(This advanced blog summarizes real estate investing tips and insights Lofty AI has acquired from working with thousands of investors and institutional funds.)
What is cash flow?
When you hear real estate investors use the phrase “mailbox money,” they are referring to cash flow.
Cash flow = passive income. It's the income generated when your rental returns exceed your monthly expenses. Meaning it's income you bring in monthly that doesn’t require a lot of your active working hours, like a typical 9-5 job.
When you're looking for a potential investment property, you want to make sure you do your due diligence when researching how much cash flow a property will generate.
When looking at a real estate investment, there are two main components you need to fully understand and be able to forecast: income and expenses.
Understanding the key financials of a property allows you to understand exactly what cash flow is.
To elaborate on this, real estate investors look for rental properties with positive cash flow returns, or, in other words, they invest in positive cash flow properties.
For buy-and-hold investors, cash flow is king.
How to calculate rental property cash flow
Here are the cash flow calculation steps broken down:
Determine the total income from the property.
Deduct all expenses relating to the property.
Subtract any debt service relating to the property.
The difference is the property's cash flow.
Let's take a look at what goes into total income and total expenses below.
The total income will generally be the same as the total rent.
There are some cases where you are receiving income from application fees and laundry. But it's generally safe to assume that total rent is equal to total income.
The gross rental income of a property is the total income from all sources before any expenses or mortgage payments are made. Some properties, like a single-family rental, will only have one source of income, the rental income. There are some cases where you are receiving income, from things like, application fees, laundry, late fees, pet fees, or product sales like boxes or moving supplies.
There are plenty of expenses that you want to take into account.
It's better to expect the unexpected when investing in rental properties.
A few examples of potential expenses you should be thinking about:
Example of calculating cash flow:
John is looking to buy a home.
His real estate broker tells him that the home will rent for $1,350 per month.
She also says he will be responsible for paying $50 per month for garbage and $100 per month for water and sewage.
Based on her experience, John's broker knows vacancy rates in the area are 5% for the year ($50 per month). She tells John to also allocate 10% each month for repairs ($120 per month).
John is also planning on setting aside 5% each month ($50 per month) for capital expenditures. Capital expenditures include anything from new appliances to a new plumbing system.
He then calculates his mortgage payment at $500 per month (taxes and insurance are not included). The property taxes are $100 per month, and the insurance would be $50 per month.
Finally, John will be using a local property management company. This company charges 10% of the rent per month to manage the property ($120 per month).
How much cash flow, if any, can John plan to receive each month?
$1,350 per month (rent)
Expenses (per month):
Property management: $120
Add all these expenses up and it comes to $1,140 per month.
Remember, Cash Flow = Rent – Expenses
$1,350 (rent return) – $1,140 (expenses) = $210 per month
This means that John will be receiving $210 per month in profit from this rental property!
That's what we call positive cash flow or “mailbox money”.
How to increase your cash flow
The most straightforward way to increase your cash flow is to increase the rent you charge tenants.
This can be done by a few different methods:
Acquiring an under-performing, mismanaged property that is charging a lower rent than the market average, and bumping up the rent to market rates.
Renovating a property by adding new amenities, like granite countertops and a new roof. Then you can bump up rents.
Acquiring a property in a rapidly appreciating neighborhood. This will allow you to increase the rent prices as the area gets better.
Basically, a favorable location and favorable market conditions will create high rental demand, so you can increase rental prices. You will also accumulate long term appreciation this way.
Big-ticket repairs and maintenance expenses can take a drastic toll on your cash flow.
This is why preventative maintenance is so important. It's like insurance against potentially large expenses that may occur in the future.
A few examples include taking care of your HVAC units, and trimming trees located close to your property. These big-ticket repairs don't happen often, but when they do you'll be happy you took the necessary preventative measures beforehand.
If you do not do these preventative measures you will have to dip into your own money, and there goes your cash flow.
For a real estate investor, turnover and vacancy are two of the biggest cash flow killers.
Because of this, it's sometimes a good idea to have tenants that sign long-term leases so you don't have to worry about finding a new tenant.
