July 17, 2024

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Why Cash Flow Projections Are Crucial to Real Estate Investors

Why Cash Flow Projections Are Crucial to Real Estate Investors

Real estate investors must understand how crucial it is to project cash flow when making an investment in real estate. After all, the success or failure of a real estate investment does ultimately depend on the property’s ability to produce revenue.

The concept is straightforward. Rental properties are subject to a flow of funds whereby money comes in and money goes out. When more money comes in from the property than goes out the result is a “positive cash flow” that benefits the investor. Likewise when more money goes out than comes in the result is a “negative cash flow” that regrettably means the investor must “feed the property” with personal cash to make up the deficiency.

That’s why prudent real estate investors make revenue projections when evaluating an income-property investment. They want to know whether the property will produce enough cash to pay its bills over time. Even if the investor decides that the investment is worthwhile enough despite its negative flows, because they are brought front and center during the evaluation, they can be anticipated and therefore are less likely to blindside the investor later after the purchase.

During their rental property analysis, investors commonly rely upon reports such as an APOD and Proforma Income Statement for these projections. Let’s consider the strengths and weaknesses of both.

An APOD (annual property operating data) is a mini income statement that is helpful to real estate investors because it gives a “first-glance-look” at the property’s financial condition. In a concise manner, it reveals the income, expenses, and cash flow. Its shortcoming lies in the fact that an APOD offers only a projection of cash flow after the first year of ownership, and it does not account for tax shelter. So look at an APOD to provide you with a “snapshot” of the property’s cash flow that might help you to make an initial decision whether or not to look further into an investment opportunity, but don’t rely upon an APOD too heavily.

A proforma income statement, on the other hand, is a more robust way to project cash flows because it anticipates a property’s financial condition beyond the first year of ownership (commonly extended out over a period of ten years). Moreover, a proforma income statement can account for tax shelter (at least those created by the better real estate investment software solutions), which enables the consideration of cash after taxes and is important to investors because they can anticipate what may or may not be left over after income taxes are paid on the property’s earnings. Its shortcoming, however, not unlike any projection, is that the numbers are projections subject to a lot of variables that can easily be skewed.

Here’s the bottom line.

You should not depend on either an APOD or a Proforma Income Statement to provide you with enough information to make a sound investment; there is much more for you to consider. Nonetheless, for real estate investing purposes, these reports can provide you with cash flow projections you must consider before you purchase any rental property so you don’t find yourself facing negative cash flows you didn’t anticipate–a prospect no real estate investor relishes.