Introduction
Are you considering investing in rental properties? One crucial concept you need to understand is "cash flow." In simple terms, cash flow refers to the net amount of money that enters or leaves your bank account each month as a real estate investor. This article will provide you with a comprehensive understanding of cash flow in real estate investing and its importance in your financial journey.
Cash Flow Investing: Prioritizing Present Gains
For certain investors, near-term cash flow holds greater appeal than uncertain long-term appreciation. Cash flow allows you to immediately utilize your profits in other projects or personal endeavors. On the other hand, some investors focus on the potential appreciation of their properties and the accompanying equity growth. These investors are willing to wait for the bulk of their financial returns until they sell the property.
While real estate markets historically experience upward trends, they also go through downturns that are difficult to predict. Relying solely on future appreciation can be risky, unless you are committed to a long-term buy and hold strategy. This is where cash flow investing shines, as it prioritizes the money in your bank account, ready to be reinvested or spent on your valued life experiences.
Understanding Cash Flow Real Estate Investing
To grasp cash flow investing, consider it similar to investing in dividend-paying stocks. With cash flow properties, you receive regular cash distributions without the need for constant involvement in managing the asset.
Let's take a quick example:
- Bob owns three rental properties, each generating $1,000 per month in rent.
- After deducting normal operating expenses like maintenance, property taxes, and property management fees (40% expense ratio) and setting aside funds for reserves (5% capital reserve ratio), Bob's monthly cash flow amounts to $1,650.
Strategies for Positive Cash Flow: Three Winning Examples
If positive cash flow sounds appealing, there are ways to further increase your monthly income as a real estate investor:
1. Raise Current Rents to Market Rates
Bob, as a proactive investor, regularly assesses market rent comparables for his properties. When he discovers that similar properties are renting for $1,050 per month, he seizes the opportunity. By renewing the leases and raising the rent for all three properties, Bob's monthly cash flow increases to $1,800.
Typically, expenses remain more static compared to rents. Consequently, when you raise rents, expenses like mortgage payments, taxes, and insurance costs often decline as a percentage of gross rental income.
2. Reduce Operating Expenses
In addition to raising rents, Bob optimizes his rental property portfolio by utilizing Stessa's free rental property software. By leveraging world-class management tools and reporting at no cost, Bob reduces his monthly operating expenses by $70, resulting in a new cash flow of $1,870 per month.
3. Add Value to Your Rental Property
Bob's journey towards maximizing his cash flow doesn't end there. He decides to convert the spare room above one of his rental homes' garages into a studio apartment, quickly renting it out for an additional $300 per month. This enhancement adds another $300 to Bob's cash flow, bringing it to an impressive $2,170 per month.
Through proactive measures like adjusting rents, utilizing property management software, and adding value to his properties, Bob increases his monthly cash flow by 32% ($2,170 / $1,650). Truly a remarkable achievement!
The Risk of Negative Cash Flow: Three Cautionary Examples
Negative cash flow occurs when more money flows out than in during a specific month. Here are three costly cash flow mistakes that real estate investors should avoid:
1. Paying (or Borrowing) Too Much for the Purchase
Investors focused on property appreciation may be tempted to overpay for an income property. This leads to larger mortgage payments that can become burdensome over time. For instance:
- Monthly rental income: $1,000
- Expenses (40% expense ratio, 5% reserve ratio, and 50% mortgage payment): $950
- Monthly cash flow: $50
If a tenant leaves and it takes one month to find a new one, the negative cash flow amounts to $950. It would take 19 months to recover from only one month of downtime!
2. Choosing the Wrong Tenants
Having a flawed rental strategy can result in negative cash flow, even with a property bought at a below-market price. Rushing to fill a vacancy without thoroughly screening tenants can lead to disastrous consequences. For example:
- Monthly rental income: $1,000
- Expenses (40% expense ratio, 5% reserve ratio, 30% mortgage payment): $750
- Monthly cash flow: $250
If the tenancy goes wrong, with the tenant disappearing without paying rent and causing significant damage, the negative cash flow could reach $3,750. Minimizing downtime resulting from non-paying tenants should be a priority if cash flow is essential to your investment goals.
3. Overspending on Expenses
Some investors splurge on unnecessary expenses, such as extravagant renovations and excessive landscaping. However, most tenants seek a comfortable place to call home, and they won't pay above-market rent for extravagant features. Overspending on expenses can quickly result in negative cash flow.
To avoid overpaying for expenses, consider shopping around for insurance, minimizing advertising costs, leveraging free property management software like Stessa, and finding cost-effective ways to maintain the property's appearance.
Frequently Asked Questions about Cash Flow Investment in Real Estate
Q: Why should I invest in cash flow real estate?
A: Cash flow real estate offers steady monthly income, and over time, your property may appreciate in value, providing an additional bonus.
Q: How is cash flow calculated?
A: Cash flow is calculated by subtracting outgoing expenses, including debt service, from gross rental income.
Q: Which areas are best for cash flowing properties?
A: Every market is unique, but generally, working-class neighborhoods with strong job growth tend to have reliable rental demand.
Q: Can I have a loan on cash flow property?
A: Absolutely! In fact, leveraging other people's money, such as bank loans, can be an effective strategy for investing in rental real estate. However, always be mindful not to over-leverage yourself.
Important Things to Know About Cash Flow
Here are key takeaways to remember about cash flow as a real estate investor:
- Cash flow represents the surplus or deficit at the end of each month.
- Appreciation is a future hope, while cash flow provides immediate benefits.
- Cash flow investing focuses on creating regular monthly income streams.
- Positive cash flow can be achieved by making wise purchase decisions, adjusting rents to market rates, and minimizing operating expenses.
- Negative cash flow occurs when expenses exceed rental income.
Before making any real estate investment, thorough due diligence is paramount. Research and make realistic projections for rental income and operating expenses. By considering these factors and doing the math, you can determine whether a rental property is a worthy addition to your investment portfolio.
Remember, cash flow is key to your success as a real estate investor. So, invest wisely, maximize your cash flow, and build a profitable and sustainable portfolio.