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Commonly, it is seen through the aspiring rental property investors know that profits are made when a real estate property is bought. But what goes unnoticed is how they can understand whether a property deal will generate a surplus with time?
Because at the end of the day, your goal from investing in rental property is ultimately to generate a positive cash flow. After all, it is the money you get to keep in your pockets after deducting all your expenses.
Yet, seeing investors not knowing how to calculate their cash flow from the rental often gets trapped. So, the question is the same; how can you calculate your cash flow from your rental properties? Thus, understanding the investors’ concern, I decided to solve the puzzle by laying down the steps involved while analyzing the rental property cash flows and also how to calculate cash flow for a Rental Property.
What is Rental Cash Flow?
Cash flow is the money movement through a rental property, similar to the way water flows over a waterfall.
First, gross cash flow begins with the rents and other incomes collected from a rental unit. The rent gets reduced by deducting the regular expenses and any debt service and ends up in net cash flow, which is the final cash flow subjected to taxation.
Steps to follow for Rental Property Cash Flow Analysis
Calculation of Cash Flow from the Daily Operations
The first and foremost step for calculating the final cash flow from your rental property is the estimation of your Net Operating Income or NPI. NPI is day-to-day operating expenses relating to the property and includes any vacancy costs, management costs, property taxes, property maintenance, and any related costs for the short-term rental generation.
To calculate the net operating income, you have to subtract all the costs mentioned from the gross rental income, including the total amount of money paid by your tenants.
For instance, a real estate property is rented out for Rs 10,000 a month, then the gross rental income will be Rs ( 10,000*12) = Rs 1,20,000.
If you assume that the monthly operating expense includes:
5% vacancy costs = Rs 6000
10% management costs = Rs 12000
Property taxes = Rs 3000 a year, i.e. Rs 250
Property insurance = Rs 14000
Property maintenance = Rs 7000
Therefore, your net operating income will be,
= Gross Rental Income – Operating Expenses
= 1,20,000 – ( 6000+12000+250+14000+7000)
= 1,20,000 – 39,250
= Rs 80,750
After you have calculated your net operating income, you need to deduct capital expenditure, if any. Capital expenditures are usually the large number of expenses that do not re-occur regularly, like the changing of the roof or sub-division of the room with a wall, etc. For this, you can keep aside a percentage of money from the cash flow, say 5%, for the contingencies.
The final cash flow from the operations will be,
= NOI – Capital Expenditure
= Rs 80,750 – ( 5% of 1,20,000)
= Rs 80,750 – 6,000
= Rs 74,750
Calculating NOI for analyzing rental cash flow can be a reliable indicator, especially for determining the potential income the property can generate with time. Together used with other methods like cash-on-cash return, cap rate, it can give tremendous results.
Calculation of Rental Property Cash Flow after Financing
However, it does happen; sometimes, investors start off using borrowed money to purchase the rental property. So, to estimate your cash flow from the rental property, you need to figure out your cash flow after financing.
For instance, let’s assume the price of the rental property is Rs 11,00,000. After paying 20% as the down payment on the mortgage, you finance the rest at 3% for the 30 years. For this, you can use an online mortgage calculator like an amortization loan calculator to calculate how much you have to pay every month.
However, in this case, the monthly mortgage payment will be Rs 26,400. As a result, the cash flow after financing will be,
= Cash Flow From Operations – Financing Costs
= Rs ( 74,750 – 26,400)
= Rs 48,350
This means you will put Rs 48,350 per month or Rs 5,80,200 per year in your bank account. However, you will still be required to deduct your income tax bill, depending on the area your property is located. This predetermined rate gets removed with the estimation of cash flow after financing to get the cash flow after the taxes.
Calculation of the Cash-Flow after Taxation
Though you calculate your operating expenses or capital expenses, before you reach what is left with you, you will be required to do the final calculation, i.e., your last cash flow after all the tax deductions.
For this, you will need first to figure out how much of your rental property is taxable. You can use the underneath formulae,
Gross rental income – operating expenses = Net operating income,
Net operating income – ( Interest expenses + Depreciation expenses ) = Taxable Income
Taxable income is quite different from your cash flow operating income or cash-on-cash return. Because everything you spend on the rental property is not a taxable expense. For example, capital expenses and mortgage principal both though cost you, but it is not tax-deductible.
For understanding what is deductible on the rental property to estimate your total cash flow, you need to know the rental property expenses eligible for tax deductions.
Calculation of the Capitalization Rate for Estimation of the Cash Flow
With an accurate picture of what rent to charge and the operating expenses, you can find your capitalization rate or cap rate. Cap rate is the expected rate of return on your rental property, calculated as,
= Net Operating Income / Asset Value
For instance, if your rental property NPI is somewhere around Rs 70,000 and your asset value is Rs 10 lakhs, then your cap rate will be-
= 70,000 / 10,00,000
= 7%
Cap rate estimates whether your income minus expenses provides a decent return based on the property’s value. Likewise, if you pay any available cash for the property, the cap rate calculation will be the return you’d be expecting. Provided conditions, if it’s under 3%, you’d need to think again before investing in the property. If the rate is over 10 %, you are receiving an excellent return compared to the property’s value.
