Calculating Cash Flow
Calculating Cash Flow for Real Estate
With any investment…an most important part of doing any investment is to know how you will calculating cash flow that will be generated. As with any investment, you want to make sure you fully understand your investment and take into consideration other factors that could impact cash flow, this would include an insurance plan that doesn’t cover a property fully, dishonest property managers that might not pay, or buying a property that you thought was a Four-plex turns out to be a tri-plex. I don’t address these issues in this article on calculating cash flow. However, I want to emphasize that if you truly don’t know the property and area then no matter how good the cash flow may appear it may be non-existent once you have ownership of the property. Note, I’m not “The Expert” on all aspects of real estate and while besides doing your own due diligence you want to find the right consultants who are experience and who understand what you are looking to achieve, this would include: mortgage lenders, insurance representatives, real estate attorneys, accountants, etc…advice. It could be well worth it prior to jumping into areas that you may not that familiar with. Again, if you buy a cash sucking machine instead, all the work in calculating cash flow can be thrown out the window. So, with this in mind let’s figure out what’s involved in calculating cash flow of a new real estate investment.
What To Look in Residential Properties When Determining Cash Flow
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When calculating cash flow you want to become familiar with the following:
Other Fees (Waste/Trash Expenses)
Other Income (eg. Late Fees)
Other Expense (Vacancies)
Now, let me explain these further so that you have a better understanding about them and how they play a part in calculating cash flow.
Taxes – Specifically, we are talking about property taxes that are determined by the tax assessors’ office. While each Tax county applies their own formula and has a different assessed fee depending on where the property is located the value that assessors use to determine taxes is below the fair market value of the property. Now, you can view the assessment of an already existing property and see what the price of the property was assessed for, along check Zillow.com or other sources to further get an idea of what the seller paid, and may be willing to take. Note, I provide additional sources in my article below named Estimating Real Estate Market Home and Rental Values. One last point that I will mention on property taxes here is that for new homes the property tax amount at purchase may be significantly lower than when it is fully assessed with the land and improvements (the home). Call the tax assessor to get an idea of what this amount to get a more accurate view of calculating cash flow of your target property.
Insurance – My experience has been that insurance can be a great thing….you never know when you will need it. Before purchasing a property, interview several insurance agents/firms in the area that you are planning to buy your investment property. Find out what type of coverage they have and determine what you are comfortable in purchasing. Note, some areas will not sell a full insurance protection package if you don’t live in the area…it’s good to know that before you buy the property. Other things to keep in mind to protect your investment and your financial well-being would be to look into umbrella insurance which provides additional protection that your insurance agent can elaborate on. Lastly, you may wish to speak with a real estate or asset attorney on placing properties into an LLC or other entity. This will potentially provide additional protection from issues that may go beyond your control during your ownership of a property. It depends on your understanding of your situation, real estate portfolio, and comfort level. However, it never hurts to ask professionals for their view to see if it’s something that might truly benefit your long term goal.
Management – In calculating cash flow you should consider the cost of a property management company. If you are not using one you can remove this expense which is usually between 8 to 12% depending on the property type, area, and the service offered. Additional expenses you should inquire about with a property management include: leasing fees, advertising fees, eviction protection fees, and fees for services such as to make your property winter ready. Ask property management companies upfront what the normal fees landlords pay throughout the year that may not be readily known by just looking at their website or during an initial conversation with them.
Maintenance – These are the usual expenses for upkeep such as lawn mowing (usually paid by tenant on single family homes), painting a door, cleaning mold in the tub, etc…you can ask your accountant specifically how to record items and if they are maintenance or repair expenses. You may see these expenses grouped together with repair expenses and you may wish to figure about 2 to 3% for this.
Repairs – Similar to maintenance though these expenses could include a broken water pipe, roof repair, a door bell not working, etc…While this expense is grouped in with maintenance fees sometimes, you should make sure to have a comfortable reserve of up to 4 to 6 months of the rental amount. This reserve will cover you for a potential vacancy that could occur and repairs made during that time.
