As real estate investors, we understand that cash flow is the lifeblood of any real estate investment. No matter the means you use to purchase a property, the fuel that drives your investment is positive cash flow. It is for this reason that cash flow analysis has become a critical method used by investors to decide whether they should or shouldn't buy a property. Cash flow is the net amount an investor receives after expenses. It is basically total income minus total expenses.
Cash flow boasts four intuitive components that every investor should be aware of when analyzing a deal. This blog provides an insight into these four components and helps you understand how to manipulate each of these metrics in order to increase your cash flow.
1. Revenue Revenue is the total amount of money a company receives from a cash flowing asset. It is the extra amount of money that investors get when they charge rent that is higher than their expenses. Consequently, revenue has an eventual effect on cash flow figures, but its impact is not immediate. Revenue shows the amount of money coming in from the sale or renting a property, while cash flow shows the total amount of cash coming in and moving out of an investment. When conducting a cash flow analysis, revenue is one of the components that you should put into consideration as it not only allows you to build wealth but can also provide a reliable cash cushion.
2. Operating Expenses When you are evaluating possible rental property purchases, you find a figure in the financials dubbed the operating expenses. Operating expenses include things like property taxes, utilities, broker fees, insurance, and property management, etc. These are aspects that go unnoticed when increasing your cash flow. Therefore, it is imperative for investors to take note of the items included in operating expense when analyzing cash flow. Having a better understanding of what makes up your operating expenses can help you to manage these expenses over time and consequently, your cash flow.
3. Debt Service Any form of financing that is payable over time is what is referred to as debt service. It is the monetary amount of periodic payment you need to make to reimburse the principal and interest on a loan. It is the cash you need to service a mortgage, bond issue, or any other loan. Debt service is essential to a real estate investor in the sense that it allows you to know if the net income on the property will be enough to service the loans, taxes, and other expenses are paid. Investors need to calculate the debt service amount to determine whether they have enough income and cash flow to service their loans.
4. Reserves Besides the day to day expenses that real estate investments incur, there is a myriad of other unexpected things that may pop-up from time to time. Therefore, it’s a smart idea to always keep some cash on reserve to deal with unforeseen challenges. In real estate, you must still cover your assets (C.Y.A). A responsible investor should always put money aside for your “oops fund” to cater for things like bathroom floods, furnace breakdowns, pipe bursts, and other plumbing defects. Keeping sufficient reserves helps to protect your cash flow and ensures that as an investor, you are ready to deal with unexpected problems without too much hassle.
It’s no secret that even seasoned investors face hurdles with their cash flow occasionally. It’s part of doing business! However, those who conduct and in-depth cash flow analysis factoring in the four essential components discussed in this piece can survive. With insightful knowledge about revenues, operating expenses, debt service, and cash reserves, investors can determine whether the cash flow from a given property will offer an excellent investment deal.
We invite you to download our latest Cash Flow Cycle eBook to get an insightful breakdown of our process when acquiring a cash flowing multi-unit property, as well as learn the four phases of the cash flow cycle.