To play it well you must understand the four financial benefits of real estate and how to maximise them. Those benefits are:
1. Cash flow
2. Equity build up (the payoff of your loan)
3. Tax benefits
4. Potential appreciation
In this article we are going to look at benefit number one.
Benefit number one – Cash Flow (cash flow before tax).
Investing in real estate is game of numbers. To play the game well you must understand how to manipulate the numbers to get the end results you want. The result being positive cash flow.
The formula to calculate the cash flow is listed below:
Gross Rental Income
Equals: Adjusted Gross Income
Minus: Operating Expenses
Equals: Net Operating Income
Minus: Debt Service Payments
Equals: Cash Flow Before Taxes
Here is an explanation of each of the factors in the formula above.
Gross rental income is the first number that you need. This number is that total income that we expect to get during the year from the rental.
Vacancy is a percentage of the gross rental income. It is based on that you won’t collect from of the rent that is expected because of bounced payments, evictions and vacant rental properties during the year. This percentage will vary depending on the supply and demand for rentals in your area. I commonly use a 5% vacancy factor when I don’t have any data to determine this. It is important to ALWAYS have a vacancy percentage.
Adjusted Gross Income is the actual money that you are going to receive.
Operating expenses are all the costs that apply to the property each and every year other than the loan payments. It includes things like taxes, insurance, repairs, utilities that you pay and any other expenses.
Net Operating Income is the amount of money that the property produces after all operating expenses. This is the most important number because this is the number use to pay any loan payments. This is also the number that we use to determine the value of the property (more about this later).
Debt Service Payments is the amount of payments that you spend per year for any loan that you have on the property.
Cash Flow Before Tax is the amount of money that is left over after you have paid EVERYTHING. This is the amount of money that you get to keep for yourself.
Ok, now that I explained what all the numbers are, here are the keys to creating more cash flow. There is only basically two ways to do it. You have to get more income by increasing the rents and/or reducing vacancies or you need to reduce your operating expenses and /or your loan payments.
If you are buying, it obvious that by paying less for the property would mean that your loan should be less, therefore your loan payments should be less and should give you more cash flow.
It is extremely important that before you every buy any rental real estate that you look at the cash flow and you should run the numbers using three different scenarios. The best case where you rents are high and expenses are low, the worst-case scenario where the rents are low and the expenses are high and then a middle scenario. If the worst-case scenario still makes sense then the property should be a no-brainer and you should go ahead and buy.