So how do you calculate positive cash flow on a real estate investment? Are you saying cash flow is the difference between the monthly rent amount and your mortgage payment? If so, shame on you.
Operating a rental property entails more expenses than the mortgage payment. Most banks use 75% of the monthly rent amount as a guide for what they think is a better indication of what you’ll actually get in the bottom line. For example, if the monthly rent is $1,000 per month, they will say you have $750 per month in income.
So where does that other 25% go? Well, that goes to maintenance, vacancy, management, taxes, insurance, legal fees, bookkeeping and other expenses you would incur running a business – and don’t you do not deceive; real estate investing IS a business.
There’s a calculation often used in commercial real estate investing that a few of us have adapted to the world of residential real estate investing: net operating income.
The net operating income calculations involved determine the actual income from the property (not including the mortgage payment).
So if you had a rental income of $1,000 a month and subtract taxes, insurance, a reasonable estimate of the effect of vacations, maintenance and management, the number you have left is your net operating income for this property.
If we calculate this number first, we can use a financial calculator to determine the maximum debt a property can bear with this monthly payment and the interest rate at which we can borrow.
If the amount we can borrow is more than the purchase price (minus whatever we are willing to use as a down payment), we can honestly say the property appears to be cash flow positive. If it’s less than the purchase price, we know we need to put more money aside or we have negative cash flow, which I think is like making a down payment over time.
So the next time you do your analysis of an investment property, I encourage you to do your own net operating income calculation to determine the cash flow on the potential real estate transaction.