How to Calculate Cash Flow for Your Rental Property
Cash flow is one of the most desired returns in real estate.
It's the most tangible return you get from rental real estate and can significantly reduce your risk in an investment property.
What Makes Up Cash Flow
Cash flow breaks down to the profit you get to keep at the end of the month after you deduct all expenses from the rents you collected.
cash flow = rent - expenses
Sounds simple, but this is a loaded, complex, and heavily debated topic.
The details are in the expenses. The classic definition of cash flow includes ALL expenses. But a lazy rental property analysis is likely to leave out costs and spit out a very optimistic cash flow forecast.
It's Not Just Mortgage PITI
Most investors who calculate cash flow incorrectly just deduct their mortgage payment from the rents they collect and stop there.
If you collect $2,000 in rent but your mortgage principal, interest, taxes, and insurance come out to $1,500, then you get to pocket $500 a month in cash flow, right? Wrong. Wrong by a lot.
It might be tempting to stop here and declare your cash flow.
It's probably positive and makes the investment look good. But you're shooting yourself in the foot, and you will very much regret it down the road when you find your personal bank account balance going down every month instead of up.
To correctly calculate cash flow, you have to consider all costs of owning rental property.
We'll break these down into 4 categories.
- Fixed Costs
- Variable Costs
- Unexpected Costs
- Business Costs
Fixed Costs When Calculating Cash Flow
Fixed costs are the best because they make our calculations easy.
We know what they are and what they will be in the future. Things like our mortgage principal, interest, mortgage insurance premiums, and even property management. We sign contracts and negotiate these expenses ahead of time so we know what they will be.
Typical fixed costs to include in your cash flow analysis:
Mortgage Principal: Check your loans amortization schedule.
Mortgage Interest: Check your loans amortization schedule.
Mortgage Insurance Premiums: Check your loan documents if you have private mortgage insurance.
Property management: Unless you self-manage. You will likely negotiate a fixed rate that goes to a property manager, such as 8 or 10% of the rents.
Variable Costs When Calculating Cash Flow
Variable costs make cash flow harder to forecast. They can change month-to-month without significant warning.
Variable costs you should attempt to plan for:
Property Taxes: Talk with your real estate agent about what to expect and how much these can increase in your area.
Insurance: Insurance premiums tend to increase over time. Ask your insurance provider what kind of increases you can expect in the future.
HOA Dues: Properly vet any homeowners associations you are buying in and ask about past and expected increases in dues.
Account for Unexpected Costs When Calculating Cash Flow
For even the most detail-oriented proactive landlords, some things are just out of your control. You don't get to decide when the toilet breaks or the HVAC stops working, but you can attempt to include reserves in your cash flow analysis to cover unexpected expenses.
Unexpected costs to expect:
Maintenance and Repairs: Average your previous year's maintenance and repair expenses to get an idea of what to expect.
Capital Expenditures: Take the time to inspect your rental property to verify the condition of major systems on the property. If certain expenses are likely to come up sooner rather than later, build a cushion into your reserves to cover it.
Vacancy: Get an idea for how quickly you can rent your property out if it were to go vacant. Break down that amount of time you would miss out on rent and deduct that from your cash flow.
Business Costs to Include in Your Cash Flow Analysis
Owning rental property is a business. You will likely have more expenses that are specific to your property and the way you run your business.
For example, in your leases do you hold the tenant responsible for landscaping? Snow removal? Replacing their own water filters? Utilities?
You need to be crystal clear on what expenses your tenants will be responsible for and account for everything else in your cash flow analysis.
Additionally, running your business will likely include even more costs that aren't related to the property itself. Think about supplies, signage, advertising vacancies, cleaning the property between tenants, taking better photos or getting professional photographers, you name it.
So now we can revisit our initial cash flow formula, and it comes out to something like this:
cash flow = rent - (mortgage principal + mortgage interest + mortgage insurance + property management + property taxes + insurance + HOA dues + maintenance and repairs + capital expenditures + vacancy + miscellaneous business expenses)
Ultimately, it is impossible to list every single expense you may encounter in the business of rental real estate. (Which is why it's technically impossible to calculate your true cash flow ahead of time..) But the more expenses you can account and plan for on the front end, the better off you will be down the road when you get hit with something unexpected. And you will get hit with MANY expenses you probably aren't expecting.
Good luck on your real estate journey and may your cash flow always be high.