Calculation of the Cash-on-Cash Return
Cash-on-cash return is a metric that can be used to calculate the cash flow on the rental property. The pre-tax cash flow was received to the amount of money invested in acquiring the rental property.
To calculate the cash-on-cash return, you need to divide the net cash flow for the year received by the amount of cash invested. Or,
= Annual Cash Flow Before Taxation / Total Cash Invested
For instance, if the purchase price of the rental property is Rs 1,50,000, and the NOI is Rs 8,500 annually. For getting the cash-on-cash return, you will be required to divide,
= 8,500 / 1,05,000
= 8%
This is the cash-on-cash return you can expect from your rental property. However, it does fluctuate throughout your holding period if you have one-time capital or other large expenses such as fixing a roof to your rental property.
Calculate The Rental Cash Flow using 50% and 1% Rule
Calculating the cash flow using 50% and 1% rules can also be an alternative way to analyze the rental cash flow. These methods are mostly used when you need to estimate the rental property’s cash flow in urgency.
Calculation of Cash Flow using 50% Rule
The 50% rule is similar to the cash-on-cash return, which can quickly analyze the cash flow’s potential. The law states that you should estimate all your operating expenses to be 50% of your rental income.
For instance, if your rental property gross rental income is Rs 1,00,000 per year, then you should assume half, i.e., Rs 50,000, will be your operating expenses. Provided, you need to include only operational costs and not mortgage payments.
This model is beneficial to quickly estimate your cash flow and profit from the rental property.
Calculation of Cash Flow using 1% Rule
The 1% rule is usually called the general rule of thumb. Sometimes, it does happen. You aren’t able to track the property expenses upfront. Thus, if you need to quickly analyze the property cash flow to determine whether the property is worthwhile, you need to use the 1% rule.
It usually calculates whether the rental property will generate positive cash flow with time or not. For instance, if your property costs Rs 1,00,000, then the rent per month should be compulsory Rs 1,000. As 1% formulae state-
= Monthly Rental Income >= 1% of Purchase Price
If the rent per month is Rs 500, then the 1% rule will not meet. Similarly, if you pay Rs 1,50,000 for a property being rented out at Rs 1,000, it would not meet the government.
The 1% rule can help narrow the extensive list of properties into a smaller list to find the best rental properties. It also helps determine whether the monthly rent returns will exceed the monthly mortgage payments.
What can be a Good Cash Flow for a Rental Property?
Determination of good cash flow on the rental property is simple and easy to find. You need to know there’s no magic number for a reasonable rate to determine a good cash flow.
A good cash flow is dependent on several factors ranging from financial goals to the minimum requirement on the investments. Also, it is dependent on whether you are looking for short-term or long-term rental income. Like the monthly rent, you receive short-term payment, whereas the property appreciation is the long-term returns.
However, the positive cash flow is when your property’s annual rents exceed both the operational expenses and mortgage payment. Together, the factors mentioned above are duly crucial for understanding the cash flow on the rental property.
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Rental Property Cash Flow Analysis FAQ’s:
What can be a good cash flow on the Rental Properties?
Positive cash flow is when your property’s annual rent exceeds both the operational expenses and mortgage payment.
What does the 1% rule state for the estimation of cash flow on the Rental Property?
It usually calculates whether the rental property will generate positive cash flow with time or not. For instance, if your property costs Rs 1,00,000, then the rent per month should be compulsory Rs 1,000. As 1% of formulae states-
= Monthly Rental Income.>= 1% of Purchase Price
If the rent per month is Rs 500, then the 1% rule will not meet. Similarly, if you pay Rs 1,50,000 for a property being rented out at Rs 1,000, it would not complete either.
How to calculate the capitalization rate on the Rental Properties?
Cap rate is the expected rate of return on your rental property, calculated as,
= Net Operating Income / Asset Value
For instance, if your rental property NPI is somewhere around Rs 70,000 and your asset value is Rs 10 lakhs, then your cap rate will be-
= 70,000 / 10,00,000
= 7%
Provided conditions, if it’s under 3%, you’d need to think again before investing in the property. If the rate is over 10 %, you are receiving an excellent return compared to the property’s value.
How to estimate the Cash Flow after Financing?
On the estimation of your financing cost, you will need to find your cash flow after financing. For example, if your cash flow from operations is Rs 850 and your financing costs is Rs 640 in that case,
= Cash Flow From Operations – Financing Costs
= Rs ( 850 – 640)
= Rs 210
This means you will put Rs 210 per month or Rs 2,520 per year in your bank account.
