Deciding which commercial income property you’d like to buy may seem like a huge pain in the neck.
Sure, you can’t wait to start earning a steady, monthly income, or to grow your investments.
But with experts touting as many as three to five different ways of evaluating a commercial income property’s returns, the process might feel as though it’s less a business decision, and more of an ancient art known only to real estate gurus.
If every time you check out an investment property you feel a sudden urge to check your email, take heart: there’s a simple method you can use to quickly yet accurately assess a property’s profit potential – and you won’t need a crystal ball to do it.
Calculate Cash Flow In 10 Minutes Or Less
Buying an income property that consistently brings in more money than was put into it requires a thorough evaluation of numerous factors. However, you can save time and get an accurate picture of an income property’s health by calculating the property’s cash flow.
Assessing and managing cash flow is actually a basic strategy that heavily impacts your success as an investor. Put simply, cash flow is the amount of money you have left after you pay all the expenses associated with the property.
Calculating cash flow is fairly easy: simply add up all the expenses associated with the property, and subtract that number from the amount of money earned from rental income. The resulting number is the cash flow, and is your net income from the property.
Don’t forget to include the mortgage payment, repair costs (use last year’s number as an estimate), maintenance, advertising costs, and management costs, if you’re not managing the property yourself. In addition, since a certain amount of tenant vacancy and credit loss is common, you should add on an additional 10%, which is the vacancy rate estimated through national surveys of commercial properties.
Assess the Property’s Profit Potential
Although you’ve figured out the net cash flow, you’re not done yet.
In order to find out whether or not the property is worth looking into further , you need to find the cash flow zone percentage. This number, which is the gross annual rent (the amount of rental income you receive per year from the property) divided by the purchase price, multiplied by 100.
For example, if the purchase price was $750,000 and the gross annual rent added up to $45,000, then the cash flow zone percentage would be 6%. A percentage between 5%-7% is considered good, and means that property is likely to generate a positive cash flow.
One caveat: occasionally a prospective property has a very low, or even negative, cash flow. As an investor, you may be tempted to ignore the warning signs and buy the property based on future appreciation of the property’s net value. However, taking on a commercial income property with a negative cash flow is an extremely RISKY proposition.
That’s because the internal rate of return on the cash flow investment is only determined when the income property is sold years later. And since most properties should be held for a minimum of 7-10 years before selling, you, as the investor, would have to absorb at least seven to ten years worth of expenses – including capital expenditures- before seeing a penny in profits.
Use This Loophole To Increase Your Cash Flow
Although it would be unwise for most investors to take on the burden of a negative cash flow property, what should you do if the cash flow zone percentage is just under 6%?
If the property looks promising otherwise, here’s one trick you can use to increase a property’s cash flow before you even buy it: raising the net income by adjusting for property depreciation.
Completely legal, property depreciation refers to the fact that a property’s net worth decreases as time passes. As a result, the IRS allows you to recover the lost income of a rental income property through yearly tax deductions, which for commercial properties is up to 39.5 years, or until the property is sold.
Although land is not eligible for property depreciation, a wide range of building components, such as:
- mechanical components,
- electrical installations,
- specialty lighting,
- wall coverings,
- cabinetry and
… are the assets commonly identified as eligible for deduction.
Property depreciation in commercial properties is complex, and in order to reap the full benefits its essential that you use an experienced accountant, who in turn will generally request a cost segregation study. This enables the accountant to reclassify expenses that would normally depreciate over a 39 year period into shorter life classes that qualify for five, seven, or 15 year write-off periods.
However, you can still get a good estimate of how much the property is expected to depreciate over the time period that you expect to own it, by using online property depreciation calculator. Add the result to the net cash flow you calculated previously. Once you recalculate the cash flow zone percentage, you may find that the number falls well within the suggested range for commercial income properties.