What is Cash Flow in Real Estate?

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Contributor, Benzinga
August 26, 2021

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All real estate investments have the same end goal: to build wealth for the investor. However, the methods investors choose to go about building this wealth may differ. Some real estate investors are home flippers who buy properties for cheap, renovate them and sell them at a profit. Another type of real estate investor buys rental properties and holds on to them while they generate income, which is known as cash flow. Long-term real estate investors prefer properties that offer cash flow because they can earn residual income while the property appreciates in value. With that said, cash flow only works if it’s a positive cash flow.

What Is Cash Flow?

Cash flow is not a river of cash that flows to an investor. It is the amount of money generated by an investment after all the expenses are taken out. The key to any investment is positive cash flow. For example, if an investor buys a $1,000,000 building that takes in $100,000 per year in rental income, but they have annual expenses of $120,000, it has a negative cash flow of $20,000 and loses money for the investor. This direction is the opposite of what investors are looking for.

What Is Cash Flow in Real Estate? 

Cash flow, specifically positive cash flow, is the ultimate goal of any long-term real estate investment. Positive cash flow in real estate happens when the investor gets more out of the investment on an annual basis than they spend to maintain it. Imagine purchasing the building in the example above and increasing the annual revenue from $100,000 to $150,000. Subtract the $120,000 annual expenses, and you have a positive cash flow of $30,000 per year or $2,500 per month. Needless to say, real estate investors want the highest positive cash flow possible. 

What Subtracts from Real Estate Cash Flow?

Any expenses associated with owning and operating investment property subtract from positive cash flow. This fact underscores the need for effective, professional management. The failure by an investor (or their chosen management company) to stay on top of expenses and more importantly, minimize them, has a negative effect on the investment’s cash flow. Examples of these expenses include:

  • Management
  • Maintenance
  • Debt service
  • Capital expenditures (capex) reserves
  • Property taxes
  • Utility costs
  • Insurance
  • Tenant delinquency
  • Vacancy loss
  • Legal expenses

A component that almost all these expenses have in common is late fees. Late fees are wasted money, and, in the case of property taxes, the penalties for late payment can be quite punitive. While interest fees and late charges for services are not as high as late property taxes, they can add up if bills aren’t paid on time. It’s a rare investment that can generate a positive cash flow if it’s just wasting money on late fees and penalties.

The potential for inadvertent losses is why management is so critical and is listed as the 1st expense. On one side, management eats into cash flow. But it’s also the investor’s 1st line of defense against loss of revenue and cash flow. Management handles the accounting and bill paying associated with the property. The simple act of getting all the invoices paid on time without late fees goes a long way towards protecting investor cash flow.

Vacancy and Delinquency

Aside from expenses, vacancy loss and tenant delinquency are positive cash flow killers. Cash flow is, after all, a measure of how much money a property is making. When it comes to most expenses, investors can write them off. Write-offs aren’t allowed for vacancy loss. That means every day units sit empty in an investor’s property, the investor is losing money they will never recoup. 

Tenant delinquencies can be just as crippling. If the current tenants are not paying their rent on time, the property may not generate cash flow. What’s worse, investors may have to dig into their own reserves to make up the revenue shortfall caused by excess delinquencies. That’s literally the opposite of positive cash flow.  

Solid management can mitigate these expenses by being proactive about renting out vacancies, collecting rents on time and paying bills on time. Whether the investor chooses to manage the property themselves or hires outside management, the quality of the management goes a long way towards determining how much cash ends up flowing into the investor’s pocket. 

How to Add to Cash Flow

The good thing about cash flow is that an investor (or their management company) can take a number of positive steps to increase cash flow. At the end of the day, cash flow is revenue. Property upgrades, such as adding a swimming pool or remodeling units with more luxurious fixtures, can increase rental revenue, which will increase cash flow. Of course, those kinds of upgrades cost money too. 

Investors can take other simple, cost-effective measures to increase revenue. Raising laundry fees, monetizing parking and making fair market rent increases on an annual basis are all proven, inexpensive ways for property owners to boost their cash flow. 

What Are the 1% and 2% Rules?

The 1% and 2% rules are basic measures of how effectively an investment is performing. They dictate that an investor should earn a minimum of 1% or 2% of the total cost of an investment on a monthly basis. For example, a $1,000,000 building should generate between $10,000 and $20,000 per month at a minimum. Properties that don’t reach this threshold are unlikely to generate enough income for the investor to have a positive cash flow. 

How to Invest in Real Estate Without Worrying About Cash Flow

If the idea of identifying solid long-term investments and then managing them sounds like too much trouble to you, you’re not alone. It really is a lot of work. Fortunately, you can invest in real estate without having to worry about this. You can buy into a real estate investment trust (also known as a REIT) or invest in a real estate crowdfunding platform

Real Estate Funds

REITs are managed funds that own and operate large portfolios of investment real estate. The advantage of investing in a REIT is that the properties in its portfolio have been carefully selected specifically for their ability to, and history of, generating positive cash flow for their investors. Real estate crowdfunding works in a similar fashion, where a majority (if not all) of the properties in the portfolio are pre-selected by an established real estate professional. Both offer investors the opportunity for a “set it and forget it” type of real estate investment that should generate positive cash flow. 

Choose Simple Investments

Another way to invest in real estate without worry about cash flow is to keep it simple. Investing in apartment buildings is expensive, and managing them yourself can be even harder. As an individual investor, it’s much easier for you to start small and buy 1 unit, such as a condominium or a duplex where you can live in 1 and rent out the other. It will be much easier for you to stay on top of and manage 1 unit than it will be to deal with a multi-unit apartment building. 

You can also think outside the box. Apartment buildings are not the only types of investment properties that generate positive cash flow. While they may not be as glamorous as luxury apartment buildings, warehouses and parking lots are low-risk, low overhead investments that can generate a ton of cash.

Benzinga’s Best Real Estate Investment Platforms

If you are interested in putting money into a REIT or a crowdfunding enterprise, your 1st and most obvious question might be which to invest in. While it’s always important to do your own research and consult with financial professionals before investing, Benzinga has an extensive array of resources for would-be investors. Here is a list of Benzinga’s preferred REIT and crowdfunding platforms.

Getting the Best Outcome in Real Estate Investment

When it comes to long-term real estate investing, a positive cash flow is the most desirable outcome possible. Properties with positive cash flow give investors the opportunity to service debt, pay off expenses and make money all while the property appreciates in value. It’s the ideal situation, but it can only exist if the investment is carefully chosen and extremely well managed. 

Frequently Asked Questions

Q

What does cash flow mean in real estate?

A

Cash flow measures how much of the income generated by a property is flowing to the investor after expenses (management, property taxes, debt service, utilities, insurance) are taken out. Long-term real estate investors are looking for properties with a positive cash flow. However, positive cash flow is not something that happens by accident. Investors must choose properties carefully and see to it that they are effectively managed. Another, less labor-intensive method of investing in properties with a positive cash flow is to buy into a REIT or real estate crowdfunding platform.

Q

What is the 2% rule in real estate?

A

The 2% rule in real estate is a simple rule of thumb that says a property should generate a minimum of 2% of the original investment cost on a monthly basis. That means a $1,000,000 property should be earning at least $20,000 per month before expenses. This rule of thumb is important because historically, investments that don’t conform to the 2% rule will not generate positive cash flow for investors.

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