“Cash flow” is an important term that is frequently used in commercial real estate. With a thorough understanding of cash flow, investors can make more informed decisions about potential acquisitions, property improvements, leasing strategies, financing, disposition strategies, and more.
In this article, we will define what cash flow is, how it is calculated, and ways to improve cash flow. Importantly, we will also look at how cash flows can influence a property’s value.
What is Cash Flow in Real Estate?
Cash flow is the generic term used to describe the total income a property generates after all operating expenses have been paid. “Cash flow” is often used interchangeably with “Net Operating Income,” or NOI, though there are distinct differences between the two.
Total cash flow is the profit after all expenses are paid – including debt service. NOI, on the other hand, is calculated as the gross income less operating expenses. It does not factor in debt service.
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Learning how to analyze cash flow and calculate net cash flow from rental properties is essential for understanding the financial performance of your real estate investments. To do this, you’ll need to understand the different sources of income – like rent and deposits – as well as expenses such as taxes, insurance, and repairs. Once you have these numbers in hand, you can subtract your total expenses from your total intake to determine your net cash flow.
When real estate operators refer to cash flow, they are generally referring to the amount of money available to reinvest into the property and/or to pay out to their investors. Debt service payments reduce the available cash flow, and therefore, total cash flow is generally less than NOI unless a property is owned outright (i.e., there’s no mortgage on the property).
Calculate Net Cash Flow from Real Estate.
Cash Flow = Net Operating Income – Debt Service
This cash flow calculation will tell you whether a property is profitable or losing money over time.
Sample Cash Flow Analysis
Let’s use a simple example to highlight how to calculate cash flow. For simplicity’s sake, let’s assume a 50,000 sq. ft. industrial property that is leased to a single tenant for $10 per sq. ft. In this case, the cash flow statement might look as follows:
|Gross Rental Income
|Effective Rental Income:
|Legal, Accounting, Etc.
|Total Operating Expenses:
|Net Operating Income:
|Debt Service Payments:
|TOTAL CASH FLOW:
In this case, we can see that the property generates $230,000 in net operating income, or NOI. This is an indication of how well the property is being managed. An owner’s ability to influence the NOI, either by increasing revenue or decreasing costs, can result in greater cash flow, assuming debt service payments remain constant. We’ll come back to this point later on.
Positive vs. Negative Cash Flow in Real Estate
Cash flow can be either positive or negative. Positive cash flow is when the property produces surplus income after all expenses, including taxes and debt service, have been paid. For example, if a property generates $500,000 in rental income and has $200,000 in operating expenses and another $150,000 in debt service, there would be $150,000 remaining in positive cash flow. This positive cash flow could be retained by the operator (a “rainy day fund”), reinvested in property improvements, and/or distributed to investors.
While most owners invest for positive cash flow, there are some situations in which a property is generating negative cash flow. This can be a one-time occurrence, or something that happens on a regular basis.
For example, if a property generates $300,000 in gross income, has $150,000 in operating expenses, and $175,000 in debt service, then the property would be generating $25,000 in negative cash flow.
There are some situations when negative cash flow might be palatable to investors. This typically occurs when either a) property renovations are being made; or b) during periods of tenant turnover. These periods of negative cash flow are generally expected to be short-lived.
However, in some instances, an investor may be willing to purchase a property with little to no (or even negative) cash flow if there are other financial considerations. For instance, an owner might realize a larger gain by using accelerated depreciation on an asset (which can be worth tens or hundreds of thousands of dollars) than they would in nominal cash flow. In situations like these, an owner might acquire an asset for the depreciation benefits, which can give them a year or two to increase the property’s cash flow so that it’s generating positive cash flow after the depreciation value has been fully realized. In other words, the value of depreciation might supersede the value of positive cash flow in some cases.
There are several factors that influence cash flows. The first category of items are sources of income. Rents are the single most important factor when determining the amount of cash flow a property will produce. There are other sources of income to consider, too. At an apartment building, for example, this could include parking revenue, pet fees, laundry fees, storage locker fees, and more.
Ways to Improve Cash Flow
The second category of items are the property’s expenses. Some of these are within an owner’s control. This might include costs associated with tenant turnover, repairs and maintenance, leasing commissions, legal fees, and more. There are other expenses that owners cannot as easily influence, like property taxes and insurance. These are generally fixed costs.
Those who want to increase their cash flow can do so by either a) increasing revenue or b) lowering their expenses. Generally, owners will seek to do both.
Here are 6 strategies for improving the cash flow at your investment property.
