Capturing POSITIVE CASH FLOW from Rentals!

Correct me if I am wrong, but isn’t the point of owning a rental property to have it earn a positive income? Not just to earn cash flow, because let’s face it, just as there is such a thing as positive cash flow, there is also a thing known as negative cash flow. So, cash flow alone is NOT the goal, although it is necessary in order to achieve the goal, with that goal being a profit from the rental property income.

Through the years of lending to real estate investors I have to sometimes scratch my head when I look at the breakdown of the income stream from their rental properties. I understand that some may be better profit production sources than others, but I am amazed at how many times I would see properties that either made very little profit, or none at all. I could only guess that the purpose of owning these losers was for the increase in equity through property value escalation. Hence increasing the owners overall net worth, since they weren’t doing much of anything for the monthly income stream.

So, lets take a look at what a rental property’s profitable income should look like. In my humble opinion, a rental property investor should design their business, and every asset within that business, to be lender friendly. What I mean by lender friendly is to underwrite their properties the way a lender were to if that lender was considering lending money with the property (the asset) as the collateral for the loan.

Why design the business to be lender friendly? Well, aside from the obvious reason that IF you ever find the need to borrow against the properties, the odds are greater that you could if they were underwritten to a lender’s point of view for profitability. You see, lenders believe that each asset should be self-sustaining. Able to pay its own bills AND make profit. If you have ever been a parent to a child, you teach it to take care of itself, as one day, when you stop taking care of it, it can survive on its own. Each rental should be that child, ready to leave the nest and survive without being carried by other assets.

Lenders utilize a formula to calculate the DSCR (debt-service-coverage-ratio) of an asset (the property). The formula essentially works this way. The income from the property (the total of the monthly lease amounts) must be able to pay the property’s bills (mortgage payment, taxes, insurance & homeowners association) PLUS have profit left over.

Example: Income from the lease is $3000. The total expense for the property equals $2000. (mortgage, taxes, insurance, homeowners assoc.). Divide the income of $3000 by the expenses of $2000 to gain the DSCR. In this case it is 1.50 ($3000 divided by $2000 = 1.5). The example property would have a 1.5 DSCR. The lender believes that a minimum of 1.20 DSCR is needed to have the property be lendable (at the time this is written, however it keeps rising). A 1.0 DSCR would be a break even asset, as the property’s income would be equal to its expenses and make NO positive cash flow.

Obviously the larger the DSCR the better as that means the property has a stronger positive cash flow. If you design your rental purchases to work the way a lender sees them as being promising as opposed to toxic, then you will discover that you have a greater cash flow per property and to your entire business.

I have always worked the projects that I was considering backwards. Start with the market rent (since this is a realistic income figure for the property), then divide that figure by the desired DSCR. If we use the example’s DSCR, it would be 1.5. Now you have the total amount of bills that can fit into that 1.5 DSCR figure. You can use this backward math to come up with the maximum price you can pay (and finance) when considering the rental property purchase.

Example: Market rent of $3000. Expenses WITHOUT the mortgage payment included are $800. This leaves $1200 a month for the mortgage payment to be included in the property’s expense and still equal a 1.5 DSCR (the total expenses including the mortgage payment would need to be $2000, when the income is $3000/month in order for the 1.5 DSCR to be gained. If the other expenses of the property total $800/month, then that leaves room for a $1200/month mortgage payment).

Now that we know that the mortgage payment can’t exceed $1200/month (for principal & interest) in order to obtain the 1.5 DSCR, simply calculate backwards what the loan amount would be to have a monthly payment of $1200. First, we need to determine the interest rate. When writing this, the current interest rate for a 30 year (DSCR type) rental loan supplied to an LLC is 7.75%. With a rate of 7.75%, that means that on every one thousand dollars borrowed the monthly payment is $7.16. Now we divide $1200 by 7.16, and we see that the maximum loan we could gain in order to have a payment of $1200 is $167,598. If the lender were extending 80% loan to value, and the loan being extended is $167,598, then the value of the rental property would be roughly $209,500 ($167,598 divided by .80 = $209,497.50).

So, using this way of calculating for value, the property that produces $3000/month with a 1.5 DSCR should not be purchased for more than $209,500 in order to accomplish this positive cash flow. Some investors use what is referred to as the 1% rule. This rule means that the gross rental income from the property shouldn’t be less than 1% of the purchase price of the property. However, this rule doesn’t take into account the bills that the property has. If the property resides within an area that has high property taxes, or flood insurance, then this rule alone is not the best tool to use.

I prefer to approach it the way lender’s underwrite, as I haven’t met too many lenders that enjoy lending on properties that can’t pay its bills.

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