Real estate investors analyzing a property to hold and rent need to calculate monthly cash flow income projections to measure the property’s ability to make money.
Some investors get into trouble and lose money because they don’t take into consideration the monthly cash flow of a property before they purchase. The importance of calculating monthly cash flow is to help with the decision to either purchase a property or not based on the amount of cash left over after all the expenses and financing.
When analyzing a property to hold and rent you’ll need to calculate your cash flow to measure the property’s ability to make money (positive cash flow) or lose money (negative cash flow). If the property has positive cash flow it means that after all of the expenses, you have cash left over, but if the property has negative cash flow, you need to make up the difference out of pocket to cover the expenses, meaning you lose money every month since the property does not generate enough cash flow to cover the expenses.
Another place real estate investors can make a wrong assumption is in analyzing commercial and multi-family (five units and above) properties. It is important to correctly calculate the Effective Gross Income by only applying the Vacancy Factor to the Gross Rental Income then adding any Other Income, like vending machines, billboards and so on.
Therefore, to analyze a property effectively you take into consideration the Effective Gross Income, Operating Expenses, Net Operating Income, Financing and finally calculate the Cash Flow to make an educated decision if the property is worth purchasing and at what price. The following are the formulas on how to analyze and calculate your Cash Flow.
Gross Income – Total income of rent received from tenants to pay for the space.
Vacancy Rate % – The percentage of time rental income is lost due to a property not being rented. Usually between 5% to 10% of the Gross Income.
Other Income – Any miscellaneous income other than rent like Vending Machines, Laundry Machines, Billboard, Signage, etc.
Effective Gross Income – Gross Income after considering vacancy and collection losses. Also known as Gross Operating Income.
+ Other Income
= Effective Gross Income (Gross Operating Income)
Property Management % – Usually between 6% to 10% of the Gross Rent. Other Income is not part of the calculation.
Other Expenses – Can be used for any other expenses. For example, the Landlord might be responsible for lawn maintenance, pool cleaning, water…
Operating Expenses – Excluding loan payments, it’s all of the property expenses. For example Taxes, Insurance, Property Management, HOA, and any Other Expenses.
+ Property Management
+ HOA (Homeowners Association Fees)
+ Other Expenses
= Operating Expenses
Net Operating Income – Excluding loan payments, it’s the Net Operating Income for the property after all Expenses. It is used to compare rental properties without the use of financing.
Effective Gross Income
– Operating Expenses
= Net Operating Income
Cash Flow Mo. – Including loan payments, Cash Flow is the total net amount after taking Gross Income minus all of the Expenses including the P.I. (Principal & Interest on Mortgage).
Net Operating Income
– P.I. (Principal & Interest on Mortgage)
= Cash Flow (mo.)
Now that you have these crucial financial assumptions, real estate investors can make an educated decision to purchase a property (or not) for passive income.
About the Author:
Marco Napoli has been investing in Real Estate for both the Residential and Commercial markets for 25+ years. “I have been involved in both flipping for a quick payout and holding investments for passive income. I have been involved with Section-8 to luxury multi-family units in the Residential sector and flipping Commercial. I am also a Software Developer which gives me a unique position to create custom tools to evaluate Real Estate Investments quickly and easily.” Contact me at firstname.lastname@example.org.