There are a lot of factors that go into any real estate investor’s decision to pursue and purchase a rental property. You always want to have a good idea of the location and its potential for future value, for starters. You also want to understand the demographics of an area—for example, are you investing in an area that will appeal mostly to retirees? How will that change any of your investment decisions, if at all?
Table of Contents - Step by Step Guide to Analyzing a Rental Property’s Cash Flow
Once you’ve identified a property to rent out, you need to take steps to figure out its financial potential. This is a foreign concept to many folks—they’ve never really thought about how to do this math. Fortunately, there are some tried and true methods for figuring out the cash flow potential of any rental property.
What is cash flow?
It’s important to first have an understanding of the terminology. First and foremost, the concept of cash is more or less synonymous with “profit” —that is, it’s the income that’s left over for you once all of the expenses are paid. It’s important to remember that cash flow isn’t just “rent paid to me minus the mortgage payment that I’m responsible for.” There is far more to cash flow than this, and property owners need to understand the expenses that can come along with a property.
What are some common expenses?
Some common expenses that can affect your cash flow are things like property taxes, various types of insurance, water bills, sewer bills, capital expenditures and more. These are all expenses that shouldn’t be unpleasant surprises, so when you’re evaluating a rental property, you need to ensure that you’re doing your homework. You should get an idea of what things like utilities, HOA fees and other “hidden” expenses might cost. Otherwise, your cash flow analysis will be all wrong from the start.
Did you pay cash?
Some real estate investors are fortunate enough to pay cash for one of their rental properties. If this is the case, then your cash flow and your net operating income (NOI) are going to be exactly the same. This is where things can get a bit confusing because NOI and cash flow are two different things. NOI is income minus expenses but assumes that you have no expenses in the form of debt service (mortgage, etc.). Cash flow does factor in the money that goes along with debt service, so whether you’re paying cash or not will affect which one of these metrics you will find most useful.
Mortgages make a difference
It should go without saying that a rental property that has a significant loan on it is going to generate quite a bit less cash flow than a more affordable property that you owe less money on. Mortgage payments bite directly into your profits, so it’s important to not be seduced by a rental property that you could charge high rents for if you don’t have much capital to work with. Your profits may be going to be eaten up by your mortgage payments, so you’re better off by calculating based on numbers that you can afford, not numbers that would be a real stretch for you.
Once you’ve established your cash flow potential, it’s possible to then figure out how quickly you’re building equity in the rental property. All you need to do is take your monthly cash flow and then add the principal portion of your mortgage payment to this figure. That will give you the total amount of cash going into your pockets, either now or in the future when you eventually sell the property.
When you arrive at this number, you can multiply that figure by 12 (12 months in a year) to give you your annual return figure—a useful number to know, as it tells you how much money is coming back to you in a typical year.
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Calculating the rate of return
Another metric that you can calculate is the rate of return. This is also known as the return on investment, and it needs to be calculated for any investment, from stocks to bonds to real estate. Your rate of return is how your cash flow relates to the cost of your investment (also known as your “basis”) —expressed mathematically, this is cash flow divided by investment basis.
To determine if you’re getting into a solid investment or not, it’s worth understanding some comparable figures in other common investments. The stock market historically has returns of 8-10 percent annually, while a high-interest savings account can be more like 2-5 percent. A certificate of deposit (CD) is usually somewhere in the middle at around 5 percent. If your rate of return is going to be something like 1 or 2 percent, you likely should look into finding another rental property to purchase or look into another investment opportunity that can offer more consistent bang for your buck.
There are several guides and math equations that will help you figure out exactly how much you can earn on a rental property in a given amount of time. Understanding exactly what you can afford and how tightly you’ll be stretched on a mortgage is the first step towards figuring out your cash flow.
If your mortgage payments are more than you can afford, then that will affect all of your other decisions. We also believe that it’s never a bad idea to work with a qualified financial professional if you feel that calculations like this can be a bit out of your depth. It is always a good idea to seek the expertise of as many resources as possible. Since real estate investment requires a good deal of capital and serious time commitments, you’re wise to do as much research as possible before signing on the dotted line.
How To Invest In Real Estate: The ULTIMATE Guide to Calculating Cashflow
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