We will show you both formulations and then add some assumptive numbers to arrive at a result.
Net Operating Income
– Interest Expense (mortgages)
– Amortized Points (mortgages)
– Depreciation (real property and capital additions)
+ Interest Earned
= Taxable Income
x Marginal Tax Rate (investor’s combined state and federal tax rates)
= Tax Liability
To complete the calculation so we can show you the final result will assume that the tax liability is $7,000 and refer back to the amount we arrived at previously for cash flow before taxes.
In this illustration we assumed that the investor had a tax liability and therefore it was subtracted from the cash flow before taxes. Had it been a tax savings, however, it would have been added instead. In other words, had the taxable income resulted in a negative amount, then that amount would have become an income tax savings which would have increased cash flow after tax.
So You Know
ProAPOD provides a real estate investment software solution that automatically calculates both cash flows and includes them in the appropriate real estate analysis reports.