How to calculate cashflow for rental properties
Generating passive income is the goal of every real estate investor, and cash flow is essential to achieve it. In this guide we’ll explain how to calculate rental property cash flow.
What Is Cash Flow?
Cash flow is the net amount of money transferred in and out of a rental property investor’s bank account. Cash flow in rental properties can be broken down into two categories:
Gross cash flow: The money collected from rent and other sources of income, like late fees and cleaning services
Net cash flow: Your remaining money after each month or year, minus operating expenses
Ideally, your rental property’s net cash flow should be positive – meaning income exceeds costs. Negative cash flow can happen when rental units are left unoccupied or maintenance costs far exceed your income.
Here are a few things that influence your monthly cash flow:
Property Location: Location plays a big part in determining cash flow since rental rates depend highly on the local market. Property taxes may also negatively impact your net cash flow.
Rental Type: Your rental property type determines how much you can get from tenants. For example, a long-term rental is more likely to generate consistent cash flow than seasonal vacation rentals.
Property Financing: Mortgage payments (i.e., how you financed the property purchase) influence your costs. A lower mortgage balance results in lower interest costs and improves your overall cash flow, but requires a higher equity down payment. The mortgage payment includes both principal repayment and interest expense. Although interest expense is the cost of borrowing, the principal repayment reduces your mortgage balance and increases your equity in the property (i.e. you own more of the property over time).
How To Calculate Cash Flow
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You can quickly calculate your rental property cash flow with this simple formula:
Cash flow = Total income - Total expenses
However, this is an extremely simplified formula. If you want to do a proper cash flow analysis, follow this three-step guide:
Calculate Gross Cash Flow
The formula for gross cash flow is:
Total rental income + Total additional income = Gross cash flow
Let’s say you have an annual gross rental income of $15,000 plus an additional income of $2,000 from late fees and cleaning services. Based on this, your gross cash flow would be:
$15,000 + $2,000 = $17,000 gross cash flow
Determine Net Operating Income
Your net operating income (NOI) is your gross cash flow minus operating expenses, including property taxes, insurance, maintenance costs, and other bills. Use the formula below:
Gross cash flow - operating costs = NOI
Let’s say your costs are $6,000 per year. Using the gross cash flow from Step 1, your NOI would be:
$17,000 - $6,000 = $11,000 NOI
Calculate Net Cash Flow After Mortgage Payments
Once you have an NOI, calculate your total net cash flow with this formula:
NOI - Annual mortgage expenses = Annual cash flow
Let’s assume you have a $100,000 rental property with a $75,000 mortgage and $25,000 down. With a 30-year fixed mortgage at 4% interest, your monthly mortgage payment should be around $357 or $4,280 in annual debt payments (don’t worry too much about that calculation). Therefore, your annual net cash flow would be:
$11,000 - $4,280 = $6,720 net annual cash flow
To summarize, in this scenario, our key numbers are:
Gross cash flow: $17,000
Net operating income: $11,000
Net annual cash flow: $6,720
What Are Some Common Expenses?
The most common expenses for rental owners are maintenance and operational costs. Here’s a list of the most common rental property expenses:
Property managers (if you don’t manage properties yourself)
Rental property marketing
Real estate agent commissions (if you find tenants through a third party)
Building maintenance and improvements
Utilities
Rental property insurance
Property taxes
Rental property licenses
Homeowners association fees (if applicable)
Mortgage payments and private mortgage insurance
Cash-on-cash invested
Cash-on-cash invested, sometimes called cash-on-cash returns, is the ratio of cash earned vs total cash invested. It is used to measure rental property investment performance. This ratio is important because real estate properties' actual cash returns usually differ from their regular return on investment (ROI).
Cash-on-cash differs from ROI because it doesn’t include debt in your calculations. It is calculated like so:
(Annual net cash flow/Total cash invested) x 100 = Cash-on-cash invested (as a percentage)
If we use the example property in our net cash flow calculations, you would get the following information:
Annual net cash flow: $6,720
Property value: $100,000
Down payment: $25,000
Annual mortgage expense: $4,280
Total cash invested after the first year: $29,280
Reminding ourselves of the formula:
Annual net cash flow / Total cash invested after the first year * 100
we get a cash-on-cash invested rate of:
($6,720 /$29,296) x 100 = 23.0%
Good rental investments typically have an 8-12% cash-on-cash return rate, so this example would be an excellent investment.
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Cash Flow Can Be Fluid
A rental investor's fluidity or liquidity measures how well they can pay bills and debts with their current assets. Tangible assets like rental properties are less liquid, while cash is the most liquid asset. Having a good cash flow means you have a lot of cash on hand to make payments.
Here are some good tips to ensure positive cash flow and accumulate liquidity:
Increase Rent: Increased rent means more income, leading to better cash flow. However, you should balance this by improving your properties to keep tenants happy.
Create Additional Services: Adding new services like a laundromat or bicycle parking is a good way to increase income and improve tenants’ comfort.
Negotiate Your Mortgage: Monthly mortgage payments tend to be expensive, so reducing your mortgage cost can increase your cash flow significantly. Ask your mortgage lender about lowering your rates or eliminating mortgage insurance.
The Importance Of ROI For Real Estate*: Return on investment (ROI) estimates how long it'll take to make your initial investment back. It also helps you compare properties in the rental market to see which is the better investment. Calculating ROI can also be useful when you’re already managing rental properties. If your expenses rise and rent income falls, you can recalculate the ROI. This will help you make an informed choice, whether it’s to sell the property or ride out the dry spell.
*the Internal Rate of Return (IRR) is more complicated to calculate than ROI, but offers a more sophisticated analysis, especially when assessing projects with varying cash flows over time. Ultimately, the choice between ROI and IRR depends on the specific characteristics of the investment and the desired level of analytical depth.
Summary
A good cash flow is essential to successful rental property management. To improve cash flow, you must increase rental income and reduce costs. A good way to benchmark your cash flow is to calculate your property’s cash-on-cash return or ROI – this allows you to see how well your rental property is performing. If your ROI seems low, you can sell your property or make changes to raise income and lower costs.