A high tenant turnover rate is never good. It can lead to a lot of other issues, like repairs/cleaning you’ll have to take care of beyond what their security deposit covers.
The issue with this strategy is if you own a property in a neighborhood that is rapidly appreciating.
In that scenario, you might, unfortunately, sign a tenant to a 3 year lease at the same rent, when just a year-and-a-half later, you would have been able to double rents because of growth of the surrounding neighborhood.
Appealing your property taxes
Property taxes can go up every year. If they increase faster than you’re able to raise the rent, you may run into a serious cash flow issue. Make sure to keep an eye on this, so its not a surprise.
Depending on the market your property is located in, it may make sense to appeal your property taxes with the local government to potentially have them decreased.
Refinance your property
It is always a good idea to occasionally monitor mortgage interest rates. If you see that the rates are falling, you may be able to refinance and lower your monthly mortgage.
Naturally, this will increase your cash flow simultaneously.
Calculating cash flow using the 50% rule
The 50% rule is a back-of-the-envelope formula. Similarly to cash on cash return, investors use it to analyze a potential deal quickly.
The rule says that you should estimate your operating expenses to be 50% of your rental income.
If a rental property makes $50,000 per year in gross rental income, you should assume that half, or $25,000 will go towards expenses,
Only operational expenses, not mortgage payments.
The 50% rule is an estimate created by experienced real estate investors. It allows you to quickly compare potential investments to identify which properties will cash flow and which ones will not.
Keep in mind that this rule is based on assumptions that have yet to be verified.
We'll be discussing the 1% rule next.
What is the 1% rule?
The 1% rule is a general rule of thumb. There are times when a property's expenses aren't available upfront. If you want to quickly analyze the property to determine whether it is a worthwhile investment to pursue, you can use the 1% rule.
The 1% rule is a formula used in rental real estate to determine whether a property is likely to have positive cash flow.
According to the 1% rule:
For a $100,000 property to be considered a good investment, it must rent for $1,000 per month or more.
1% rule formula = Monthly Rental Income ≥ One Percent of Purchase Price
The 1% rule is helpful for a few reasons:
It helps you narrow a large list of properties into a smaller list of the best properties.
It helps you determine if the monthly rent returns will exceed the monthly mortgage payment.
If the rent is only $500 per month, the $100,000 price will not meet the rule.
Or if you had to pay $150,000 for a property that rents for $1,000, it would not meet the rule either.
Believe it or not, there's also the 2% rule...
The 2% rule states that a rental property is only a good investment if the monthly rental income is equal to or higher than 2% of the total price. Finding a property that fits the 2% rule mostly happens in areas like the midwest and the southern US. Properties meeting the 2% rule can often become harder to find in more expensive cities like New York, Los Angeles, and Boston.
There is no magic number that is the perfect or right amount of cash flow to earn. It's common, after reviewing your financial goals, to establish a minimum cash flow per investment or a minimum return requirement, based on what you want to achieve.
When you're evaluating properties, this can help guide you in eliminating any that do not meet your standards for investing.
For a rental property to have good cash flow, it just needs to have positive cash flow. It's that simple.
These gains come in short-term as well as long-term rewards. The monthly rental income is the passive income, while gaining appreciation on the property is the long-term financial reward real estate investors acquire down the line.
Positive cash flow means your property's rent exceeds both operational expenses and mortgage payments. That's passive income right there!
Why do you want positive cash flow?
Cash flow creates more opportunity
Positive cash flow allows you to exponentially grow your financial resources by reinvesting your profits from an investment property into another investment of your choice.
Cash flow creates safety
To help create a larger savings reserve, the extra monthly income you receive from cash flow can protect you against unexpected life expenses like medical bills, job loss, car maintenance, etc.
Cash flow creates freedom
By building up your cash flow and enabling passive income, you no longer have to work 9-5 for a paycheck. While your properties are accumulating cash flow, and your investments are running smoothly, you're able to spend more time with family and friends. You get to focus on more important things like education, growth, and passion projects.