Cash Flow Survival Guide - Know Thy Fundamentals!
Let’s talk cash flow for a second…
Well, maybe this will take a little longer than a second, but definitely a worthy topic to understand as a real estate investor or business owner in general. When most people think about cash flow, a good majority of the time people relate that idea to money flowing into the business; which yes, cash flow IS money coming in. One of the biggest aspects of cash flow not taken into consideration when determining its value (especially when analyzing a potential real estate investment) is expenses. When I’m talking about expenses, I’m not just taking into consideration a mortgage but rather ALL expenses that COULD arise and should be budgeted for before actually determining the true incoming/outgoing cash flow of your monetary investment.
Note: This example can also be used for a townhouse or condo, just add the extra condo fees onto the monthly expenses.
Depending on the deal with the tenants, the landlord may be paying heat/water and electrical, heat/water, or the tenant may be paying all utilities but for this example I’m going to go with a common split of landlord paying heat and water and tenant is paying electrical bills.
I’m going to use a simple example of a typical real estate investment; a single family home that is currently rented out. So let’s say the property is renting for $1,500 per month to some lovely long-term tenants. The mortgage payments are $850/month, taxes are $140/month, and insurance is $90/month. There are also payments of $65/month for water and $150/month for heat.
Right O, and here is how we determine if our property is cash flowing in the positive or negative.
Revenue
Monthly Income from gross rent: $1,500
Expenses
Mortgage payment: $850
Insurance: $90
Taxes: $140
Water: $65
Heat: $150
Maintenance and Repairs ($1,500×10%): $150
Vacancy Allowance ($1,500×5%): $75
*Management Fee If Applicable ($1,500×10%) $150
Total Monthly Expenses: $1670
Total Net Income ($170)
So based on the example above, we are operating at a NEGATIVE cash flow of $170 every month which is unsustainable in the long run if you are looking to purchase more investment properties.
And yes, there are consequences to negative cash flow…
This lack of revenue will end up increasing your debt ratio. The result? Lenders will be a lot more reluctant to loan you any more money for future purchases. With 2 or 3 underperforming assets, you will end up hitting a wall resulting in the inability to take title on future investment properties.
What a lot of rookie or first time investors do not account for when calculating cash flow is a strong reserve fund for Maintenance and Repairs, Vacancy, and Management fees. The percentages allocated to each reserve fund are standard but can vary depending on the state of the property, tenant profile, and vacancy rate in the neighbourhood. If the property is “pretty,” well maintained, and doesn’t need any major structural improvements then you can get away with a lower reserve fund. Also, if you have a rougher tenant profile in a transition area, you may want to have a larger reserve fund for repairs and maintenance.
If you did want to increase the revenue in the above example, one thing you could try is to get the tenant to pay for all utilities (heat/water/electrical). Also, depending on the interest rate of the mortgage it’s not a bad idea to look into refinancing and float on a variable rate thus decreasing your mortgage payment.
Always do your diligence before purchasing real estate investments or ANY investment for that matter.
Keep The Cash Flowin,
Real Estate Investment Specialist
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