Cash Flow: In the Right Direction
By Wade
Ogletree
Cash flow can be two of the most beautiful words in real estate, but,
like the tide, cash can flow in two directions. It is overly simplistic
to state that a positive cash flow is always the goal. In some cases the
only profit in a property is the after tax return on investment, but we
will set that consideration aside for the moment and concentrate on a
positive cash flow, as if that alone were the ultimate goal of
investing. To achieve that goal, we must first understand what cash flow
really is.
Cash flow sounds like it should be intuitive, and in a sense, it is.
When all is said and done did you make or lose money on a particular
investment? Intuitively, that is cash flow, be it positive or negative.
Of course, cash flow is also the end result of a list of terms: gross
scheduled income, gross operating income, and net operating income. Each
of which plays an important role in understanding a potential
investment's profitability. By understand each term, we can see the
chain of income and expense that ultimately leads us to cash flow.
We begin with gross scheduled income which is the theoretically
highest possible income at a given rental rate. It assumes no vacancies.
When you account for those vacancies, then you have the gross operating
income.
Net operating income is what you have left after your standard
operating expenses. Operating expenses for residential rental properties
may include: real estate taxes, property insurance, repairs and
maintenance, utilities, management, janitorial, and interior/exterior
decorating. All that gets subtracted from the gross operating income to
determine the net operating income.
To finally determine your cash flow, you must now take your debt
service into account. Subtract that from your net operating income, and
your result is the cash flow. A positive cash flow means you made a
before tax, cash profit. A negative cash flow means you had to go into
your other income to support the property. There are many factors that
can make a property with a negative cash flow profitable, but,
especially for the small investor, a property with a positive cash
flow—even a small one—has the ultimate advantage of not impacting
the investor's other finances. The fact that the property pays for
itself allows the small investor to hold on to it comfortably while
looking forward to further profitability in equity and tax deductions.
The key to creating a positive cash flow is simple and yet sometimes
temporarily elusive. We understand intuitively that higher income and
lower expenses will give us that positive income. Sometimes the location
of the property is key. Property taxes in California and Florida are
high, while they are low in Alabama. Of course, rental rates are much
lower in Alabama, too, unless you can take advantage of prime locations
like Alabama's Baldwin County. There a landlord can enjoy higher rates
and lower property taxes.
Even in a prime location like Baldwin County, however, rental rates
will not be consistent with purchase prices. There are windows of
opportunity where you can buy a property and charge enough rent to
generate a positive cash flow. At other times, prices skyrocket while
rents lag behind. That means the increased debt service will not be
offset by increased rents, at least, not at first. The industry follows
this cycle repeatedly, and when it does, we are reminded of an old axiom
temporarily forgotten: most rental properties do not make a profit for
the first two years.
Sometimes, ironically, the key to creating a property with a positive
cash flow is to hold one with a negative cash flow in a market where
rents will rise. As an alternative to supporting a negative cash flow,
an investor may choose to forgo building equity instead. An
interest-only loan will reduce debt service and may create a positive
cash flow. The investor will not be building equity but will be enjoying
the benefits of the tax deductions. The lender can fashion the loan to
shift to normal amortization after a set interval, by which date rents
should have had time to rise.
Note: Author Wade Ogletree is also the creator of this site, Southern
Investor.
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