So, how do you calculate positive cash flow on a real estate investment? Are you saying that cash flow is the difference between the monthly rent amount and your mortgage payment? If so, shame on you.
There are more expenses to running a rental property other than the mortgage payment. Most banks use 75{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} of the monthly rent amount as a guide for what they believe to be a better indication of what you’ll actually take to the bottom line. For example, if the monthly rent is $1,000 per month, they will say that you have $750 per month of income.
So, where does that other 25{bcb10712eadb32c7e50a15bcbfb14ed4d7108a9fa2a5dcafffbff4bd1d9a4f28} go? Well, it goes toward maintenance, vacancy, management, taxes, insurance, legal, accounting and the other expenses you would from running a business-and don’t be fooled; real estate investing IS a business.
There is a calculation that is used often in commercial real estate investing that a few of us have adapted to the residential real estate investing world: net operating income.
Net operating income calculations involved determine what the true income is from the property (not including the mortgage payment).
So, if you had a $1,000 per month rental income and subtracted the taxes, insurance, a reasonable estimate of the effect of vacancies, maintenance and management, the number you are left with is your net operating income for that property.
If we calculate this number first, we can use a financial calculator to determine what the most debt a property can support with that monthly payment and the interest rate we can borrow at.
If the amount we can borrow is greater than the purchase price (minus whatever we are prepared to use as a down payment), then we can honestly say the property looks like it has a positive cash flow. If it is lower than the purchase price, then we know that we need to put more money down or that we have a negative cash flow which is really, in my mind, like making a down payment over time.
So, 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 deal.
