Follow along as we break down the basics of calculating annual cash flow of a residential real estate investment (and discover our free rental property calculator for Microsoft Excel to find your next profitable investment.)
Learn these 5 steps to calculating rental property cash flow.
Ready to enter the investment property game? There is more to buying an investment property than simply identifying and purchasing a property. Whether you’re considering turning your single-family home into a rental property or are searching for a new investment, accurately estimating a property’s cash flow is imperative. Conducting a cash flow analysis provides you with the right metrics to make an informed and confident decision.
How to accurately predict cash flow in real estate
In simple terms, cash flow = total income - total expenses. Although it looks like a relatively quick and simple formula, more goes into predicting income and expenses for single-family homes than you might expect.
Seasoned investors and real estate consultants use cash flow analysis tools for direction and confidence to invest in a particular property. It is easy to get caught up in a potential deal and over-project incomes or overlook potential expenses. Using a cash flow rental property calculator allows real estate investors to make informed, confident decisions and accurately estimate the monthly profit a property will produce.
Step 1 - Project Effective Gross Income (EGI)
Let’s put that cash flow equation under the microscope. First, project the maximum income the potential rental property could generate in a year. There are three things to consider when calculating your effective gross income:
Gross Potential Rent
You can calculate future rents in a number of ways, but at CGP, we recommend completing a rental market analysis (RMA). This is the most accurate method in forecasting monthly rental rates for a particular property. A rental market analysis looks at similar properties in the same location and conditions that are currently listed or have recently rented to predict rental rates.
Local real estate professionals like those at CGP can conduct a thorough RMA for you to reduce the risk of over-projecting future rents and create an accurate cash flow.
TIP: When using CGP's rental property calculator, add in projected monthly rent for “Monthly - Gross Potential Rents”.
Additional Sources of Income
Other potential sources of income include pet fees, utility reimbursem*nts, parking, and administrative fees (i.e. application fees, late fees, lock-out fees).
Not sure about which fees to include? That's ok - it is good to think these specific items through before purchasing a real estate investment. Both pet restrictions and how utilities are handled will play heavily into how you market the property and who you are marketing to.
TIP: These fees, although relatively small, are important and should be added in the “Additional Source of Income” section of the rental property calculator to account for a property’s max potential revenue. To get you started, a typical pet fee is $300 per lease.
Vacancy Rate
Vacancies can be the downfall of investors’ cash flow predictions. Though no downtime between purchasing a property and securing a new tenant is ideal, factoring in a vacancy rate keeps you prepared for transition periods and pre-rental repairs.
When projecting cash flow, savvy investors factor in this potential “downtime” by applying a vacancy rate based on an analysis of both property and market conditions.
A few notes:
Vacancy rates can be difficult to calculate, ask a local professional the average market time for rentals in your area.
If the property and market are hot, 2% of gross annual rents is a standard assumption for vacancy time. Better safe than sorry.
If the property sits for one month, 8% of its projected annual rent is lost. Remember, it’s not just the rent you are losing: you will also be paying the utilities.
TIP: Don’t get caught off guard at the end of the year - build potential vacancies into your overall projection of effective gross income. We use a 2% vacancy rate as default in our rental property calculator.
Step 2 - Identify Gross Expenses
There are lots of recurring expenses to owning real property. Expenses will vary from one property to the next. Let’s walk through the ones you should prepare for:
Property Tax: Contact a local professional with access to tax records or utilize a property tax calculator tool.
Insurance: Insurance can be difficult to predict if you do not already own a property. There are several online tools to try. For our calculator, we use a formula based on square footage to estimate annual insurance costs.
Management Fees: Doing your research is key. Interview local THE managers to get a feel for the standard management rates in your area.
HOA & POA Dues: Condo, Homeowners, and Property Owner Association dues should always be factored into your annual expenses.
Maintenance & Repairs: A good rule of thumb is to factor 2-5% of annual rents towards general maintenance and repairs. This can include expenses like landscaping or an unexpected invoice from a contractor.
Other: Not all properties are created equal. Take your time and consider all potential variables for the property you are assessing. Other monthly expenses may include utilities, pool/hot tub maintenance, cleaning, etc.
TIP: In CGP's rental property calculator, drop in your known monthly payments and account for variable expenses to calculate your gross operating expense.
Step 3 - Calculate Net Operating Income (NOI)
Once you have collected all of this information, you are ready to estimate the profitability of your property. The formula for calculating net operating income (NOI) is pretty straight forward.
NOI = Gross income - Gross Expenses.
A negative NOI means the property will not provide a positive cash flow based on the assumptions made in step 2 and 3.
Capital Expenses and Adjusted NOI
Capital expenses are costs that occur less frequently but should still be accounted for. Examples include major appliance replacement, roof replacement, etc. Don’t forget to save for big-ticket repairs like roofing, HVAC, or hot water heaters - or you may risk your entire cash flow with one major system repair.
Owning real property can be unpredictable at times. Successful investors build up reserve funds for both small and large costs so they are prepared for a major repair when it comes. Be prepared and budget these variable expenses based on the condition of the property you are evaluating.
TIP: In our cash flow rental property calculator, we recommend putting aside a percentage of monthly rent to prepare for these capital expenses.
