Analyzing a Property Using Cash Flow Analysis

Is it a good deal? Have you ever asked yourself that question when you’re looking at a property?

There are four ways to make money from real estate: Cash Flow, Appreciation, Principal Paydown, and Tax Benefits. Understanding this will help you to determine whether or not a property is a good investment.

We will first discuss the viability of a property using the Cash Flow Analysis. I will explain each of the line items in the spreadsheet below and their correlation. We will go over them from the top and work our way to the bottom to define cash flow and its significance in finding a good investment opportunity.

First, we will define Gross Rent, Vacancy, and Effective Gross Rent.

Gross rent refers to the amount that a property can be rented for on the market, while vacancy refers to the total cost you will incur while the property is vacant. The Effective Gross Rent is the difference between the Gross Rent and the Vacancy.

Moreover, there are several ways to calculate vacancy. Some people put a percentage in this line item. I calculate it by finding the average vacancy frequency of the property and the potential gross rent I will lose during the period.

For example, on average, every three years one of my properties will become vacant. To fill the vacancy, it takes me at least a month to market it, which is including the turnover. This means the property is going to be vacant one month out of every three years (36 months).

To calculate the vacancy, I take the 1 month gross rent ($1,600.00) that I will be losing and divide it by 36 months. Therefore, I can expect to lose $44 per month due to vacancy over the next 3 years.

Next, let us identify the items that constitute the Total Expenses, which are the following:

1. Management Fee - This is the amount you will be paying a property manager. You are probably going to pay about 8-12% on a single-family rental in management fees in the current market. However, I recommend paying the management fee based on the effective gross rents, i.e., what’s actually collected, not based on scheduled rents.

2. Taxes - These are your real estate taxes. The city, county, and school taxes are all lumped in here.

3. Insurance - This refers to your monthly payment on your Homeowners insurance.

4. Utilities - Usually, you do not pay anything in utilities because you will be billing the tenant(s). In my properties, I pay for sewer and stormwater, so the tenants are only billed for the usage of water.

5. Rental Permits/Licenses - Some municipalities collect rental permits or rental licenses while some do not.

6. Repairs and Maintenance - The allocation for this item depends on the condition of the house you buy. On average, my properties end up costing me about $50 a month per property for repair and maintenance.

7. Condo Fees - This is a levy paid by every property owner in a condominium complex to cover ongoing maintenance costs. Typically, I stay away from condominiums because condo fees usually kill the cash flow. For example, if I have a $300.00 condo fee to pay for a property, my cash flow will only be $74.00 per month. However, if you own a condominium and can still make it work, that is where you can account for the condo fees.

8. Advertising Fee - This refers to the advertising cost required to hire a property manager or realtor when you are renting out a vacant unit. I use the same principle in calculating Vacancy here.

9. Capital Expenditures - This can vary from property to property. The amount you put here will depend on the condition of the home when you place it into service. When you buy a brand new or rehabbed home, you probably should have a low capital expenditure budget. But, if you purchase a house that hasn’t had any work done in 15 years, you can probably expect this to be a higher number.

To calculate your Total Expenses, simply add up all the expenses above.

Now, you will calculate the Net Operating Income. This is obtained by subtracting the Total Expenses from Effective Gross Rent, which in our example above is $1,092.00.

You are now ready to determine your Cash Flow. This is obtained by subtracting the Mortgage Payment, which includes the principal and interest, from the Net Operating Income. In our example, the mortgage payment is $718/month, which brings us to a Monthly Cash Flow of $374.00, and $4,484 annually.

But, determining if a property is a good deal or not doesn’t end there. We need to take one more step to do that, which is to divide the Annual Cash Flow by the Total Cash Invested in order to determine the Cash on Cash Return Percentage.

In our example above, the Total Cash Invested is $47,000.00. This is based on the value of the home being at $200,000.00 with an 80% down payment. The mortgage for the property would probably be at $160,000 with an interest rate of 3.5%.

So, $4,484 divided by $47,000 brings us to a Cash on Cash Return of 9.54%.

You can use this information as a means of comparison with the other properties in the area. If your Cash on Cash Return value is higher than the average Cash on Cash Return in your market, then it is safe to say that the property is indeed a good deal.

Furthermore, your Gross Rents can grow over time while your mortgage payment is usually fixed. This means growth in your Cash on Cash Return!