GUEST POST: Carter Froelich, CPA www.thepropertyledger.com
The basic premise behind preparing a cash flow analysis related to a real estate investment is that you want to purchase a property such that the cash flow generated from the real estate investment is positive from the first month. More specifically, you want the rents collected from the property to not only pay for the monthly operating expenses of the property, but also the debt service on funds which may have been borrowed to purchase the property. In my mind, if an individual is purchasing properties which do not generate a positive cash flow from the date of acquisition, that individual is not an investor in real estate but is rather a speculator in real estate. Our articles are going to focus on real estate investing and not real estate speculating.
The Property Ledger™ was developed to provide real estate investors with an accessible financial tool which would not only crunch the numbers related to the cash flow of a single real estate asset but also that of your entire real estate portfolio. However, when teaching course on how to utilize The Property Ledger™ it became apparent that many investors were not fully up to speed on the financial terms which are utilized in the preparation of a cash flow analysis. To address this issue I will be presenting a series of articles which deal with the terms, concepts and fundamentals of cash flow analysis. The first of these articles will deal with key financial terms utilized in cash flow analysis revolving around the determination of rental income.
Rental Income – This is also known as “Scheduled Rents” or “Gross Scheduled Rents” and represents the total rental revenue which the property would achieve upon the collection of the rents of the occupied units as well as the potential market rents from all of the vacant units for a 12 month period using the current market rental rates for your particular property. Market rents are derived from your investigation of the market in which your property is located. Additionally, if the property in question is currently not achieving market rents you would need to determine the costs necessary to bring the property up to current market rental rates and included this cost in your cash flow analysis. Using The Property Ledger™ this is done in the “Future Improvements” section of the cash flow analysis. As a general rule of thumb, a single family home should generate a monthly rental rate of between 1.00% and 1.33% of the purchase price to support a 100% financed transaction. For example, if you purchase a home for $100,000, you should ideally rent the home from between $1,000 to $1,300 to have a positive cash flow. Remember that all market rents are determined by the market so it is important to have working knowledge of the market in your area. In performing your market analysis you may want to utilize our Real Estate Navigation Forms™ .
Other Income – Other income comes from sources other than rental of the units. Such income may include coin-operated equipment such as washers and dryers, soft drink and candy machines, and electronic games. This category also includes rents from storage lockers, boat docks, and parking for which tenants pay as well as late fees.
Gross Rental Income – Represents the total of Rental Income plus Other Income.
Vacancy Allowance – As we all know it is unlikely that all of our units will be occupied 100% of the time. As such, it is important to factor into the cash flow analysis the downtime which an investment property is estimated to experience during the year to account for the fact that tenants move out of units and that it takes time to ready the unit for leasing and to lease the unit to a new tenant. This is especially important in that we have already assumed in our Rental Income estimate that 100% of our units are leased at the beginning of the year. Here again, it is important for you to have a good understanding of the submarket in which your property is located. In a well located enchanted area in which there is a huge demand for rental property, you may want to utilize a 4% to 6% vacancy allowance. This would allow for a 15 to 20 vacant days per year per unit. If you are in a less desirable area in which there are multiple competing properties for lease you may need to use a 15% to 20% vacancy rate which would equate to 55 to 73 days vacant. The time it takes to lease a property will have a significant impact on the cash flow of your investment property. This is why it is important to purchase investment grade property in enchanted areas. For more information on this topic you may want to review the Lynch Pins of Real Estate Investing.
The other factor to include in your Vacancy Allowance estimate is an allowance for uncollectable rents. This is why sometimes this category is also referred to as “Vacancy and Collection Allowance”. This may be not be a factor if you are purchasing property in great locations with high demand from credit tenants, however, if your property is located in less desirable area with less qualified tenants, this figure could add another 2% to 3% to your Vacancy Allowance.
Effective Gross Income – Represents Gross Rental Income less the Vacancy Allowance and represents your best estimate of the available funds which will be collected during the year and available to pay operating expenses and debt service.
The subject of operating expenses will be discussed in our next issue.
Carter Froelich, CPA is the founder of The Property Ledger™ a web based real estate investment software. To get a free 30 day trial of The Property Ledger™ see our web site at www.thepropertyledger.com.