Does John T Reed's formula for positive cash flow make sense?

Question

A week or two ago there was a discussion regarding the 50% rule based on this "positive cash flow" article by John T Reed (actually Reed uses 45%, but that's neither here nor there for my question).

In the article Reed presents a formula for determining if a rental property will have positive cash flow or not, but I can't make sense of the reasoning behind the formula and Reed doesn't really explain it. I'm wondering if anyone here can explain the reasoning and comment on the formula's validity.

He says,

so that's,

LTV * C < CapRate --> positive cash flow

(C = Annual constant)

He goes on to define the terms like so,

LTV = Loan/Value

C = (annual payments) / (loan balance)

Cap rate = NOI / Price

NOI (Net operating income) = income - expenses

If you do some algebra you can restate the formula as,

(loan/value) * (price / loan balance) * annual payments < NOI --> positive cash flow

Being somewhat simple minded I would have thought that the formula for positive cash flow would be simply,

annual payments < NOI --> positive cash flow

But I don't understand the multipliers on the left side,

(loan/value) * (price/balance)

Can anyone explain to me why they should be considered?

One final observation, if we assume a "no money down" deal, we can somewhat simplify the formula:

Loan = price - down payment

let down payment = 0

then,

Loan = price

therefore,

(price^2/(value * balance) < NOI --> positive cash flow

but I don't know if that really helps or not.

Anybody got any ideas?

Account Closed · Answer

Immediate cash flow is ONLY important if you need it from day one.  Generally you give up lots of profit to chase immediate cash flow.

Ching W. · Answer

I understand that this is an old thread. I am a new member. I saw this topic while searching for something else.  Hope I can help a little.

I did not read the article by John T. Reed. We know that if we want to purchase a property for cash flow, the annual loan payment must be less than the net operating income (NOI). I think his formula is just another way of saying this, using only ratios. The math is straight forward.

Annual Loan Payment < NOI

Annual Loan Payment / Purchasing Price < NOI / Purchasing Price

You've probably reThe right hand side is the cap rate.

(Loan Amount / Purchasing Price) x (Annual Loan Payment / Loan Amount ) < Cap Rate

Now we have the formula

C*L/V  < Cap Rate

It needs some explanations.

1) the value here is the purchase price which may or may not be the market value.  it’s the value the purchaser and the seller agree in this particular transaction. Basically, the formula just tries to answer this question: if we agree to pay this much for the property, if we take out this much loan, will it cash flow? L/V is the loan we take out relative to the purchase price we agree to pay.

2) the loan balance in the annual coefficient is the initial loan balance (the loan amount), instead of the loan balance in the process of paying it off. Again, the word “balance” caused the confusion. This formula is meant to help assess the deal before a purchase.

This formula is for purchasing purposes. Can we apply it for subsequent years? Of course we can if we really want to. But we must be careful with what we do.

1) as the loan is being paid off, the loan balance becomes lower. Does it make cash flow harder? No. Because in the meantime, the “loan amount” in the L/V ratio is also lower. That L in the numerator of L/V is always the same thing as the L or B in the denominator of C. Remember we introduced L just to make ratios? So they always cancel out.

2) as the market value goes up, does it make cash flow easier? No. Because that V in L/V is actually your purchasing price which does not go up or down. If your annual mortgage payment remains fixed, cash flow solely depends on the NOI.

Hope it helps.

Account Closed · Answer

I'm following this topic because I'm interested in the answer to your question as well.  Since I'm brand new to REI, I don't have much to offer as far as answering the question.However, the  (loan/value)  and   (price / loan balance)   terms change with each payment. Therefore, perhaps these terms just add more accuracy to the picture of current  cash flow?

Scott Pigman · Answer

(bump)

I guess math scares people :-S

Scott Pigman · Answer

Some observations on the formula:

• as the balance decreases it gets harder to cash flow
• as the value increases, it becomes easier to cash flow

Neither of those facts make sense to me, but the first one is especially hard to wrap my head around. Why should paying off your balance make it harder to get cash flow?

Does John T Reed's formula for positive cash flow make sense?

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