Real Estate Financing and Investing/How To Determine Cash Flow for Real Estate

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A necessary task in analyzing an income producing property is determining the before tax cash flow. When you know the cash flow, you can figure your return on your investment, calculate the tax shelter, and evaluate the investment, in other ways. You don`t need to be a real estate expert to determine a property`s cash flow, common sense and some uncomplicated research will provide you with a base figure.

Example
John Smith recently calculated the cash flow of a property offered to him for investment. We will go through his analysis, step by step, as an example of the process and format which you can follow. Mr. Smith is considering a duplex apartment. The property is located in an attractive suburb. The cost of the building is $219,000 and a $175,000, 30 year mortgage at 12% fixed rate is anticipated. The projected figures are based on the first full year of operation.

Step 1. Figuring gross income
The building has two three bedroom apartments. To judge how much the apartments could rent for, Mr. Smith compared his building to ones in the area which were similar in quality of location and construction. He studied advertisements and questioned area real estate brokers. After weighing this information, he decided the three bedroom could rent for $950. Thus, the total maximum yearly rental income was $22,800.

2 x $950 = $1,900

$1,900 x 12 = $22,800

Additional income of $800 from laundry fees would make the possible total gross income $23,600.

Step 2 Vacancy and credit losses
To estimate the reduction in gross income caused by vacancies and bad debts, Mr. Smith looked at the result of the survey conducted by the local realtors and apartment associations. He estimated that the vacancy and bad debt rate would be 2% of possible gross income or $472 (2% of $23,600). Please refer to Table 1 (Annual Property Operating Data).

Step 3 Operating expenses
For estimates of operating expenses, Mr. Smith carefully examined the record of previous costs by category. He came up with the cost figures as shown in the chart, which are basically the previous costs plus adjustments for inflation.

Step 4 Net operating income
The projected operating expenses totaled $4,510 or 19.50% of gross operating income ($23,128). This left a net operating income (NOI) of $18,618 ($23,128 - $4,510). Now we proceed to calculating before tax cash flow:

Step 5 Debt service (principal and interest payments)
Payments at 12% on a $175,000, 30 year fixed rate mortgage would be $1800.08 per month or $21,601 annually (principal amount is $635)

Step 6 Before tax cash flow
The estimated before tax cash flow was ($2,983) on an investment of $44,000 ($219,000 - $175,000).

TABLE 1. ANNUAL PROPERTY OPERATING DATA
(12 months - projected)

   Gross Scheduled Income $22,800
   + Other Income 800
Total Gross Income 23,600
   - Vacancy / Credit Losses (2%) 472
Gross Operating Income (GOI) 23,128
Operating Expenses (with percent of GOI)
   Property Insurance 1.93% $446
   Real Estate taxes 13.22% 3,058
   Repairs and Maintenance 1.45% $335
   Water and Sewer 2.90% $671
Total Operating Expenses 19.50% 4,510
Net Operating Income 80.50% 18,618
   - Debt Service (Principal and Interest) 21,601
Before-Tax Cash Flow ($2,983)

In order to compute after tax cash flow, we have to add principal payments and deduct annual depreciation as follows:

Before Tax Cash Flow $(2,983)
Add: Principal 635
Less: Depreciation 5,575*
Taxable Income (loss) $(7,923)
Your Income Tax Rate 0.35 (35%)
Value of Taxable Loss $2,773

(*) Assumption: The depreciable base of the building is 70% of $219,000 = $153,300. Annual depreciation is therefore $5,575 ($153,300/27.5 years by straight line).

Then your after-tax cash flow is:

Before Tax Cash Flow $(2,983)
Add: Value of Taxable Loss 2,773
After Tax Cash Flow $(210)

Note: Due to the deductibility of interest payments and annual depreciation for income tax purposes, after tax cash flow is reduced by a substantial amount (In this example, after tax was only $210 as compared to before tax of $2,983). Don`t forget: We did not even take into account the potential appreciation of the property. The return on your investment in this building should be calculated on the basis of both annual after tax cash flows and the selling price of the property at the end of the holding period.