Do you have a rental property that you’re thinking of buying? If so, analyzing the rental property cash flow is a crucial step to understanding whether the property will be profitable. There are two ways to do this: with simple estimates or a more detailed analysis of expected income and expenses.
Rental property cash flow refers to the difference between the rental income generated and the expenses incurred by the rental property owner. A positive cash flow means that the rental property is generating more income than it is costing to operate and maintain, while a negative cash flow indicates that the rental property is losing money.
If you’re new to rental properties, you might be wondering how to analyze rental property cash flow. Luckily, it’s not as difficult as it sounds. In this blog post, we’ll walk you through the basics of rental property cash flow analysis as well as its importance when considering rental properties.
What Is Cash Flow?
First, let’s start with a definition of cash flow.
Rental property cash flow is the money that flows in or out of the rental property. Cash flow can be used as a measure of profitability for the rental property. Analyzing cash flow allows you to better understand your rental income, expenses, and performance of the rental property.
Just like any other business, cash flow is the key to rental property success. By analyzing rental property cash flow, you can make informed decisions about which property to invest in. Or if you already own a rental property, how to improve your rental business.
There are two types of cash flow: positive and negative. Positive cash flow occurs when the rental income is greater than the expenses associated with the property. Negative cash flow occurs when the rental expenses are greater than the rental income.
There are a few key things to keep in mind when analyzing rental property cash flow:
- Rental income
- Vacancy rate
- Operating expenses
- Debt service
- Taxes
By understanding these key components, you can better analyze rental property cash flow.
Importance of Cash Flow Analysis
Cash flow is the lifeblood of rental properties. You can ensure that you invest in a property that will continue to produce a positive cash flow by analyzing rental property cash flow. Cash flow analysis is a tool to help you determine if a rental property is right for you. Analyzing a rental property’s cash flow is a more detailed analysis, and often the next step after using the 1% rule.
A rental property can be analyzed on its own or with other rental properties. Cash flow analysis should cover all aspects, including net operating income (NOI) and cash-on-cash return (CoC).
An important aspect of rental property cash flow is NOI. NOI is a measure of rental income after all operating expenses are paid. To calculate NOI, simply take your rental income and subtract your operating expenses.
Cash-on-cash return (CoC) is another key metric in rental property cash flow analysis. CoC is a measure of the cash flow you can expect to receive from your rental property. To calculate CoC, divide your NOI (after financing) by the amount of cash you have invested in the rental property.
You can use these key metrics to compare potential investment properties to make an informed decision about the best property for you.
What Is Considered “Good” Cash Flow For A Rental Property?
So, what do real estate investors consider to be a good amount of cash flow for a rental property? It’s a bit of a misleading question because cash flow is only part of the equation for return on investment.
The other part of the equation is how much you have invested. When you divide the cash flow by the amount you invested, you get the cash-on-cash return. This scales up or down. Whether you have invested $50,000 or $1,000,000, you can compare the cash-on-cash return. And, this is how savvy rental property investors analyze rental properties.
They look at the cash-on-cash return. A good rule of thumb for a beginning rental property investor is a minimum cash-on-cash return of 8 to 12%. That means that if you have invested $100,000 in a rental property, you would want to see a minimum of $8,000 to $12,000 in annual cash flow.
Of course, the higher the better. Some rental property investors strive for a 20% cash-on-cash return. That would mean that on a $100,000 rental property investment, you would want to see an annual cash flow of $20,000.
It’s important to remember that these are just general guidelines. You will want to do your own due diligence on any rental property you are considering investing in.
But, if you are looking for a good place to start, aim for a 12% cash-on-cash return and you can’t go wrong.
Methods For Estimating Rental Property Cash Flow
Now that we have a good understanding of what cash flow is and how it can be used to measure the performance of a prospective rental property, let’s take a look at a few common ways to estimate the cash flow.
Cash Flow Analysis Using Estimated Expenses
The first method for estimating the cash flow of a rental property is to estimate the expenses as a percentage of the gross income. You’ll need to know what you can reasonably rent the unit for per month.
Once you have a good idea of what your monthly rent will be, multiply it by 12 to get the yearly income.
The next step is to estimate the expenses. A general rule of thumb is that the expenses (excluding financing) typically cost half of the income of the property. This is called the 50% rule. It’s not set in stone; sometimes 45% is more accurate, and sometimes 55% is more accurate. It depends mostly on your local market. If you’re in doubt, you can use a higher percentage to more conservatively estimate your expenses. With more experience, you’ll be able to refine this estimate for your local market.
Finally, add the cost of financing into your expenses and subtract the total expenses from the gross income. The difference between the estimated income and expenses is the cash flow.
This method isn’t very accurate, but it’s a good starting point. Using this method, you can start to weed out potential investments that don’t produce enough cash flow. However, you should not base your investment decision solely on this rough estimate.
If you want to learn more, check out our detailed resource on the 50% rule of real estate investing.
To get a more accurate picture of the cash flow, you’ll want to use actual income and expenses.
Cash Flow Analysis Using Actual Expenses
This method is similar to the first one, but instead of estimating the expenses, you’ll use actual numbers. You’ll need 12 months’ worth of rental income and expense data to do this accurately.
If you’re looking at a rental property that’s already established, you can ask the current owner for 12 months of rental income and expense data (this is called the T-12 or Trailing-12). Keep in mind the information the current owner gives you may not be completely accurate for your situation. For instance, they may manage other units and get a discount on certain services.
If the rental property isn’t currently being used as a rental, you’ll have to estimate the income and expenses. You can estimate the income by looking at comparable rental units in your area. Expenses are a bit more difficult to estimate. We put together a guide to all the possible expenses you might find in your rental property.
To help you better estimate your expenses, we put together a comprehensive list of expenses for a rental property.
Regardless of how you find the estimated expenses, you’ll want to make sure you budget for all of the most common rental property expenses including:
- Property Management
- Property Taxes
- Insurance
- Maintenance and Repairs
- Vacancies and Turnover
- Financing
Similar to the cash flow estimate using the 50% rule, you’ll simply subtract the estimated expenses from the gross income to come up with the cash flow.
How To Calculate Cash On Cash Return Of A Rental Property
While cash flow shows you how much profit is left over for you to withdraw from the property, cash on cash return is used to show the performance of the rental property. Regardless of how much money you invest into a property, you can get an apples-to-apples comparison between properties with cash on cash return.
Cash on cash return is expressed as a ratio, or percentage, of the cash flow divided by the amount invested. For example, if you have a rental property that costs $100,000 and it generates $12,000 in cash flow per year, your cash on cash return would be 12%.
($12,000 ÷ $100,000) x 100 = 12%
You can use this ratio to compare rental properties against each other or any other investment you’re considering. If you’re looking at two rental properties and one has cash on cash return of 12% while the other has a return of 15%, the property with the higher return is likely the better investment.
Summary
Calculating the cash flow of your rental property is a critical step in understanding the profitability of your investment. By taking a closer look at the cash flow and cash on cash return, you can make informed decisions about which investment property is best for you.
You can use the 50% rule as a first step in screening potential properties and eliminating the worst options. Once you have refined your list of properties, you can perform a detailed analysis of the cash flow and cash on cash return to compare your options. With a clear understanding of the rental market and your investment goals, you’ll be well on your way to finding the best rental property for you.
What are some other methods you use to screen rental properties? Let us know in the comments below!