Investing in real estate rental property requires a great deal of research, and understanding how a property is going to generate cash flow from rental operations is an important aspect of that process.
A simple cash flow calculation can illustrate the potential of rental real estate as an investment. Let's use a fourplex as an example and assume that all four units are destined for full-time rental. You've done your research and you made a good buy on the property.
Here's what you can expect in cash flow from a rental.
Start With the Basics
The purchase price of the property was $325,000. You put 20% down—$65,000—and financed $260,000. The mortgage is a 30-year loan at 6.5% with a principle/interest payment of $1,643 a month.
Taxes and insurance at the time of purchase are $3,600 a year, or $300 a month, for a total payment of $1,943 a month.
Calculating Cash Flow
You're seeing a steady rental demand for these units, all of which stay occupied most of the time, but we'll calculate a 6% vacancy and non-payment risk to anticipate real cash flow just to be prudent.
The units are all identical. They each rent for $900 a month.
The calculation would break down this way:
- Gross rental income is $900 x 4 units x 12 months = $43,200 per year.
- Your payments are $1,943 x 12 months = $23,316 per year.
- The previous owner's repair expenses averaged $1,700 per year.
- Vacancy and credit loss is estimated at 6% of rents, or $2,592 per year.
- You spend about $400 each year in miscellaneous and advertising costs, and you manage the property yourself.
$43,200 (gross rental income) less $2,592 (vacancy factor) less $23,316 (mortgage, taxes, and insurance) less $2,100 (repairs and costs) equals $15,192. This works out to $1,266 per month in positive cash flow over 12 months.
Costs can be tricky, however, because some don't happen every month. Stay on the safe side by treating them the same way as vacancies at a realistic percentage.
Cash on Cash Invested
Divide your actual cash investment of $65,000 down into the annual return of cash—which is $15,192—to analyze your return as "cash on cash invested." This is a yield of 23% on your cash invested. There are few investments out there that yield this kind of return.
Cash Flow Can Be Fluid
Cash flow is a function of a great many inputs, and any or several of them can change and damage or improve the scenario. Some are influenced by the market and the economy.
For example, a major local employer might close or move, so the demand for rental property plummets overnight. This is something you can't control, but you can potentially avoid disaster by doing your due diligence about the health and plans of local employers.
You're probably in good shape if the major employers are profitable with long leases that have recently been renewed.
Other factors that are out of your control include real estate taxes and property insurance. Taxes and premiums can increase, raising operating costs and lowering operating income and, by extension, cash flow. But these negative factors can be compensated for with other factors over which you do have some control.
For example, you might be able to find ways to reduce marketing, management, or maintenance costs. You can raise rents if the rental market is strong, but this can be a delicate balance because it might increase vacancies. The loss of income from more vacant units can easily wipe out any gains from increased rents.
This is by no means the only way to calculate cash flow for a rental property, although it might well be the easiest. You can include additional calculations on the way to your bottom line.
Some other methods include tax savings you might realize thanks to property ownership, and still others separately break down net operating income. But this simple formula should give you a clear-cut head start on what you need to know before investing.