Rule #1: NEVER Invest In a Property With Negative Cash Flow
Use A Simple Cash-Flow Analysis To Avoid Negative Cash Flow
Welcome back, fellow Hybrids!
In today’s newsletter, I will break down the components of a cash-flow analysis and how you can use it to avoid a negative monthly cash flow.
Because let’s face it, you aren’t getting into real estate investing just to lose money every month…
(Today’s issue takes ~5 minutes to read)
Solid and predictable cash flow is the bedrock of a successful real estate portfolio.
Unfortunately, many investors overlook cash flow, believing they will make all their money through appreciation in property value.
BREAKING NEWS: Future appreciation doesn’t pay today’s bills!
Furthermore, appreciation is not guaranteed, especially in the short term.
This is why the first rule of real estate investing is to NEVER invest in a rental property with negative cash flow!
Here are some of the consequences of buying a property with negative cash-flow:
You will pay out of pocket to cover fixed monthly expenses
No buffer for CapEx & unexpected repairs
Inability to absorb higher operating costs & rising inflation
The good news is it doesn’t have to be this way. You can avoid locking yourself into negative cash flow by building your offers based on a cash-flow analysis.
Here's how, step by step:
Step 1: Estimate your gross income
Sources of income include:
Rent
Tenant Passthroughs (such as utilities, application fees, etc)
Pet Fees
Laundry or Parking Charges
Storage
A best practice (and step you shouldn’t skip!) is to estimate a % of your income toward vacancy and subtract it from your gross income. This % varies, but I like to use 8% (approximately 1 month per year).
You now have your gross cash-flow!
Step 2: Forecast your operating expenses
There are significant operating costs to running a rental. You need to account for all of them!
Expenses include:
Maintenance & Repairs: 8-10% of rent
Property Management: 8-10% of rent
CapEx: 8-10% of rent (important, especially on older properties)
Insurance (homeowners, umbrella, flood, etc)
Taxes - use county assessor’s website for historical tax info
Utilities: (unless tenants are paying directly)
Lawn Care: (unless tenants are paying directly)
HOA fees (if applicable)
Other: (think of this as the emergency or contingency fund)
This is the most essential part of the analysis!
Missing a line item or underestimating an expense category can cost you dearly in the long run!
Step 3: Calculate your projected Net Operating Income (NOI)
Net operating income measures an income-producing property's profitability before adding in any costs from financing or taxes.
NOI = Gross cash flow/income – Gross operating expenses
NOI is a key indicator of whether a property is worth the expense of owning and maintaining it.
But the story is not yet complete…
Step 4: Subtract your debt service costs
Unless you paid for your property in cash, you will likely have used debt financing (aka mortgage loans).
You’ll need to subtract those costs to arrive at your net cash flow.
Net cash flow = NOI – Debt service
Mortgage payments include the following components:
Principal - Reduces the balance of your loan
Interest - Interest paid to your lender to service your loan
PMI - Private Mortgage Insurance, which insures the lender on loans with less than a 20% down payment
You can remove PMI in the future once your Loan-to-value is lower than 80%
Note that taxes & insurance are often included in the escrow payment through your lender.
Make sure you do NOT duplicate those costs if you included them in step 2!
The net cash flow you calculated is a key indicator of whether you’ve picked a good investment.
Congratulations, you’ve completed your basic cash-flow analysis!
If you need to draw a binary conclusion, make it this:
Positive net cash flow = Good! 🟢
Negative net cash flow = Very bad! 🔴
By ensuring positive cash flow, you reduce your investment risk. You can invest knowing you have the money to pay for operating expenses and loan payments.
What To Do If A Property Produces Negative Cash Flow
The best answer for your average everyday investor is to walk away.
Remember, future appreciation doesn’t pay today’s bills!
If you decide to invest in a property that you know produces negative cash flow, you will be stuck feeding it every month with your own money.
It’s up to you if you can live with that.
Don’t Forget Uncle Sam!
While real estate is full of incredible tax benefits, it’s crucial you remember to account for any income tax liability you may incur.
Even if you don’t have tax liability, you will likely work with a CPA to prepare your taxes. The average CPA charges $300/hour. Budget accordingly!
Free Resources To Calculate Cash Flow
If you want to start doing your own cash-flow analysis, I recommend the following resources:
DealCheck (Affiliate Link) - Import property info directly by keying in the address & analyze deals in 5 minutes or less. The FREE version allows up to 10 properties. No CC required.
Ostrich Chrome Extension - Calculate net cash flow directly from Zillow listings. With one click and ~5 seconds, you’ll have an estimated net cash flow.
That’s all for today. Wishing everyone a happy, healthy holiday. I’ll see you next Thursday!
-Aaron