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Analyzing Cash Flow of an Investment Property
Real estate cash flow is usually the single most important thing to analyze and understand when looking at real estate investments. Knowing in advance how much cash flow your investment will produce makes you a much more educated buyer, and gives you a much, much better chance of finding and buying a property that meets or exceeds your goals. Also known as financial modeling, here are the basics in how to estimate and analyze cash flow. To analyze your own properties, download our real estate model. o Revenues - First, estimate how much in monthly revenue your investment property will generate. Include payments for rent, storage, parking, laundry and any other cash that you collect as a result of owning the property. You should assume a 10-15% vacancy rate, so slash the monthly rate by that amount. o Costs - Second, estimate the total monthly costs of owning and managing the property. It is best to break these costs out on a spreadsheet, so that you can change each variable as well as compare each property you look at to others. To download a semi-detailed real estate model in Excel, please click here. The costs you'll need to estimate include mortgage, first mortgage, property taxes, water, sewer, garbage, maintenance, insurance, advertising, association fees and any other cost associated with owning or managing the property. To get good estimates of each line item, check with your real estate agent, friends in the area, or make phone calls to people that can answer your question (For example, call your insurance agent and get an estimate of insurance. Or call the water department and ask for their average rate per family.) o Cash Flow Estimate - Now subtract the cash costs above from the monthly revenues to derive the estimated monthly cash flow. This is how much money you will expect, on average, to net each month. To get a feel of how this number changes, play with various variables in the model to find their sensitivity. For example, the difference between being cash flow profitable and not may be that you need to get a loan rate of 0.5% lower, or maybe that you'd need to increase rents by $300 per month. Use realistic estimates because the more realistic the model, the more likely you will be to meet or exceed your financial goals. Another way to look at this measure is that if the cash flow estimate is positive (and your estimates are correct) then the property will finance itself. And if the real estate cash flow estimate is negative, then you will have to come up with approximately that much money each month to keep the property going. Of course, over time, your rents should increase faster than your expenses and this number should improve each year. o After-Tax Cash Flow - Take the cash flow estimate above and add back the tax impact of the deductible interest rate and of the depreciation of the building you are buying. The estimates are done automatically on our real estate model (our free Excel version). The estimated tax credit for the first year equals 90% of the monthly mortgages times your tax rate. For the depreciation tax credit, assume the building is worth 60% of the total purchase price and that you depreciate it over 25 years. To calculate the monthly tax credit, take 60% of the purchase price, divide by 25 years, multiply by your tax rate, then divide by 12 months. Add these two credits back to your model and the resulting figure is your after tax cash flow. This is the number you look at to see if the property you are looking at to buy will pay for itself over time. If this number is negative, you should think about either putting down a bigger down payment, buying a different investment property, or just make sure that you feel comfortable that you'll be able to make up any cash shortfalls each month for at least the next few years. o Total Monthly Return - Once you've calculated the after-tax cash flow, it is time to add in the expected returns that you'll get from both capital appreciation and from debt pay down. To calculate the capital appreciation, multiply the purchase price by the expected annual increase in real estate in that region, divided by 12 months. Next, to calculate the amount of debt pay down that is essentially added to your net asset value, assume for the first few years that 10% of your total debt payments (mortgages) gets applied to your principal balance. So to calculate your monthly debt pay down, multiply your total mortgages (not including PMI or escrow) by 10%, then divide by 12 months. Now add these figures to the after tax cash flow and you have the total monthly return that you can expect to get from your investment. Even though cash flows are often negative in new real estate purchases, this number should be positive. If it's not, you should probably keep shopping around for another investment property. o Return on Investment (ROI) - Return on Investment is a measure of what percent of your initial investment you will get back each year. This return is similar to computing an implied interest rate that you will receive for your investment. You should compare this ROI to expected ROI's from other investment properties that you look at, as well as to the interest rates you could earn investing in other asset classes such as stocks or bonds. If the ROI on your real estate investment is not higher then what you could get on other investments, then you should either look for a better ROI or invest in something else. To calculate ROI, take total annual return (total monthly return from above times 12 months) divided by your initial investment (or down payment). o Return on Assets (ROA) - Similar to ROI but based on total asset value, this real estate metric is a measure of the percent return on the total asset value that you hold. It is a measure that shows approximately how profitable the entire investment is and is sometimes used to measure performance when little or no money is put down on an investment. To measure ROA, divide annual total return (total monthly return times 12) by the total purchase price. o Payback Time / Years to Breakeven - This is a measure that computes the number of years before your investment has paid for itself. It is computed by dividing the initial investment (or down payment) by the total annual return (total monthly return times 12 months). Although not a true measure of payback time, it is a good gauge as to how long it will take to make back your money. This measurement doesn't account for things such as commissions on any sale (which would increase this metric), changes in interest rates, or any other changes to the model.
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