Understanding the 3 Parts of Cash Flow

Last week I talked about 5 ways to cash flow in low cash flow appreciation markets.  This week I'd like to dig deeper into the 3 categories of Cash Flow: Income, Expenses and Debt Service. Each category is quite extensive, so let’s dig deep!

Income

I look at income in 4 ways:

1. Rental Income
2. Other Income
3. Actual Income
4. Projected Income

Rental income is the profit from renting units on a month to month basis. Other income consists of the dollars received from sources other than monthly rents. For example, income can be generated through coin operated washer and dryers, utility bill backs, etc. Actual income is just that, the actual income a property is currently providing at time of analysis. Finally, projected income is an estimate of market rents and other income, assuming actual income is less than market rates.

It’s easy to see how different owners and investors can come up with large discrepancies when valuing income real estate. Income is just one piece of the puzzle and we already have quite a few ways to consider that side of the equation. I like to break the income down into these categories to get a good feel of what it is we are buying. What value are we placing on the asset for the owner’s current income? What value are we placing on the asset after we improve rents and are there other sources of income that are not yet being realized? It is quite often that our offer is a 3 or 4 cap based on actual income, but becomes a 5 to 7 (hopefully higher) cap once we reposition the asset. The actual “cash flow” comes after repositioning the asset and obtaining a cap rate above and beyond the cost of debt service (based on our actual acquisition price versus the new income stream).

Expenses

Actual Expenses

1. Property Taxes
2. Insurance
3. Utilities
4. Management

Allowances

1. Maintenance & Reserves
2. Vacancy

Expenses are really broken down into 2 categories: actual expenses and allowances. Actual expenses are real expenses you will experience on a month to month or annual basis. Allowances are used when factoring longer term ownership of a property.

Property taxes and insurance are the “PI” part of PITI. They are actual expenses seen on a month to month or yearly basis. Utilities and property management are also actual expenses realized on a month to month or annual basis. Pretty simple.

Maintenance/Reserves (also known as repairs and capital reserves) and vacancy are allowances used to project expenses out over a longer period of time. For example, you may have a fully occupied building for 2 years or more. During this time, you’ve realized 0% in vacancy, but projecting no vacancy over a long period of time will eventually result in an underestimated expense ratio. The majority of properties we buy have 0% vacancy in the owner’s eyes. They are never vacant. In fact, our last duplex seller had no vacancy for his 28 years of ownership. Both tenants were in place when he purchased the building in 1986 (we paid a 1.7 cap based on actual income, increasing the rents by 3 or 4 times the actual rent then results in a 5.1 to 6.8 cap).

The allowance part of expenses is where the biggest divide comes between buyer and seller in the market place. We are negotiating with a seller right now that self manages all of his properties and does all his maintenance. His actual expense ratio is in the low 20’s since he has no management fees, minimal vacancy, low maintenance, and no reserve accounts. We are hundreds of thousands of dollars apart in price. He believes he has a 2 million dollar asset. That makes sense given his actual income reported on his taxes and cap rates for similar properties in the neighborhood. However, when you factor in vacancy, management and maintenance/reserve allowances our expense ratio is much closer to 45% (we used 3% vacancy, 7% management and 10% reserve/maintenance allowances). That is a huge discrepancy in expenses and hence, a huge discrepancy in valuation. The sad part of that equation is that 20% is a low expense allowance for those categories. The property has older units. We will probably see much higher initial maintenance and capital reserve expenditures during the initial ownership and tenant turnover of the asset. Vacancy is pretty accurate for the high demand area and property management is market rate. Still, we are a long ways apart just due to the allowance part of our equation.

Debt Service

1. Principal Payments
2. Interest Payments

For clarification, debt service is not a factor of value. Debt service is a factor to the owner when looking at cash flow. A free and clear property gets 100% of the NOI (net operating income) as ultimate cash flow to the property owner. However, real estate is a commonly leveraged asset. So, cash flow is the difference between NOI (income less expenses) and debt service. Once a property is acquired, reducing debt service really only comes from refinancing or changing the interest and principal payment ratio. Changing the interest and principal payment ratio cannot happen on a fixed rate loan, especially with a conventional loan. However, this can be the case when you’re non conventional note allows for differing payment structure. One reason we use the term “interest only or more” payments on our private notes, is because it creates a variable that we can use to change our cash flow in the debt service part of the equation.

Cash flow ultimately comes from higher income, lower expenses, lower interest and lower principal payments. Now that we have an understanding of cash flow, next week we will get into the world of cap rates. Until then, happy investing!!!