What Is Cash Flow Anyway?

by | BiggerPockets.com

If you’ve been learning about or involved in real estate investing for any amount of time, you’ve no doubt heard the term “cash flow.”

Cash flow is important. We can all agree on that. The problem is not everyone can agree on what it really means.

What Is the Definition of Cash Flow?

Cash flow is defined as how much money is leftover after all expenses are paid on a rental property.

However, the issue become slightly complicated when you take into consideration that not every investor uses the same formula for calculating it.

Some people take the rent, subtract the monthly expenses, and call that cash flow. But this formula does not include random expenses you cannot see coming—things like repairs, vacancies, and big-ticket items that need to be replaced like roofs and air conditioners.

The danger with not including these items is you may start spending the cash flow you’ve been generating. Then you’ll find yourself without anything left to pay for repairs or vacancies.

When others describe cash flow, they include every expense they can think of—vacancy at 10 percent of the gross rent (even if vacancy doesn’t occur very often), repairs at 10 percent of the gross rent (even if the lease says the tenant has to pay for repairs), and so on.

The problem with this formula is that it can make real estate investing seem unprofitable. If something doesn’t seem profitable, people won’t spend time pursuing it.

So which is the best way to calculate it?

closeup of hand holding fanned cash

Related: Visualizing Cash Flow: How to Accurately Budget Expenses

How Does Cash Flow Work?

First, you need to identify why you’re asking this question. In general, there are two uses for cash flow.

  1. The first is to have extra money to spend. People who see cash flow this way are often looking to retire early through real estate and need cash flow to supplement their W-2 income.
  2. The second is to protect your investment. People who see cash flow this way want to make sure they are making enough money to pay for the property’s expenses—but that’s all. They keep anything extra in a reserve account. This line of thinking looks for wealth to come in property appreciation and loan pay down, not through income the property generates.

So who’s right? A lot of it depends on the individual person’s financial situation, investing strategy, or the property itself.

Why Is Cash Flow Important?

What’s important is getting very clear with yourself. What’s your purpose in investing?

Do you want to retire early? Do you want a higher return on your savings? Do you want to hold property long-term for huge appreciation gains? Do you just need a tax shelter?

Real estate has so much to offer—unfortunately, none of it is one-size-fits-all.

Once you understand your purpose, it’s much easier to determine what kinds of property you should be buying, how much you should be spending, and which strategies you should be utilizing.

Summary

Cash flow can mean different things to different people. But we can all agree it’s the money you make from a property’s rent after the expenses are paid.

As you continue to learn more about real estate, pay careful attention to the formulas we use to determine how much a property will cash flow—or if it will cash flow at all. As a general rule, never buy a property that doesn’t cash flow unless you have enough income coming in that you can afford to run at a deficit for a long period of time.

To sum it up: 

  1. Only buy properties that cash flow positively.
  2. Know the reason why you’re investing and what your goals are.
  3. Understand that cash flow is not a standard term that means the same thing to everyone.

Hopefully this provided some clarity about what cash flow is, how it works, and why it’s important. Watch the video above for even more information!

What else should investors consider when thinking about and calculating cash flow? 

Comment below!

 

 

About Author

David Greene

David Greene is a former police officer with over nine years of experience investing in real estate that includes single family, multifamily, and house flipping. David has bought, rehabbed, and managed over 35 single family rental properties, owns shares in three large apartment complexes, and flips houses. He also owns notes and shares in note funds. A nationally recognized authority on real estate, David has been featured on CNN, Forbes, and HGTV. Now the co-host of the BiggerPockets Real Estate Podcast, David has a passion for teaching and helping others grow wealth through real estate. In 2016, David started the "David Greene Team" and became the CEO of the top producing Keller Williams East County team as well as the top producing real estate agent. The author of Long Distance Real Estate Investing and Buy, Rehab, Rent, Refinance, Repeat, David has won several awards including second place for real estate book of the year awarded by the National Association of Real Estate Editors (Long Distance Real Estate Investing).

8 Comments

  1. Costin I.

    There is wide confusion between Net Operating Income (which is Gross Rent minus Operating Expenses) and Net Annual Income (which is the NOI minus mortgage expenses and vacancy and is the annual cash flow)
    People that take the rent, subtract the monthly expenses (as in only mortgage, taxes and insurance, prop management) and call that cash flow are fooling themselves as the property will have vacancy, will have repairs, will require capital improvements (replacement of roof, failure of big mechanical items requiring expensive repairs or replacements) and will have additional expenses that sooner or later will eat the cash flow for long periods of time.
    This is what should be included in one’s valuation of expenses and cash flow:
    1) Mortgage
    2) Mortgage insurance (PMI or MIP) or FHA Risk base
    3) Property Taxes
    4) City Taxes
    5) HOA (Home Owner’s Association) Dues and Fees and Assessments
    6) Insurance
    a) Property Hazard Insurance (0.3-0.45%)
    b) Flood Insurance
    c) Earthquake Insurance
    d) Umbrella Insurance
    7) Vacancy Rate (usually 8% – the equivalent to one month a year, or 5-6% if multifamily and/or if experienced, if not use 8%)
    8) Utilities (you’ll have these if your tenant is not covering them and/or during vacancy)
    a) Water § Sewer § Garbage
    b) Electricity
    c) Natural Gas
    d) Propane
    9) General Maintenance (usually 5%)
    a) Upkeep § Landscaping
    b) Snow removal
    c) Repairs
    d) New Appliances
    e) Make ready
    10) Capital Expenditures (usually 5%, higher is the property is old and obsolete, less if fully rehabbed and all mechanicals and roof are new)
    11) Property Management (8%, even if you self manage, your time still has value and there might be a time when you’ll want to be completely hands off or you’ll not be able to do it, vacation, retirement, etc.), including…
    a) Office Supplies (e.g. stamps, envelopes)
    b) Software
    c) Gas/Mileage
    d) Advertising + Payroll
    e) Concessions
    f) Lease loss
    g) Lease renewal fees
    12) Lawyer/Law office/Legal fees
    13) Accounting/Bookkeeping/CPA/Tax preparer/Tax advisor

  2. John Teachout

    People may choose to not include things like cap ex and vacancy in their calculations but that is just “pretending” the property is more profitable than it is. We actually take cap ex off the top and put it into its own bank account. Sooner or later (sooner) there’s going to be large expenses. My HVAC guy and I are on a first name basis. No matter how someone “chooses” to calculate it, there is the “real life” version as opposed to the “pretend” cash flow. The comprehensive list in a preceding post is a good place to start. Sometimes it’s easier to work the numbers than to find a deal that actually works.

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