Ryan Price

In a previous post I talked about using cap rates to compare investment real estate.  Cap rate is a great way to compare potential investments, but when it comes down to selecting a property its all about cash flow!

What is Cash Flow?

Cash flow is actual money coming into (or out of) your pocket each month.  Its the cold hard cash you actually have access to.  Its the stuff you can hold in your hand, fill up the bathroom tub, and swim in.  Cash is king, and in investment real estate cash flow is king.

Cash flow is usually calculated either on an annual or monthly basis.  Either way works, and often they are done together.  If you’ve ever taken a look at a company’s official financial documents (everyone’s favourite night-time reading) you’ve likely seen a cash flow statement before.  Good news for real estate investors: calculating cash flow for income properties is a lot more straight-forward than an entire business.

Cash Flow = Income – Expenses

Jaw-droppingly difficult, I know.

Similar to the cap rate calculations, income is usually straight forward.  Its simply the rent you’re collecting each month.  The expenses, unlike cap rate calculations,  include your mortgage (or other loan) repayment.

Sample Cash Flow Calculation

Lets continue using our imaginary Triplex in London, ON from the previous post.  To refresh:

Our example home is a Triplex close to the university with an asking price of $279,000.  The units rent for $1,000 (Unit 1), $800 (Unit 2) and $600 (Unit 3) and the tenants pay all utilities.  Taxes are $3,200/yr and insurance is $600/yr.

Lets say we ended up agreeing on a price of $265,000.  We put the minimum down payment required for an income property (20%  = $53,000 in our case) leaving us with a mortgage of $212,000.  This boils down to mortgage payments of around $1,200 per month.  Your mortgage payment will vary depending on the type of mortgage you choose.  In this case, we went with accelerated bi-weekly payments on a 5 year fixed mortgage at 4% amortized over 25 years.  You can use the RBC Calculator to play with mortgage payments.

So, we now know our income and expenses:

Income
Rent is $2,400/mnth ($28,800/yr).  Factoring in our vacancy allowance of 6% gives us an adjusted income of:
$2,256 ($27,072/yr)

Expenses
Mortgage: $1200 ($14,400/yr)
Taxes: $267 ($3200/yr)
Insurance: $50 ($600/yr)
Maintenance: $220 ($2650/yr)
Total: $1737 ($20,850/yr)

This gives us a very favourable cash flow of +$519/month ($6,222/yr).  From cash flow alone this means an annual return on investment of 11.7%.

It is important to note that this is an ideal scenario and in reality finding a multi-family property with 4 units or less that has this kind of cash flow is very rare.  In reality, a property like this might include utilities which would add another $300 per month to your expenses or you may want to allow for a higher vacancy allowance (some investors like to use one month, or 8.33%).

How to Come Up with the Numbers

When we’re doing calculations on a potential investment we like to stay conservative.

• Be slightly pessimistic in what each unit will demand for rent.  If you’re planning on charging $1600 for a unit, do your cash flow analysis at $1450 to make sure it still works if you end up having to lower rent to attract a tenant.
• Leave a buffer for variable expenses like utilities.  If an increase in utility costs by 10% kills your cash flow you need to be aware.
• The 1% of purchase price rule of thumb for maintenance costs is generally a good one.  If the property you’re looking at is going to require significant ongoing maintenance be aware of this and up the number appropriately.  This number may seem high month-to-month but its meant to build a reserve over time for major repairs such as re-shingling the roof or replacing a water heater.  You likely won’t use your full maintenance budget every month, so put the excess in a reserve fund for major repairs.
• For fixed costs such as mortgage payments or property taxes you should be safe without a buffer for these numbers.  Just be aware that property taxes change from year to year.  The change is usually insignificant but do your due diligence and be aware if your city is about to make a major hike to property taxes (usually as a result of budget deficits or new political/economic landscapes).
• Make sure you’ve thought of everything.  Ask other homeowners in the area about the costs of ownership to ensure you’re not leaving something out (condo fees as an example).
• Don’t include one-time expenses like closing costs or immediate planned renovations.  These aren’t on-going expenses so it doesn’t make sense to include them in your cash flow analysis.

Most of all: do your research!  The more time you spend getting to know an area and a property the more confident you can be that you’ve covered all expenses and have accurate estimates.  Ask your realtor about market rent, vacancy rates, school reputations, etc.  Check Kijiji and Craigslist to see what others are offering in the area.  Ask for utility bills for the past year or 6 months.

Anything you can do to make your estimates as accurate as possible will lead to less surprises down the road.

Beware of Negative Cash Flow

If a property does not have at least a neutral cash flow you should stay away.  A property with negative cash flow means that you’ll be putting your own money into the property.  Every month. For as long as you own it.  This kills your personal cash flow, causes unnecessary stress, and will likely drive you away from income properties leaving a bitter taste in your mouth.

A neutral or positive cash flow that used conservative numbers is the minimum requirement for a property you should be investing in.  A property that is truly an asset will mean that it doesn’t cost you money.  If you lose your job the property still pays for itself and, if it has positive cash flow, has a little left over for you.

In investment real estate, cash flow is king!