So how do you calculate the positive cash flow of a real estate investment? Are you saying that cash flow is the difference between your monthly rent amount and your mortgage payment? If so, shame on you.
There are more expenses to managing a rental property besides the mortgage payment. Most banks use 75% of the monthly rent amount as a guideline of what they think is a better indication of what you’ll actually get in the bottom line. For example, if your monthly rent is $1,000 per month, they would say you have $750 per month in income.
So where does that other 25% go? Well, it goes towards maintenance, availability, administration, taxes, insurance, legal, accounting, and other expenses you would have running a business, and don’t be fooled; real estate investing IS a business.
There’s a calculation often used in commercial real estate investing that some of us have adapted to the world of residential real estate investing: net operating income.
The net operating income calculations involved determine what the true income of the property is (not including the mortgage payment).
So if you had a rental income of $1,000 per month and you subtracted 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 is the maximum debt a property can support with that monthly payment and the interest rate at which we can borrow.
If the amount we can borrow is more than the purchase price (minus what we’re willing to put down), we can honestly say that the property appears to be cash flow positive. If it’s lower than the purchase price, then we know we need to give more money or we have negative cash flow which, in my opinion, is really like making a down payment over time.
So the 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 of the potential real estate deal.