Utilities – When you purchase a property find out if the tenant can pay for this in their own name. Some utility companies want to bill the owner directly and have the owner then bill the tenant. You can also have your property management company take care of this. I prefer the tenant be responsible for their bills, since if they stop paying I’m not stuck with their utility bill too. Understand who is responsible for the bills if the tenant does not pay since it varies with each utility company. For multi-family properties up to the four-plex, still considered residential real estate, the common utilities you may need to pay for directly if the services have not been divided up. Know how to treat the separation of utility costs since this will be important in calculating cash flow.
Mortgage Payments – These payments may be impounded and include the property taxes and insurance. Make sure you know if they do or not when calculating cash flow. Also, you may have PMI (Private Mortgage Insurance) if you put a down payment less than 20%. This is another good item to be aware of and know in what year you may request for it removed from your payments. While some lenders may assess to remove this item or not, I believe you need to be proactive and request once the property has the 20% plus equity they require to then remove PMI. Removing this expense at some point in time could at least save you $100 plus per month. If it’s in the payment though make to add it in calculating cash flow. We are not going to speculate on what might happen…it’s best to know where your investment property stands today.
Other factors that you will need to speak to a lender about include the loan amount, term of the loan, and interest rate. Lastly, make sure you understand how the loan is written and the potential consequences as it relates to calculating cash flow in the future. Your cash flow will change based on whether you have a fixed or variable loan, and if there are any surprises such as the recasting of a loan at some later date. Make sure you fully understand this when calculating cash flow. You can do this by either by reading the document yourself or by asking questions to your lender or attorney. Note, you can call the lending company up and you may not get an informed answer…make sure you get the right information from right individuals. You want to speak with knowledgeable and experienced individuals…why? Because if you listen to anyone again you can forget about calculating cash flow. This is another important area to make watch over carefully.
HOA Fees – They may or may not be an expense for your property. Make sure you know though if HOA (Home Owners Association) fees are necessary…since again this is important in calculating cash flow. You may wish to find out too by calling the HOA company for that property to find out what the projected fees will be for the upcoming year, since they do tend to increase slightly each year.
Other Fees (Waste/Trash Expenses) – You may other fees that are to be paid. Again, do your research and ask your realtor and/or the seller of any other such fees. Sometimes, you might find fees that can be lowered. You can do research on this, however, only include any expenses if you know the actual expenses. When calculating cash flow we want to work with real numbers not ‘what ifs’. If you are a more advanced investor you may have a better pulse on this and can estimate the cost though if you are just starting off I would not recommend guessing.
Income – This is the rental income that is brought in.
Other Income (eg. Late Fees) – This is additional income beyond the regular income. Other items related other income would be late laundry income, vending machines, parking space rental, and pet fees.
Other Expense (Vacancies) – One other item that should be considered is vacancies. A range of 4% to 12% may be taken into account depending on where you are buying the investment property. Before calculating cash flow you need to again research the area and this is one of the things to find out about. You can get much of this information by searching online, reading books and magazines, and to be followed up by interviewing a number of different realtors in the area and/or appraisers to find out what this value might be.
So, after you have gotten all of the items needed for calculating cash flow. Take the time and put in an excel sheet or write it down on paper.
Minus Estimated Vacancies – Other Expense
Note, there are different ways to show this information for calculating cash flow…however, the main point is to recognize that all the income and subtract it from the expenses to determine the cash flow. If you have more income than expenses then it’s a positive number…I prefer this approach to investing. Some investors will purchase a negative cash flowing property hoping it will go up in value which can be much riskier. If you do go for a more riskier real estate portfolio I would recommend a more balanced real estate portfolio where at least some provide positive cash to offset the difference or you have other means of income that can act as a buffer and reserve if you ever need it.
Here are a few Real Estate Calculators for Calculating Cash Flow:
Interest.com Mortgage Calculator
BankRate.com Mortgage Calculator
You can also download Mortgage Calculators at: Realtyinvestorsoft.com
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