The Truth About Cash Flow for Investment Homes

Comparing the cash flow of investment properties is difficult, even for experienced real estate investors.  

“$3,000 Annual Cash Flow!” 

“Get Positive Cash Flow With No Money Down!” 

“31% Cash-on-Cash ROI!”

The marketing pitches are alluring, to be sure.  But common sense tells us that things that sound too good to be true often aren’t.  How is an investor to know?  A little basic knowledge and some due diligence up front will go a long way in answering this question.

There are three primary ways that an investor makes money in real estate: from cash flow, property appreciation, and paydown of the mortgage (reduction of debt liability.)  Building equity through appreciation and paydown of the mortgage are generally well-understood by most investors.  Cash flow is much more ambiguous.

Conceptually, it seems simple enough:  cash flow is the difference between the checks you write each month and the checks you deposit.  However, many sellers of investment property have a much looser definition of cash flow, or make very unrealistic assumptions about it, and therefore can easily mislead an unwary investor.  Most commonly, the key elements of cash flow that are misstated are rents which are overestimated, or expenses which are understated or omitted entirely.

Let’s examine the elements which comprise cash flow with an example.  Figure 1 shows all of the elements that are required to calculate the true before-tax cash flow (BTCF).  It assumes a single-family home that is purchased for $80,000 and is rented for $800/mo with a 5% vacancy rate.  Property management is assumed to be 10% of the gross operating income (GOI) and the repair allowance is assumed to be 5% of GOI.  Property taxes and insurance are assumed to be $800 each, with no landlord-paid utilities.  The mortgage is assumed to be at an interest rate of 7.25% fixed for 30 years with a 10% down payment.

Figure 1 – Cash Flow Statement

In this example, after including all of the expenses and allowance for vacancy and PMI, the true cash flow is actually a negative $222 per year!  Yet sellers of investment properties will often claim that the cash flow is positive.  This is because it is common for marketers of such properties omit many of the expense categories to make the cash flow sound larger than it actually is.  Using the foregoing example, Figure 2 shows some common ways cash flow may be misrepresented from the example in Figure 1.

Figure 2 – Common Misrepresentations of Cash Flow

In each of the foregoing instances, the “cash flow” that the seller might advertise is positive, when in fact it is actually negative $222 after including all of the costs.  The most common omissions from the cash flow calculation are the maintenance allowance and the PMI, which in this example comprise an expense of $936 between them.

So it is incumbent upon you, the investor, to perform your own due diligence.  Use the template in Figure 1 to study the seller’s numbers.  Have a detailed dialogue with him to understand how he calculated cash flow, and fill in the blanks or correct the assumptions where information is missing or inaccurate.  Most of the components of the cash flow calculations are precise numbers which can be identified or estimated very accurately, including GSI (gross rents), property taxes & insurance, property management expenses, the mortgage payment and PMI.  The vacancy rate, allowance for repairs and utilities (if any are paid by the landlord) must be reasonably estimated.  Some due diligence guidelines:

Gross rents (GSI):  Use caution when acquiring properties that have not been leased to a tenant.  Property sellers advertise that a property should rent for a certain amount, but in fact the actual rent when it finally leases may vary.  If you plan to purchase an un-rented property, validate the estimated rent by talking with the property manager who will be placing your tenant to get actual rents on comparable properties.

Vacancy allowance:  Vacancy rate is a function of many factors, including how often a tenant fails to pay rent, the condition of a home, how long it takes to get a property back in rentable condition after a tenant leaves, how high the asking rent is relative to market conditions, the demand for rental property, the length of the lease, etc.  A vacancy rate of 5%, or about 18 days per year, is considered excellent.  In most markets, a typical property will average 7-8% (26 – 28 days per year) if the property is in reasonable condition. 

Good property management is the key to minimizing the vacancy rate, including careful screening of tenants before leasing, proper maintenance and inspections of the home, and rapid repairs and cleanup after a tenant leaves.  Ask the property manager what kind of vacancy rate you can anticipate.

Property management:  For single family homes, property management costs 8 – 12% of the actual rents collected.  Markets with higher rents tend to have lower property management fees on a percentage basis.  For properties that are self-managed, this cost is much lower.

Property taxes:  Taxes and tax assessment methodologies vary widely between states and counties within states.  Call the county tax assessor’s office where the property of interest is located to learn how taxes are assessed and collected, and get an estimate for the property in which you are interested.  Often the seller will know the tax information on a property.  Many counties have the information available online.  Be sure to use the non-homesteaded, non-owner occupied tax rates, as these typically apply to rental properties and are usually much higher than taxes paid by an owner occupant.

