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AutenRealty.com Cash Flow FAQs
Cash Flow FAQs
1) What is Cash Flow?
2) What is the Cash Flow Model (CFM)?
3) How is the Cash Flow Model calculated?
4) An example of the Cash Flow Model.
5) What benefits do I derive from using the Cash Flow Model?
6) What is "Due Diligence"?
Cash Flow Defined
Cash Flow is the amount of cash a property investor receives after deducting operating expenses and loan payments (if any) from the gross income. Actually, there are typically three different cash flows involved in a simple real estate investment:
1. At Acquisition: The initial outlay of cash for down payment, loan points, closing costs, etc., represents an investor's initial investment. Cash flows from the investor to the investment.
2. From Operations: Cash flow from the day-to-day operations of a real estate investment can be negative or positive. Positive cash flow means that more cash is coming in than going out. Thus, cash is flowing from the investment to the investor. Negative cash flow means that there more cash going out than coming in. Thus, cash is flowing from the investor to the investment.
3. At Disposition: When the property is sold, the net gain/loss is considered an additional cash flow. If the sale generates a profit, cash flows from the investment to the investor. If the sale generates a loss, cash may needed to flow from the investor in order to pay off outstanding liens and closing costs.
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Cash Flow Model
The CFM is used by many real estate professionals and investors to analyze all types of investments. Because of its versatility, it can be used to review and compare everything from a small residential property to large commercial properties. It is the starting point for identifying properties that may meet a buyer's investment criteria.
The CFM is used because it includes the cash flow involved in acquisition as well as the cash flow from the first year's operations.
Simply put, cash flow analysis begins with the income received. Then operating expenses are subtracted to arrive at the net operating income (NOI). Next, the annual mortgage (principal and interest) payments are subtracted to arrive at before tax cash flow.
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Steps to Calculate Before-Tax Cash Flow
Line 1. GROSS SCHEDULED INCOME
Line 2. minus Vacancy & Credit Losses
Line 3. equals EFFECTIVE RENTAL INCOME
Line 4. plus Other Income
Line 5. equals GROSS OPERATING INCOME
Line 6. minus Annual Operating Expenses
Line 7. equals NET OPERATING INCOME
Line 8. minus Annual Debt Service
Line 9. equals BEFORE-TAX CASH FLOW
Line 1. Gross Scheduled Income (GSI) is the maximum amount of annual rent that would be generated if the property was 100 percent occupied all year.
Line 2. Vacancy & Credit Losses represent an estimate of rental income that will be lost because portions of the property are not rented or because existing tenants fail to pay rent. When expressed as a dollar amount, it is referred to as the vacancy loss. When expressed as a percentage, it is called the vacancy factor. Each market and sub market has its own vacancy factor, which can be obtained by asking appraisers, property managers, and loan officers.
Line 3. Effective Rental Income is obtained by subtracting Vacancies & Credit Losses from Gross Scheduled Income. It represents the potential amount of rents for the year.
Line 4. Other Income refers to income from sources other than rents. Other income can have a significant effect on cash-flow analysis. Typical sources of other income include:
- Laundry machines
- Rental application fees
- Storage fees
- Parking fees
- Vending machines
- Late fees paid by tenants
Line 5. Gross Operating Income (GOI) is obtained by adding Other Income to Effective Rental Income. Gross operating income is the total pre-expense income.
Line 6. Annual Operating Expenses are the actual costs involved in running the property. An annual expense budget should include sufficient funds to ensure that the property continues to produce market rents. If maintenance is deferred for a prolonged period, the property's ability to compete for the best renters will be diminished. Operating expenses can include:
- Property tax
- Maintenance and repairs
- Management fees
- Services (garbage, janitorial. pool. elevator, lawn, etc.)
Annual Operating Expenses do not include loan payments or cash outlays for major improvements. These outlays, called capital additions or capital reserves, must be placed on a cost recovery, or depreciation schedule, and deducted over time.
Line 7. Net Operating Income (NOI) is obtained by subtracting Annual Operating Expenses from Gross Operating Income. NOI is a key component in cash-flow analysis.
- It is the estimated amount of money the property will produce to cover the annual debt service.
- It is used by investors and appraisers in conjunction with a cap rate to determine a property's value. NOI is a common factor that can be used to evaluate an investment regardless of whether an investor is paying cash or using financing to purchase a property.
Line 8. Annual Debt Service is the total of all monthly loan payments (principal and interest) paid throughout the year on all mortgages.
Line 9. Before-Tax Cash Flow is obtained by subtracting Annual Debt Service from Net Operating Income.
Before-tax cash flow is what the investor has left of the property's income after all expenses are paid except income taxes. If annual debt service exceeds net operating income, this number will be negative. (Cash is flowing from the investor to the investment.)
