There are plenty of factors that contribute to a successful real estate investment business — purchasing profitable properties, maintaining relationships with vendors, understanding the market and how to make it work to your advantage.
But there’s one part of your business that’s so important that it should be protected at all costs. Your real estate cash flow.
Cash flow refers to the money coming into and going out of your business at any time. When you have a positive cash flow, it means more money is coming into your business than is going out (or, in other words, your liquid assets are greater than your costs). Negative cash flow is the opposite; your expenses each month are greater than the amount of cash coming in.
Cash flow and profit are two separate things. Your real estate business can be profitable but still have a negative cash flow, which affects your ability to pay your mortgages, vendors, and bills and can put you at risk of losing your properties.
That’s why it’s so important to protect your real estate cash flow. Having a positive cash flow is the only way to scale your business and continue to buy properties. Without it, your business is likely to fail — even if you’re profitable on paper.
But how exactly do you do that? How do you make sure that your portfolio of properties generates positive cash flow and doesn’t bring down your business?
How to Determine If a Property Is Cash Flow Positive
The first step to ensuring you don’t run into any cash flow issues with a property is to know your expenses.
Monthly expenses to consider for a property include:
- Monthly mortgage payments
- Taxes and insurance
- Vacancy and non-payment
- Vendor costs
It’s important to factor in around 6% of your rental income for vacancy and non-payment; even if you’re buying in a hot rental market and feel confident you’ll be able to successfully fill your units and retain tenants, it’s important to factor in the worst-case scenario to get a more accurate cash flow prediction.
Once you know how much you need to spend in order to own and maintain a property, it’s time to compare that to how much cash the property will bring in each month.
Let’s say you purchased a 10-unit apartment building for one million dollars and put 20% down, leaving you with an $800,000 mortgage.
With a 30-year mortgage at 4% interest, your monthly mortgage payment would be $3,819. Let’s say your insurance and taxes were $1,500 per month and your vendor costs (including a property manager) were $1,000.
And let’s say you rented each of the 10 units for $900. Let’s look at how that plays out for your cash flow:
$3,819 (mortgage payment) + $1,500 (property taxes and insurance) + $540 (6% vacancy and non-payment) + $200 (average repair costs per month) + $1,000 (vendor costs) = $7,059
And let’s compare that to the cash generated by rentals each month:
10 units X $900 (rent) = $9,000
So this rental property would generate a positive cash flow because the income generated by the property is greater than the costs (or, in other words, you’ll have more money coming in than you’ll have going out):
$9,000 (cash generates) - $7,059 (costs) = $1,941 (positive cash flow)
Factors Working Against Cash Flow
In a perfect world, your cash flow would stay the same each month. But typically, that’s not the case. There are a number of factors that can work against cash flow, and if you don’t anticipate them, you can find yourself in a sticky situation without enough cash on hand to keep your property afloat.
Things that might negatively affect your cash flow include:
Changes in Property Taxes
If the property taxes rise in your area, that change in expense can turn a positive cash flow property negative.
Changes in Mortgage Payments
Changes to your mortgage payments, including balloon payments and monthly increases due to an adjustable rate, can also affect your cash flow.
While minor repairs won’t have much of an effect, massive repairs (like replacing a roof) can throw a wrench into your cash flow.
Now, if you want to protect yourself from these events having a major impact on your cash flow (and potentially sinking your property), it’s important to prepare for them.
Build an emergency fund to help carry you through the months where unexpected events add significant costs to your budget.
Or you can add potential expenses, like rising property costs or major repairs, into your cash flow forecast; that way, if they happen, you have the money to cover them, and if they don’t, you have extra money to reinvest in your business.
But What About Appreciation?
Now, if you’re a long-term-strategy kind of person, you’re probably thinking:
“What about appreciation?”
That’s a great question. What about appreciation? Can long-term appreciation make up for a short-term negative cash flow?
The answer is — it depends.
Buying in a market that pretty much guarantees appreciation — like Los Angeles — can definitely make you a LOT of money in the long run. But in order to get to the place where you can collect on your appreciation, you’ll likely be dealing with negative cash flow every month. So, in order to collect that big pay-off, you need to be able to deal with losses each month.
For some people, that business model makes sense. If you have the money to invest, betting on a property appreciating can be a high-risk, high-reward situation. But if you don’t have the money to keep your property afloat each month, it doesn’t matter how much it’s going to appreciate — you won’t be able to keep it.
As you grow your portfolio, buying properties based on appreciation might be a worthwhile gamble.
But if you’re just starting out — or if you don’t have the cash to support a property where the costs outweigh the profit — you’ll definitely want to stick to rental properties that generate a positive cash flow.
Stay on Top of Cash Flow With a Cash Flow Forecast
Clearly, you see the importance of a positive cash flow in your real estate investment business. The best way to stay on top of your cash flow — and make sure it’s flowing in the right direction — is to create a cash flow forecast that anticipates your expenses and income for the next 12 months. Having a clear picture of cash in and cash out for an entire year will help you make better decisions in your business.
Be sure to factor in special considerations to your real estate cash flow analysis — for example, if you know your units tend to have more issues with the heating system in the winter, up your costs for repairs during the colder months.
Creating a cash flow forecast can be as simple as creating a spreadsheet that lists your income and your expenses for each month. Or if you own multiple properties (with multiple sets of expenses and sources of income), it might make more sense to use accounting software or hire a bookkeeper to manage your analysis. Using software or a professional bookkeeper will allow you to manipulate your data and generate reports that give you a better understanding of your overall cash flow and the cash flow from each of your properties.
In the real estate world, cash is king. That’s why, in order to be successful, your real estate cash flow needs to be protected at all costs.