Insurance:  Lenders will require that a home carry hazard insurance, sometimes called landlord insurance.  Ask for a quote from your insurance company.  Insurers will want to know how much coverage is desired, the amount of the deductible, and what special coverages are needed.   Special coverages may include general liability, loss of rents, flood insurance (if the home is in a flood zone), etc.  Be sure you are using a number that adequately insures your interest in the property, as many sellers will only use minimal insurance coverage and the lower premiums in their cash flow calculations will reflect this.

Repair and maintenance allowance:  This is one of the most overlooked expense categories, and it can vary widely from year to year.  A recently renovated or a newer home will usually have lower annual repair costs, on the order of 5% of GOI.  Homes that have not been renovated or have significant deferred maintenance pending, such as a roof needing replacement, may experience 10% and up.  Examples of home construction features that should lower the cost of maintenance include:

·         Brick construction

·         Hardwood, laminate, or tile floors instead of carpet or linoleum

·         Tile countertops

·         Vinyl or masonite/concrete siding

·         Newer roof

Be sure that you understand the condition of the home that you are buying, as all homes require preventive maintenance, repairs and cleaning.  Ask the property manager for insight on what these expenses are like for comparable properties.

Utilities/other:  Include utility estimates if any utilities are landlord-paid.  In most circumstances, the tenant is responsible for paying the utilities.  Other expenses might include applicable homeowner association (HOA) fees, landlord-paid yard care, etc.

Principal and interest:  This is usually the largest expense category, and is a function of the size of the mortgage, interest rate, and amortization period.  There are many online calculators that can be used to calculate the monthly payment.  Cash flow is improved by putting a larger amount down and borrowing less.  Talk to your lender to learn about current interest rates and about buying down (lowering) the interest rate by paying points.

PMI:  Private mortgage insurance is required on mortgages where the loan-to-value ratio is less than 80% (i.e. when the down payment is less than 20% of the appraised value of the home.)  It is important to note that payment of PMI should not be a long-term obligation.  As the loan is paid down and as the property appreciates in value, the equity in the home will rise.  When equity exceeds 20% of the home’s value, the investor should then apply with the lender to have the PMI requirement removed; it does not happen automatically.  Lenders require that PMI be paid for a minimum of one year.  If a home was purchased below its market value, the initial equity in the home may also be factored in to determine if PMI is required after this one year period. 

Interpreting Cash Flow

An investment metric related to cash flow which is commonly misunderstood is cash return on investment (ROI), sometimes called cash-on-cash ROI.  Cash ROI is the annual before tax cash flow (BTCF) divided by the total initial out-of-pocket cash investment in the property.  The initial cash investment is the sum of the down payment, closing costs, and the cost of initial upgrades to the property, if any. 

In the example in Figure 1, the BTCF was negative $222.  If closing costs were $3,000, the 10% down payment was $8,000, and there were no initial upgrades, the total initial cash investment would be $11,000.  Therefore the true cash ROI would be negative 2.8%.  It is common for sellers to omit the closing costs and to use the overstated cash flow numbers similar to those in Figure 2 when stating cash ROI, resulting in an inflated cash ROI figure.

Importantly however, negative cash flow does not necessarily mean the investment is a poor one.  If the cash flow is negative and the investor can afford it, it may be worthwhile if the expected appreciation is exceptional.  For example, finding properties with positive cash flow in the coastal areas of California in 2004-2005 was impossible with 10% down, but investors did extremely well because of the double-digit appreciation in that timeframe.   Ideally, most investors seek properties with good appreciation potential that have at least some positive cash flow, and there are still regions in the U.S. where this is possible, even with a 10% down payment.

Since rents usually appreciate faster than expenses, cash flow often increases over time.  Also, after factoring in depreciation benefits, after-tax cash flow can be positive even if BTCF is negative.

Many sellers include depreciation benefits in their cash flow calculations in an attempt to derive after-tax cash flow (ATCF), as it makes the cash flow numbers look better.  While this tax benefit is real, the amount of benefit each investor varies widely, as each individual investor’s personal tax situation is different.  Consequently it is recommended that cash flow be compared on a before-tax basis excluding depreciation.  This will provide an undistorted picture of the comparable performance of one property to the next. 

In the end, it is critical when comparing cash flow on investment properties to measure cash flow in an accurate and consistent manner so that comparisons are made “apples to apples”.  Use the categories in Figure 1 as a checklist when comparing the cash flow returns of various properties, and perform the necessary due diligence to validate the numbers.  After factoring in appreciation and paydown of the loan, an investor can make an informed, lower risk decision when purchasing investment property that will deliver exceptional returns.

About the author:  Kevin Conlon is co-founder of Meridian Pacific Properties, Inc., a real estate investment property dealer.  He has invested in single-family residential property continuously since 1981.