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Cash Flow Analysis 101

  Rental Properties

Cash Is King 

This statement has been around as long as business has – and it still holds absolutely true today. It is rule Number One in real estate rental investing. Rules 2 through 100? - refer directly to Rule Number One.

The Importance of Cash Flow Analysis

As part of your over all Internal Rate of Return study, your cash flow analysis is critical when considering a residential real estate investment.  It defines your fallback position and answers the questions, “What happens if I can’t sell the investment at the price I need or want at the time I need or want?” and, “Can I afford to carry it until I can sell it?”.

Spreadsheets

While it is not absolutely critical for doing the analysis itself, learning how to use a spreadsheet such as Microsoft’s Excel is quite useful.  Once set up properly – a spreadsheet allows you to immediately see the effect changing an assumption (e.g. the rental rate) has on the overall profitability and return outcome of your investment.

Positive vs Negative Cash Flow

Positive cash flow means that the income it produces is enough to cover its expenses, reserves for replacements and debt service without having to add money each month or at the fiscal year end.  Negative cash flow is just the opposite. Your rental property income doesn’t cover the expenses.  Absent some other mitigating circumstance like a favorable forthcoming zoning change, generally a rental investment that doesn’t produce positive cash flow is not a good investment.  

The Simple Analysis Isn’t Difficult

Interestingly enough – a simple cash flow analysis is rather simple and easy to do.  It requires a minimal amount of research and few assumptions.*

The first thing to do is to simply set up line item columns.  On top will be the income.  We prefer using three columns – one for factors, one for monthly figures and one which is annualized.   See Figure One.

Income Determination

The income is determined simply by taking the monthly rental rate and multiplying by 12.  If there is any other source of income, it too would be added here.  Typically a residential rental only has the rent paid by the tenant as the sole source of income.   This total is called the Potential Gross Income. It is the total revenue the property could bring if rented out for an entire year without interruption or collection problems. 

Next you need to figure in an interruption in rents and/or a collection problem.  While you may not ever encounter a collection problem, you will inevitably have a vacancy.  Even a 1 month vacancy between a move out and a new tenant moving in is 1/12 or 8.33% of the potential revenue.  

Next we subtract the vacancy factor and the collection factor from the Potential Gross Income.  This gives us our Effective Gross Income – what we actually have to pay expenses – money we can “count on” per se.

Figuring Expenses

Next we move to expenses.   There are two kinds – Fixed and Variable. Fixed expenses do not change with occupancy. An example would be landlord and liability insurance.    Variable expenses can change each month. An example might be utilities (if included as part of the rent), management fees and repairs. 

Though not an actual expense, this section also includes a dollar amount for replacements. For example – eventually the dishwasher or HVAC system will have to be replaced. A number in the expense section is added to cover what these replacement expenses might be. Because each item has a different useful life period (a dishwasher 7 years, a roof 20 years) and different cost to replace, it will not be exact and it can be somewhat arbitrary and difficult to pin down a precise figure.^  

NOI - The First Bottom Line

Subtracting the Effective Gross Income from the Expenses gives us our net operating income or NOI.   As you will see in other articles on our website – the NOI is a critical number when valuating a property.

BTCF – The Second Bottom Line

The next deduction below the NOI is the cost of debt service.  This is from where any financing payments are deducted. 

The sum left over is the Before Tax Cash Flow (BTCF).   If this number is negative – the property does not cash flow and eventually you will be adding money in order to meet all of the debt obligations associated with the property. This might be every month, or with every large expenditure such as property taxes. 

One benefit a rental property has is that if the BTCF number is positive – it is possible to shield it from income taxes by using depreciation.

Depreciation

Depreciation is an accounting concept and method whereby the original cost (the cost basis) is incrementally reduced to generally coincide with the asset’s time for replacement.  For example:  A widget has a useful life  of 10 years afterwhich it will need to be replaced.  The original cost is $1000.  Thus, the widget will be depreciated by $100 each year at the end of which it will be replaced. ** 

Real estate is depreciated as well.  The schedule for residential property is 27.5 years and is set by the IRS.  Depreciation is taken on the cost basis of the improvements only – not the land.

Thus, if your BTCF is $3000 for the year on a $300,000 residential investment allotted 80% to improvements and 20% to land the depreciation will be .8 x 300,000/27.5 or $8,727.  This means you would owe no income tax on the $3000.**

In summary – cash is king and positive cash flow produces cash after the expenses and financing are paid.  This is the type of residential investment preferred by most investors.

Contact us today to help you identify your investment property.

^If you want a more precise number here you could make a list of all the items that will need replacing at some point, figure out what the lifespan of each item is and the cost to replace it.  Then you simply take the replacement cost and divide it by the lifespan and that will be the annual amount needed for that item.  You would then add up all of the annualized numbers and that would be your more precise replacement number.   Eg.  Dishwasher and Roof.   Dishwasher $300 7 year & Roof $9000 20 years.   $300/7 + $9000/20 or approximately $493 per year divided by 12 ($41) would be the monthly replacement factor for these two items.   This is very similar to figuring out depreciation schedules. 

*This explanation is meant to be used as a concept teaching tool only and not as a guideline for your own specific property. It uses completely hypothetical numbers and expenses which have no correlation to one another or any property and should not be relied as a model for your investment property.  Your income sources and amounts will differ and your expense amounts and types will differ. Your financial advisor and tax & accounting professionals should be consulted before making any investments.

**These examples are completely hypothetical and are not based upon any particular set of correlating facts or figures.  The examples are for teaching purposes only and only as examples of the concepts.  Income tax deductions, depreciation and methods of tax planning are complex and vary widely and are highly specific to your own situation. Your financial advisor and tax & accounting professional should be consulted extensively for actual tax and investment planning and performance.