Bring all leases up to market rent.
Owners often become complacent, especially when they have good tenants who pay their rent on time each month. Owners may be hesitant to raise the rent upon lease renewal. However, over time, this can widen the gap between income and expenses. Inflation will generally cause operational costs to increase over time, and those costs will chip away at the cash flow unless rents are raised concurrently.
Implement a stronger collections program.
Missed rent can negatively impact cash flows, even if rents are only a few days or weeks late. Unless owners have significant reserves, this can create a “cash flow crunch” that becomes especially problematic when unexpected repairs or maintenance arise that must be funded immediately. Unpaid rent can also create follow-on expenses, such as legal fees, when third parties need to play a greater role in rent collection efforts. Creating a strong collections program, where notices and late fees are clearly spelled out, can result in more positive cash flow.
Audit all vendor contracts and re-negotiate terms.
Many owners “inherit” the vendors of the prior owner. Others, especially longtime owners, become comfortable with their existing vendors and fail to do a regular gut check as to whether they’re paying market rates. It is best practice to audit all vendor contracts at least once every two years. Review the terms and see if there are opportunities to renegotiate better rates that will result in cost savings. This should include property management fees, contractor fees, marketing/leasing fees, legal fees, and insurance policies.
Consider refinancing your commercial loan.
Most people purchase real estate with some form of debt. The most common source of debt is a traditional bank loan. Depending on the terms of your existing loan, and depending on the current capital market environment, it may be worth refinancing your loan. There are two strategies to consider: first is to lock in a lower interest rate. Those who secured fixed-rate debt on their properties within the past 10 years may find it hard to get a lower interest rate today than what they already have. A second strategy is to refinance into a longer-term loan. By spreading mortgage payments over a longer duration (perhaps to a 30-year loan instead of a 10-year loan), this lowers the monthly payments which, in turn, boosts cash flows.
Invest in property improvements.
It may sound counterintuitive–spend money to make money? But sometimes, a property is long overdue for a facelift. Cosmetic and functional improvements have the potential to translate into substantially more revenue after rents are increased accordingly. The one-time hit could lead to years of increased cash flow. Of course, a thoughtful analysis should be done beforehand to ensure that the cost of the proposed improvements will in fact generate the future rents needed to justify those improvements. Adding an Olympic sized swimming pool, for example, is typically not going to pencil out as a worthwhile investment.
Consider more sustainable building features.
Now is a great time to increase your property’s energy efficiency. The Biden Administration’s Inflation Reduction Act introduced a range of tax benefits for “going green”. There are attractive financing programs, tax credits, and rebates associated with certain property improvements. Moreover, these building upgrades often help to reduce an owner’s operational costs by lowering their utility bills. Collectively, these savings can result in substantially more cash flow.
How Cash Flow Impacts Property Value
We alluded to this earlier but it’s worth elaborating: cash flows can directly impact a property’s value. This is because NOI, an important component of any cash flow analysis, is used to calculate cap rates. And cap rates are one of the key metrics used to value properties.
One way to establish a property’s value is to divide NOI by cap rate. Using the example outlined above, if a property has $230,000 in NOI and is trading in a 6-cap environment, that property would be worth approximately $3.83 million ($230k / 0.06).
Now, most strategies aimed at increasing cash flow will simultaneously boost NOI. The exception is when you refinance to lower the cost of debt service. So, owners who are able to increase revenue and/or otherwise lower their operational costs will also increase their NOI. Let’s say these efforts increase NOI to $290,000. That same property, with its more substantial cash flow, will be worth an estimated $4.83 million ($290k / 0.06) – a one million dollar increase in value! This is because investors place such a high emphasis on a property’s in-place cash flows (i.e., the NOI) when assessing its worth.
Using Cash Flow to Calculate Investment Returns
Cash flows can also be used to assess “cash on cash” returns – another important metric that investors use when analyzing a deal’s potential (and actual) profitability. The cash-on-cash return is calculated as the amount of cash received in a given period divided by the amount of the initial investment. It is measured on an annual basis.
By way of example, let’s say someone invests $100,000 in a deal and receives distributions worth $7,000 that year. They will have earned a 7% cash-on-cash return.
The more cash flow a property generates, the more money will be available to redistribute back to investors, thereby increasing the CoC returns.
Investing in real estate can be rewarding and lucrative, but it’s important to know how to maximize your profits. With a thorough understanding of cash flow, you can take advantage of potential opportunities and minimize any risks associated with investing in real estate.