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An Example of the CFM for a hypothetical property.
Assume that we are looking at a 3-plex (1 duplex with a garage apartment).
- The property is listed for $200,000.
- One side of the duplex rents for $1,000 per month. The other side rents for $900 per month. The garage apartment rents for $700 per month.
- The total monthly income is $2,600 per month.
- The average vacancy in the area is reported to be 10%.
- The current owner receives an additional $480 per year from pay laundry machines.
- The tenants pay all utilities.
- Assume that 95% financing is available at 7.0% on a 30-year fixed-rate loan with monthly payments of $1,147.15
- The annual operating expenses are as follows:
- Taxes $3,267
- Insurance $1,542.75
- Property Management $2,284.80
- Repairs & Maintenance $1,428
- Services - Landscaping $480
- Total Annual Operating Expenses $9,002.55
What is the first year's before-tax cash flow?
1. Gross Scheduled Income. . ……… $ 31,200 ($2,600 x 12 months)
2. - Vacancy & Uncollected Rents… - $ 3,120 (10% of $31,200)
3. = Effective Rental Income. . . …. . = $ 28,080
4. + Other Income. . . . . . . . . . . . . …+ $ 480 (laundry machines)
5. = Gross Operating Income. . . . . ..= $ 28,560
6. - Annual Operating Expenses…….- $ 9,002.55
7. = Net Operating Income. . . . …...= $ 19,557.45
8. - Annual Debt Service. . . . . . . . .. - $ 13,765.80 (Mtg. $1,147.15 x 12)
9. = Before-Tax Cash Flow. .........…= $ 5,791.65
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Some Common Uses of the Cash Flow Model
Either the information derived from, or used as input for, the CFM can be used in several valuable calculations, such as:
- The relative value of the property.
- The cash on cash (C/C) return.
- The debt coverage ratio (DCR).
Everything you need to calculate these items is contained within the nine lines of the CFM. Of particular interest are:
Line 1 Gross Scheduled Income
Line 7 Net Operating Income
Line 8 Annual Debt Service
Line 9 Before-Tax Cash Flow
Determining the Value of Investment Property
Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.
Gross Rent Multiplier (GRM)
The simplest way to obtain a rough estimate of the value of a property (the "ballpark value") is to use the Gross Rent Multiplier (GRM). It can be calculated using the estimated Gross Scheduled Income (GSI - Line 1) for year one, multiplied by a factor known as the GRM. It is usually derived from comparable properties in the marketplace. But it may also be adjusted by the investor to reflect their specific requirements. This method compares the property's sale price with its current annual gross scheduled income to determine whether the income will cover mortgage and operating expenses. The higher the GRM, the more likely the property will yield a negative cash flow.
The Gross Rent Multiplier is calculated using the following formula:
GRM = Sale price divided by the first year Gross Scheduled Income (also refered to as Gross Annual Rents).
Example: $200,000 sales price divided by $31,200 Gross Scheduled Income = 6.41.
Pros: The GRM is a convenient tool because of its simplicity.
Cons: The usefulness of the GRM is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.
Example Using the Gross Rent Multiplier to Determine Investment Value
Suppose a potential buyer's GRM requirement is 6. (This means the investor will pay no more than 6 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $31,200. The investment value, or the amount this investor would be willing to pay for this property, is:
$31,200 x 6 = $187,200
Capitalization Rate (Cap Rate)
The overall income capitalization rate, or cap rate, is another useful ratio for estimating real estate value, and is one of the most widely used formulas. Cap rate is a way of evaluating the return on investment (ROI) for a property.
Cap rates can be developed by analyzing the income and sale prices of comparable properties. Cap rates are generally more precise than gross rent multipliers because they are derived from net rather than gross income. Also, cap rates are more sensitive to such things as vacancy rates and operating expenses. Because older buildings tend to have higher operating expenses, cap rates also reflect the age, quality and condition of the property.
The cap rate is the ratio (expressed as a percentage) between purchase price and the first-year net operating income (NOI) of the property.
Cap Rate = NOI divided by the purchase price.
Example: An investment property selling for $200,000 with an estimated first-year NOI of $19,557 would have a capitalization rate of 9.78% ($19,557 divided by $200,000).
Pros: The main advantage of using a cap rate is its simplicity. It also accounts for vacancy and operating expenses.
Cons: The main problem with using cap rates is the difficulty in collecting detailed income and expense information. Furthermore, a cap rate is limited because it only looks at only a one-year forecast and does not take into consideration any financing or tax implications.