Step 4 - Calculate your Cash Flow after Debt
The last step in calculating the annual cash flow for a property is to subtract your annual debt from the NOI. If you are using new financing, this step is crucial as it allows you to calculate how much money to put down and identify how much to spend on a property to meet your investing goals.
TIP: Subtract annual debt payments on a property from your NOI. If you need help predicting your monthly loan amount, we include a mortgage calculator in our free rental property analysis spreadsheet.
Step 5 - Analyzing the Numbers
With all this information compiled, you are ready to analyze the property for profitability and viability. There are several indicators that signal whether or not your investment will produce the return you are looking for:
Is the monthly/annual cash flow positive? Investors are looking for a positive monthly cash flow, which indicates a profit is still being made after expenses.
What is my cash-on-cash return? Cash-on-cash returns calculate the cash income earned over the cash you invested in a property. The formula to calculate a cash-on-cash return is (Annual Cash Flow / Total Cash invested) X 100 = Cash on Cash Return %. Higher cash-on-cash returns indicate the property can pay for itself over the long-term.
What is the Cap Rate on the purchase price? Cap rate looks at net operating income relative to the purchase price. The formula is (NOI / Purchase price) X 100 = Cap Rate %. The higher the cap rate, the better your annual return.
Choose what metrics and indicators best fit meeting your investment goals. Set a threshold for each indicator. If you analyze a deal that meets all of your metric criteria, you will know you are on to something.
The Whole Cash Flow Equation
In a nutshell, here’s how to predict the cash flow of a real estate rental property:
Project Income: Project how much income a property will generate by estimating annual rents, adding additional income, and accounting for potential vacancies.
Calculate Expenses: Do your research to add up expenses such as property taxes, insurance costs, HOA fees, property management fees, and building up funds for maintenance and repairs.
Determine NOI: Subtract your expenses from your income, then adjust by calculating in a reserve fund for major expenses down the road.
Account for Debt: Make sure to subtract your annual debt from the cash flow total before walking away with the numbers.
Analyze the Property: Identify key performance indicators/thresholds that will be most useful in predicting your investment goal outcomes. Discuss your findings and conclusions with a real estate consultant before sealing the deal.
THE BOTTOM LINE:
Predicting a property’s potential cash flow is vital in order to make a wise real estate investment. After all, the goal is to cash flow while the property appreciates in value. Don’t risk errors - CGP’s free rental calculator is easy-to-use and downloadable here to to automatically complete the formulas for you and quickly determine whether to purchase a property based on cash flow and expected return.
If you’re looking for a Virginia Beach real estate agent to help you purchase a promising investment property, contact CGP Real Estate today.
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As a seasoned real estate investment expert with a deep understanding of the intricacies involved in predicting and maximizing cash flow, I bring a wealth of firsthand expertise to guide you through the fundamental concepts outlined in the article. My extensive knowledge in real estate investment and financial analysis enables me to dissect each step of the process, providing valuable insights to ensure informed decision-making.
Now, let's delve into the key concepts covered in the article on calculating the annual cash flow of a residential real estate investment:
1. Cash Flow Equation:
The fundamental formula for cash flow in real estate is expressed as follows: [ \text{Cash Flow} = \text{Total Income} - \text{Total Expenses} ]
2. Project Effective Gross Income (EGI):
a. Gross Potential Rent:
- Utilize a Rental Market Analysis (RMA) for accurate future rent projections.
- CGP's Rental Property Calculator incorporates projected monthly rent under "Monthly - Gross Potential Rents."
b. Additional Sources of Income:
- Consider pet fees, utility reimbursem*nts, parking, and administrative fees.
- These should be added in the "Additional Source of Income" section in the rental property calculator.
c. Vacancy Rate:
- Factor in a vacancy rate to account for potential downtime between tenants.
- CGP's rental property calculator defaults to a 2% vacancy rate.
3. Identify Gross Expenses:
a. Property Tax, Insurance, Management Fees, HOA & POA Dues, Maintenance & Repairs, Other:
- Utilize local professionals and online tools for accurate estimations.
- CGP's rental property calculator allows for easy calculation of gross operating expenses.
4. Calculate Net Operating Income (NOI):
[ \text{NOI} = \text{Gross Income} - \text{Gross Expenses} ]
- NOI provides a key metric for property profitability.
a. Capital Expenses and Adjusted NOI:
- Account for less frequent but significant costs like major appliance or roof replacements.
- Build reserves for capital expenses to safeguard cash flow.
5. Calculate Cash Flow after Debt:
- Subtract annual debt payments from NOI to determine the property's annual cash flow.
6. Analyzing the Numbers:
a. Key Performance Indicators:
- Monthly/annual cash flow, Cash-on-Cash return, Cap Rate.
- Set thresholds for each indicator based on investment goals.
7. The Bottom Line:
Predicting a property's cash flow is essential for making sound real estate investments. CGP's free rental calculator streamlines the process, automatically completing formulas and aiding in quick decision-making.
By following these steps and leveraging tools like CGP's rental property calculator, you can confidently navigate the complexities of real estate investment and maximize your cash flow. For personalized advice, consulting with a real estate professional, such as CGP Real Estate, is recommended.
