The term “cash flow” brings up images of, well, a flow of cash. And, the basic meaning isn’t too far off the mark. Overall, cash flow is defined as the amount of profit (mainly consisting of rental income) from an investment property, minus debt service payments (i.e., mortgage payments), capital expenditures for upgrades, property expenses, and vacancy/credit loss.
In other words, cash flow is the income that remains after you pay off various expenses.
There are, however, deeper meanings to this concept. Cash flow is one of the most understood tools — and sometimes, the least understood — when it comes to successful real estate investing. While you don’t have to be a trained CPA and know all of the ins and outs of cash flow, understanding the various facets of this term is helpful when it comes to buying, maintaining, and selling a real estate asset.
Different Ways to Flow Cash
In the real estate investment world, there are actually different types of cash flow, including the following:
- Net operating income. This is defined as revenue generated from a property, minus all reasonable operating expenses. If you own an office building, the rent you collect from the tenants is your revenue. The operating expenses focus on the costs of running and maintaining your building, such as insurance premiums, utilities, property taxes, repair costs, maintenance fees, and legal fees.
- Equity build-up. If you took out a mortgage to acquire the above-mentioned office building, you would pay it off in monthly installments. The longer you pay off that mortgage, the more you chip away at the principal. This, in turn, increases your equity, which represents the difference between your office building’s fair market value, and the remaining amount of money you owe on the property. This is considered cash flow for purposes of either borrowing against the property, or refinancing the mortgage.
- Capital appreciation. Capital appreciation is an increase in the asset’s market value, and is realized when you sell. When it comes to your office building, you might decide to improve it by adding a new roof, building a parking lot, or putting high-credit tenants in place. These actions boost the property’s value.
Examining these cash flow types can help provide you with the appropriate information as to the effectiveness of a particular real estate investment.
The Tax Discussion
No investment conversation would be complete without tax talk, and discussing cash flow in the context of real estate isn’t much different. Specifically, the conversation should focus on pre-tax cash flow versus after-cash tax flow.
- Pre-tax cash flow. Sometimes known as before-tax cash flow, pre-tax cash flow is calculated by subtracting mortgage payments from a property’s net operating income. Most times, pre-tax cash flow is useful to know before you decide to invest in real estate.
- After-tax cash flow. This is defined as the amount of cash flow remaining after deductions. Such deductions include mortgage interest payments and depreciation; the result is a reduction in your real estate income, which also reduces your tax liability. But maximizing after-tax cash flow doesn’t just happen; it requires careful planning and tax-shelter understanding.
Cash Flow — Your Best Due Diligence Tool
The great thing about cash flow is that it tells you a great deal about a property, especially during the due diligence period. Cash flow analysis delves into all kinds of issues, ranging from capital expenditure (or lack thereof) on an asset, to breakeven occupancy ratios, to tenant risk assessments. The latter, with its focus on credit quality and past payment history, can tell you if your tenants are capable of continuing to pay you rent.
From an investor standpoint, your real estate’s cash flow is important. It represents a source of income, while protecting your asset(s) through capital expenditure, maintenance, and upgrades. As such, an understanding of this concept is essential to your pursuit of the best ongoing performance and value from your property investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.