By Fred Matera, CIO, Redwood Trust A lack of affordability will lead to near-term weakness,…
By Jack Jerue
One of the most appealing aspects of real estate investing is the potential for long-term “passive” income. Many successful real estate investors have used rental property cash flow to amass their wealth. Although simple in concept, it is important to understand the fundamental drivers of rental property cash flow- and the subsequent rate of return- to ensure a potential deal is a worthwhile investment.
Savvy investors use a few equations and metrics to determine the potential returns of new investments and to evaluate their existing holdings. Having a system in place allows investors to quickly identify profitable opportunities and avoid bad ones.
Whether you are a seasoned investor, or newer to the space, the process below can be used to analyze new deals, or to ensure your existing assets are performing relative to your desired return.
Calculating Cash Flow
Calculating a property’s cash flow is the first step in evaluating a deal. When investors say the word “cash flow” they are referring to the net income generated from the property. Cash flow is typically more relevant than net operating income, as the cash flow equation is inclusive of the debt service payments that directly impact an investors profitability.
The net income is the money that will stay with the investor after all expenses are paid for.
For the example below, I will run through a scenario for an investor interested in buying a $250,000 property, with assumptions for rents and expenses.
Step 1: Estimate Gross Cash Flow
The gross revenue generated from a rental property is the total income generated from the asset, typically calculated on a monthly or annual basis.
• Gross Annual Rents: $21,600 annually ($1,800 x 12 months)
• Vacancy Assumption (7%): $1,512 annually ($21,600 Gross Annual Rents x 7%)
• Credit Loss (1%): $216 ($21,600 Gross Annual Rents x 1%)
• Gross Annual Cash Flow: $19,872 ($21,600 Gross Annual Rents – $1, 512 Vacancy Assumption – $216 Credit Loss)
Step 2: Forecast Operating Expenses
Operating expenses include all expenses the property will incur over the course of a year excluding the mortgage payments. For this example, we will assume the property is managed by a third party.
• Property Taxes (1% of Assessed Value): $2,500
• Insurance: $1,700
• Property Management Fee (7% of Gross Annual Rents): $1,512
• Maintenance/Capital Expenditures: $700
• Total Annual Operating Expenses: $6,412 (All Operating Expenses Combined)
• Annual Operating Income: $13,460 ($19,872 Gross Annual Cash Flow – $6,412 Total Annual Operating Expenses)
Step 3: Calculate the Debt Service Payment
The debt service payment refers to the principal and interest payments that will be paid to finance the asset. For this example, we will assume a 75% LTV loan at 5.00% interest rate, amortized over 30 years.
• Property Value/Purchase Price: $250,000
• Loan Amount (75%): $187,500 ($250,000 Property Value x 75%)
• Monthly Mortgage Payment: $1,007 (P [ I ( 1 + I )^N ] / [ ( 1 + I )^N – 1 ])
• Annual Mortgage Payments: $12,084 ($1,007 Monthly Mortgage Payment x 12)
Step 4: Calculate Net Cash Flow after Debt Service
The final step is to calculate the total or net cash flow. To do so, take the gross cash flow, then subtract the operating expenses and debt service payments.
• Annual Cash Flow Calculation: Gross Cash Flow – Total Operating Expenses – Debt Service Payments
• Annual Cash Flow: $1,376 ($19,872 – $6,412 – $12,084)
Based on this example, the property would net the buyer $1,376 annually.
*The cash flow calculation could go a step further by subtracting the rental income taxes and accounting for depreciation on the asset.
Making Sense of the Numbers
As previously mentioned, there are many equations and ratios that can be useful in evaluating the potential profitability of an investment property. There is no perfect approach but having benchmark metrics to reference can simplify the investment property buying process and help compare deals in similar markets. We will use the numbers from the example above to evaluate the deal based on a few common rules and equations.
Debt Service Coverage Ratio
Debt service coverage ratio, or DSCR, is a metric used by both lenders and investors. Asset-based lenders like CoreVest use this ratio to ensure the sponsor can service the mortgage payment from the property’s operating income. Investors can use the metric to ensure they do not take on too much leverage, or to amend their offer to ensure the property sufficiently covers the mortgage payments without needing to dip into reserves.
• DSCR Calculation: (Net Operating Income / Debt Service)
• DSCR: 1.11x ($13,460 / $12,084)
A DSCR of 1.11 means there the operating income is 1.11x the debt service. Lenders typically underwrite to a minimum 1.20 DSCR, which means in this example the investor may want to reduce the debt service amount by lowering their LTV.
Cash-on-cash (COC) return is the percentage of your investment you make back this year in cash flow. This is exclusive of appreciation, and for simplicity, we will assume no closing costs were incurred and no rehab was put into the property. Cash-on-cash return is a useful metric as you can think of the opportunity cost of deploying your cash into an alternative investment.
COC Calculation: NOI / Cash in Deal (Purchase Price – Loan Amount)
COC: 2.2% ($1,376 / $62,500)
The cash-on-cash return for this year would be 2.2%. This is helpful to know as you can compare what the return would have been if deployed elsewhere. If the expected return would be higher in a different investment, it may be wise to look elsewhere.
The 1% Rule of real estate investing measures the price of the investment relative to the gross income it is expected to generate. To pass the 1% rule test, an asset must have monthly gross rents that exceed 1% of the purchase price.
• 1% Rule Calculation: Gross Rents / Property Value
• 1% Rule: .7% ($1,800 / $250,000 = 0.007 or 0.7%)
The subject property does not exceed the 1% benchmark, so it would fail the 1% rule. Keep in mind this metric is less relevant for investors targeting higher appreciation in lower yielding markets. However, this metric can be useful when evaluating markets as a whole or a specific asset relative to a like-asset in the same market.
The 50% rule is a ratio used by investors in determining if the projected operating expenses are in line with the gross revenue generated from the asset. If the operating expenses are projected below 50% of gross rents, then an investor may be underestimating expenses and could be disappointed with the actual cash flow after purchasing. In our example, the operating expenses were outlined above, but include items such as property taxes, insurance, and property management.
• 50% Rule Calculation: Operating Expenses / Gross Rents
• 50% Rule: 32% ($6,412/$19,872)
In our example, the projected operating expenses are only 32% of potential gross rents, which indicates the expenses may be under-projected. Knowing this, an investor can verify the property’s taxes, receive an estimate for insurance and see the market rate for property management to ensure the projections are accurate.
Final Thoughts on Cash Flow and Return Metrics
Finding an investment strategy that works for you takes trial and error. Every market differs, as does each investor’s short and long-term real estate strategies. Regardless of the strategy, understanding the drivers of cash flow and finding metrics that work for you will help you to be successful in the space.