Cash Flow: In the Right Direction
Cash flow sounds like it should be intuitive, and in a sense, it is. When all is said and done did you make or lose money on a particular investment? Intuitively, that is cash flow, be it positive or negative. Of course, cash flow is also the end result of a list of terms: gross scheduled income, gross operating income, and net operating income. Each of which plays an important role in understanding a potential investment’s profitability. By understand each term, we can see the chain of income and expense that ultimately leads us to cash flow.
We being with gross scheduled income which is the theoretically highest possible income at a given rental rate. It assumes no vacancies. When you account for those vacancies, then you have the gross operating income.
Net operating income is what you have left after your standard operating expenses. Operating expenses for residential rental properties may include: real estate taxes, property insurance, repairs and maintenance, utilities, management, janitorial, and interior/exterior decorating. All that gets subtracted from the gross operating income to determine the net operating income.
To finally determine your cash flow, you must now take your debt service into account. Subtract that from your net operating income, and your result is the cash flow. A positive cash flow means you made a before tax, cash profit. A negative cash flow means you had to go into your other income to support the property. There are many factors that can make a property with a negative cash flow profitable, but, especially for the small investor, a property with a positive cash flow-even a small one-has the ultimate advantage of not impacting the investor’s other finances. The fact that the property pays for itself allows the small investor to hold on to it comfortably while looking forward to further profitability in equity and tax deductions.
The key to creating a positive cash flow is simple and yet sometimes temporarily elusive. We understand intuitively that higher income and lower expenses will give us that positive income. Sometimes the location of the property is key. Property taxes in California and Florida are high, while they are low in Alabama. Of course, rental rates are much lower in Alabama, too, unless you can take advantage of prime locations like Alabama’s Baldwin County. There a landlord can enjoy higher rates and lower property taxes.
Even in a prime location like Baldwin County, however, rental rates will not be consistent with purchase prices. There are windows of opportunity where you can buy a property and charge enough rent to generate a positive cash flow. At other times, prices skyrocket while rents lag behind. That means the increased debt service will not be offset by increased rents, at least, not at first. The industry follows this cycle repeatedly, and when it does, we are reminded of an old axiom temporarily forgotten: most rental properties do not make a profit for the first two years.
Sometimes, ironically, the key to creating a property with a positive cash flow is to hold one with a negative cash flow in a market where rents will rise. As an alternative to supporting a negative cash flow, an investor may choose to forgo building equity instead. An interest-only loan will reduce debt service and may create a positive cash flow. The investor will not be building equity but will be enjoying the benefits of the tax deductions. The lender can fashion the loan to shift to normal amortization after a set interval, by which date rents should have had time to rise.
