A cash flow analysis is a important part of analyzing a prospective real estate investment property. Used to determine the liquidity of an investment, a cash flow analysis shows the total net amount of cash received during a defined period.
In order to calculate the cash flow, you need to first decide whether or not you need the cash flow BEFORE taxes (CFBT) or AFTER taxes (CFAT).
The CFBT is calculated by adding the total rental income to any other income from the property (such as parking, and from laundry and vending machines), and subtracting from that sum any operating expenses, cost of debt service, leasing commissions, capital additions, and funded reserves.
The cash flow after taxes is calculated according to the following formula:
Net operating income
– Cost recovery
– Amortization of loan points
Real Estate taxable income
× Investor’s marginal tax rate
Tax liability (savings)
Net operating income – Annual debt service Cash flow before taxes – Tax liability (savings) = Cash flow after taxes
Although there are numerous ways to determine cash flow, the most important factor is ensuring that the data you use is as ACCURATE as possible.
There are several places where you can get accurate information, but in the beginning you’ll want to start out with primary sources, such as:
- property management records,
- personal records from the owner,
- copy of the owner’s rental property income tax schedule and
- copies of the current lease and all rental agreements.
Next, you’ll want to ask the seller the following questions:
- What are the current rents according to the lease and rental agreements?
- Are these rents inline with current market prices?
- How long do the rental agreements run, and when were rents last increased?
- Do the tenants pay on time?
- Do the property manager’s records show collected rents?
- What is the vacancy rate for this property right now?
- How does that compare to the current market?
- Do you anticipate any vacancies in the near to immediate future?
- Does the property need to be upgraded in order to be fully competitive with the market?
- What are the contract terms for the vending machines on the property?
You’ll be using the data you collect in order to how and when money goes INTO the investment, and how and when money comes OUT of the investment. After your analysis is complete, make sure not to make the mistake so often made by inexperienced investors, and that is, buying a property with a negative cash flow.
Never assume that a property will “catch on,” or “pick up” in the future. While there might be a possibility that profits will go through the roof at some unknown point in the future, you could go bankrupt waiting for it to arrive.
Instead, always go for a positive cash flow property, keeping in mind that in order to be truly safe, it’s wise to assume you’ll have more unexpected expenses than you anticipated.