How to Calculate Rental Property Cash Flow?
Before any real estate investor commits to a rental property, they should figure the cash flow on rental property investments. Will the investment property produce enough profits?
Knowing rental property cash flow is a good rule of thumb before entering a long-term commitment. This process requires the guidance of an excellent real estate agent, financial advisor, and a realistic approach to predicting income vs. expenses.
How can you figure cash flow on a rental property to determine if it’s a good investment for you? This guide will help you with the basics.
Short Term vs. Long-Term Estimates
Calculating cash flow is simpler when you figure in short-term profits (such as in fix and flip real estate investing). Paying cash instead of using a lender also simplifies your monthly expenses calculations.
Your bottom-line estimate becomes less accurate when you calculate the positive cash flow of long-term holding periods. Since factors like fluctuating property values and inflation are at play, investors must keep a few formulas handy, such as net present value, to estimate profits from a long-term rental investment.
This information will empower you to make the best cash flow analysis. When you stick to the best practices, you can get a reasonable idea of how much cash flow to expect in either situation.
How to Calculate Cash Flow on a Rental Property
When you calculate cash flow on a rental property, the formulas get more complicated if you need to estimate buy-and-hold cash flow for long time periods. To determine the amount of cash a property can get you, consider this basic formula:
(Gross rental income + additional income) – (vacancy rate + Any additional holding costs) = Cash Flow
To make accurate assessments, please keep these numbers in mind:
- The purchase price and the anticipated sale price of the property (important for big-picture sell-off profits and to help you find out how long to hold a property before breaking even. Factors like depreciation and rental market trends influence this timeline.)
- Monthly mortgage payment (if applicable)
- Property taxes and Insurance (part of a mortgage payment or paid separately if you pay in cash)
- Anticipated monthly rent.
- Additional income from the rental like late fees, pet fees, application fees, etc.
- Estimated vacancy rate and non-payment risk.
- Estimated maintenance costs.
- Other operating expenses related to the investment property.
These cost vs. income figures make it simpler to calculate a realistic monthly cash flow on rental units. Other rental property expenses, like property management fees, should also go into your spreadsheet to give you the most accurate estimate of net cash flow.
A Closer Look
Here’s how you can plug in some numbers to get a fair assessment of profits. Let’s assume we bought a single-family house that has a mortgage payment of $1,200/month and has a market monthly rent of $1,800.
- Gross monthly rental income: $1,800, which equals $21,600 per year.
Now, let’s deduct the most common total expenses.
- Estimated vacancy rate/non-payment risk = 21,600x 0.06 = $1,296 per year.
- Mortgage payments = $1,200 per month, or $14,400 per year. (If there isn’t a mortgage, then you still pay property insurance and property taxes).
- Estimated maintenance costs = $1,200 per year
- HOA fees (if applicable)
From these numbers, take your overall profits of $21,600 – ($1,296 + $14,400 + $1,200) = $4,704.
- Note that this is an extremely rough estimate of potential profits, and every investment is unique. Also, maintenance costs can fluctuate greatly. For instance, you may just need to replace HVAC filters and clean carpets for one rental, but another may need more rehab. It’s important to consult a financial advisor to get the most accurate estimate of your return on investment.
If you don’t have to pay a mortgage on the property, then extra costs like interest rates won’t factor into your expenses, and you can reap more immediate income. This gives you more gross rental income and flexibility on your holding timeline.
Using the Cash-on-Cash Return Formula
Cash on Cash Return (CoC return) is another financial metric used in real estate investment to evaluate the profitability of an investment property. It measures the annual pre-tax cash income generated by the property relative to the total cash invested in the property. The formula for calculating Cash on Cash Return is:
CoC Return = (Annual Pre-Tax Cash Flow / Total Cash Invested) × 100
- Annual Pre-Tax Cash Flow is the net operating income (NOI) minus the annual debt service (mortgage payments, property taxes, insurance, etc.).
- Total Cash Invested includes the initial cash investment, such as the down payment, closing costs, and any renovation or improvement costs.
The result is expressed as a percentage, representing the return on the actual cash invested in the property. A higher Cash on Cash Return indicates a more profitable investment.
Typically, investors consider cash on cash return between 8 to 12 percent to be good. Alternatively, 5 to 7 percent can also be acceptable in some markets. If your rental income isn’t high enough to cover operational, maintenance, and risk-related costs, you can end up with negative cash flow.
- Note: It’s essential to consult a financial expert to consider other factors like property appreciation, potential for future value increase, and overall investment goals when evaluating real estate investments.
Using the Cap Rate Formula
The cap rate is another formula you can use to estimate the amount of money your rental can bring in. This commonly used metric in real estate investment evaluates the potential return on an investment property. The formula for calculating the Cap Rate is:
Cap Rate = (Net Operating Income (NOI)Current Market Value or Acquisition Cost) × 100
- Net Operating Income (NOI): The annual income generated by the property after deducting operating expenses but before deducting mortgage payments and income taxes.
- Current Market Value or Acquisition Cost: The total cost to acquire the property, including the purchase price, closing costs, and any initial renovation costs.
The result is expressed as a percentage, representing the rate of return on the investment based on the property’s income. A higher Cap Rate generally indicates a potentially higher return, but it’s important to consider other factors, such as the property’s condition, location, and the investor’s specific goals and risk tolerance.
Expert analysts generally agree that an ideal cap rate is between 5-10%. Conversely, a cap rate lower than five percent may have less risk but would require a more extended cost recovery period.
Using Cash Flow to Determine Holding Times
Once you know a rough estimate of your property’s cash flow, you can use more advanced formulas to determine its future value. Since a dollar today isn’t worth the same tomorrow, you should calculate your cash flow’s net present value to determine future profits.
Whether you bought the property with a mortgage, or all cash dramatically affects how long you need to hold a rental to reap financial benefits. This calculator also allows you to estimate cash flow in light of potential rent increases while figuring risk factors via a “discount rate.”
Finding the Ideal Holding Time
Using this calculator, you will find that a $200,000 house at an 8% discount rate needs to be held for at least a decade to have an NPV of -$167,631.44, which brings you into the “zone” of selling for profit.
However, holding the property for only three years leaves you at an NPV of -$187,877.34, which gives you limited space between the purchase price and what is left on your loan. When a mortgage is in the mix, your analyst will likely tell you to hold for extended periods to pay down your loan enough so that closing costs and other selling fees don’t eat up your profits.
The More Information, The Better
As with all formulas, no estimation can be exact. No calculator can predict when a roof will fail or when there will be a recession, but your best protection is knowing as much as possible about what to expect. For instance, if you know extra costs, such as property management fees or marketing costs, it’s best to deduct those from your cash flow.
If you know the exact cost of an expense, such as the going rate for professional cleaning or maintenance, plug them into your spreadsheet so that you don’t have to do any guesswork. Update the numbers as time passes to ensure that your cash flow accurately reflects your profits minus expenses.
Finding Rental Properties
Another critical aspect of calculating cash flow is finding an appropriate rental property in the first place. Since there are many options out there, an experienced real estate agent specializing in investments can help you identify the most profitable and in-demand rentals for your buy-and-hold business.
It’s also wise to work with a financial analyst who can help you calculate your estimated cash flow through the lens of Net Present Value. With this support in your pocket, you can thrive and reach your maximum potential as a real estate investor.
Would you like to find out more about finding rental properties? Our experienced team of real estate agents is ready to help you today. Contact us today to connect with one of our real estate experts.