When you work with real estate investor clients, it's important that you have the knowledge to help them determine the viability of investments. Cash flow is quite important, as it disregards whether some things are deductible for tax purposes. A tax return tells you some things, but cash flow tells you more.
After all, each investor has different personal and investment business goals and different tax liability based on their total income and other factors. We don't really care about that. We care about how the investment will perform, and we leave it to the investor to see if it meets their goals and personal tax situation needs.
The rental property investor is very interested in cash flow. It's the primary reason for most of them in getting into a deal. Sure, the property should increase in value over the ownership period, and they can make a profit when they sell it. But, it's that monthly check in the bank that's the big draw.
Time Required: 15 minutes after data is gathered.
- Begin with the Net Operating Income of the property.
- Subtract the money out for debt service. This is the amount spent on the entire mortgage payment, interest, and principle.
- Subtract any capital expenditures. This would be money spent for improvements on the property, whether they are deductible that year or not. This is actual cash spent.
- Add any loan proceeds. This is the money borrowed on a loan other than the original mortgage. If you made capital improvements but took out a loan to pay for it, put that loan amount here as an addition.
- Add any interest earned. Should the property have loans or investments out that provide cash in as interest, add that in here.
- You have now come to the result, which is the Cash Flow Before Taxes (CFBT) for this property. Here's the line itemization:
- Begin with Net Operating Income
- - Subtract Debt Service
- - Subtract Capital Improvements cash out
- + Add Loan Proceeds for loans to finance operations
- + Add back any interest earned
- = Cash Flow Before Taxes
Other Benefits of Rental Property Investing
Cash flow is the big draw, but it's only one of several great benefits available to rental property investors. There are more people every year converting some of their other asset classes, like stocks and bonds, to real estate. Mostly they're into the rental property, and mostly single-family homes. It's natural, as they have experience in single-family homes; they live in one.
The average new investor is comfortable with single-family rentals, and most have rented either an apartment or home in their lives. So, they can more easily make the investment leap in that market. In fact, some find it quite exciting to go from past tenant to landlord.
There are some great tax breaks in rental property investment. Of course, you can normally deduct all expenses for management, advertising, maintenance, and normal repairs. You can also deduct the mortgage interest. But, one really nice deduction comes without having to spend a dime cash out of pocket. It's the depreciation deduction. The IRS allows you to take depreciation of the rental structure over 27.5 years. The land value must be subtracted out.
This results in a few thousand dollars in deduction every year, but you never actually spend that money. So, it's like Uncle Sam is putting money into your pockets. Always consult an accountant though. If you sell the property later you may have to give back some of this as recaptured depreciation expense.
The rental property also is generally less risky than stocks. Though bonds can be less risky, they also normally have far lower yields. The return on investment, ROI, is much better with a rental property.
These are good things to know if you're going to discuss rental property investing with a novice. Everybody has to start somewhere.