The What, Why, and How of Rental Income Property Cash Flow
Cash flow is one of the major benefits investors get by investing into income-producing property; and alone, cash flow has been known to make or break income property deals by its favorable abundance (immediate or potential) or by the lack thereof.
Often referred to as the bottom line of a real estate investment, cashflow represents the amount of actual cash an income-producing property generates at the end of any period (monthly or annually) after all expenses and debt service have been paid. Namely, cash inflow less cash outflow equals cashflow.
It should be noted that the data and formulation given below concerns only cash flows collected that are still subject to income taxes (i.e., cash flow before taxes, or CFBT). It does not include the adjustments typically made for taxes and depreciation (i.e., cash flow after tax, or CFAT).
We'll begin with a definition of the various components included in the formulation then show you the formulation itself.
1. Gross Scheduled Income This is the total amount of rental income that the property would generate were it totally occupied and contained no vacant units. In cases where there are vacant units, you would apply either a market rent or perhaps one of the property's established rents. Just bear in mind that you're computing the rental property's gross "scheduled" (or potential) income so be sure that this amount reflects 100% occupancy.
2. Vacancy and Credit Loss This is where we adjust for losses due to unoccupied space or nonpayment of rent by the tenants. Typically shown as a percentage of the gross scheduled income, it may be what the actual vacancy rate is at the time of your real estate analysis or perhaps an average percentage of what the property has encountered over the past several years. To be on the safe side, though, always include some percentage for vacancy even when there are none at the time you're evaluating the property.
3. Other Income This is rent the landlord might be collecting in addition to the dwelling units such as a coin-operated laundry facility, storage units, or garages.
4. Gross Operating Income Unlike the potential income illustrated above, this represents the actual amount that the landlord can expect to collect.
1. Operating Expenses These are the expenses incurred to maintain and keep an investment property operational and in service. In other words, these are the costs that are necessary to keep the revenue stream flowing.
This would include costs such as real estate property taxes, insurance, water/sewer, trash, electric, maintenance and repair, landscaping, property management, pest control, snow removal, legal fees and so forth.
Operating expenses do not include federal or state income taxes, mortgage payments, depreciation or capital improvements (e.g., a new roof or siding). These only become a factor when the owner's tax liability is taken into account and you want to compute cash flow after taxes.
2. Debt Service As it sounds, this is the amount paid to service the debt (i.e., the mortgage payment). In this case, it includes the entire amount of a mortgage payment even though the interest portion is deductible.
Gross Scheduled Income
less Vacancy and Credit Loss
plus Other income
equals Gross Operating Income
less Operating Expenses
equals Net Operating Income
less Debt Service
equals Cash Flow
Rule of Thumb
When doing a real estate analysis on any rental income property, don't be tempted to over-inflate the numbers simply because you like the property, or under-inflate the numbers because you don't. Use realistic numbers in your forecast and let the bottom line speak for itself. It's the only proven way you can make prudent real estate investment decisions.
Here's to your real estate investing success.