Examples Using a Cap Rates to Determine Investment Value
If you purchase a property for $200,000 that produces an annual NOI of $19,557; this property would have a Cap Rate of 9.78% ($19,557/200,000). Based on this calculation the property will generate 9.78 of the purchase price in income (not considering income tax or financing) per year. If you were looking at another property with a purchase price of $200,000 that produced an annual NOI of $25,000, this would obviously be a better deal with a calculated cap rate of 12.5% (25,000/200,000).
A variation of the cap rate formula can be used to determine investment value (price) when the cap rate and the net operating income are known. Suppose a potential buyer is looking at a property listed for $250,000 with an estimated first-year NOI of $22,800. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.75%. We can use the formula below to determine the purchase price he would be willing to pay.
$22,800 (NOI) divided by 0.0975 (cap rate requirement) = $233,846.
Cash on Cash
Another measurement of investment performance is Cash on Cash (C/C). C/C return measures the return on cash invested in an income producing property. It is expressed as a percentage and is calculated by dividing before-tax cash flow by the amount of cash invested.
Cash on Cash = Before Tax Cash Flow divided by the Total Initial Investment (Cash Out Of Pocket)
Example: If before-tax cash flow for a property is equal to $5,791 and our cash invested in the property is $44,000 (down payment of 20% on a $200,000 property plus $4,000 in points and closing costs), C/C return is equal to 13.16% ($5,791/$44,000 = 13.16%).
Pros: C/C takes into consideration vacancy and uncollected rent, operating expenses, and debt service (if any). It can be useful when comparing investment properties
Cons: C/C does not take into consideration anything past a first-year forecast. It only considers before-tax cash flow and doesn't take into account an investor's individual income tax situation or the wealth building potential of a property via appreciation.
Debt Coverage Ratio (DCR)
The Debt Coverage Ratio (also known as Debt Service Coverage Ratio) is a widely used benchmark which measures an income producing property's ability to cover the monthly mortgage payments. Lenders generally use a debt coverage ratio as a lending guideline.
The DCR is calculated by dividing the net operating income (NOI) by a property's annual debt service. Annual debt service equals the annual total of all interest and principal paid for all loans on a property,
Example: A property has an annual NOI of $19,557 and debt service (principal and interest) of $13,765. The DCR is 1.42 ($19,557/$13765 = 1.42).
A DCR of less than 1 indicates that the income generated by a property is insufficient to cover the mortgage payments and operating expenses. For example, a DCR of .9 indicates a negative income. There is only enough income available after paying operating expenses to pay 90% of the annual mortgage payments or debt service. A property with a DCR of 1.42 generates 1.42 times as much annual income as the annual debt service on the property or 42% more income (NOI) than is required to cover the annual debt service.
Many lending institutions require a minimum DCR value to procure a loan for income producing properties. DCR requirements for lending institutions may vary from as low as 1.1 to as high as 1.35. From a lending institution's perspective, the higher the DCR value, the more available income to cover the debt service and thus less risk.
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What is "Due Diligence"?
Your cash-flow analysis will only be as accurate as the information you plug into it. That is why "due diligence" is imperative in obtaining accurate input data for the CFM. Due diligence can be defined simply as the responsibilities of a person or business to exercise proper care and planning prior to making any business decision.
There are a multitude of details which must be considered when purchasing a parcel of real estate. Many of these details are easily overlooked. The function of due diligence is to independently verify all representations made by a prospective seller, and to uncover pertinent facts which have not been disclosed, but are important to the buyer.
After identifying a target property, due diligence starts during the contract negotiation stage. Including a list of required due diligence items is essential in the purchase agreement. It is expected that there will be some negotiation as to what will and will not make it to the final draft. Ample time should be allowed to complete due diligence.
Due diligence must include an evaluation of:
- Actual and Pro Forma cash flow projections
- Appraisal, environmental and engineering reports
- Sales and rental comparables
- Market trends and property values
- Financing strategies and alternatives
To complete these analyses, a buyer should request that the seller produce the following documentation (While these are not exhaustive document lists and questions to ask, they should give you an idea of the types of information that you will need in your decision-making process):
- Monthly P&Ls (at least one year, preferably two years)
- Balance sheet (three years)
- Rent roll (including term, deposit and payment history)
- Tax returns - Schedule E (three years, preferably five years)
- Insurance policy, including all riders, risk assessments and disclosure affidavit for carrier
- Existing loan documents including notes, deeds of trust, closing statements and title policy rate riders
- All leases, entire copies plus any addendums or riders
- All security deposit records
- Any service contracts - trash, extermination, maintenance, management, commission agreements, union agreements, vending, billboard, pay telephone, etc. and any contract to be assumed by purchaser
- Copies of all prior inspections, appraisals, engineering reports, environmental reports
- Survey (as built), legal description, architectural and engineering plans and specifications
- Payroll register, list of employees including name, position, wage rate and entitled benefits
- Business licenses that might be required
- Utility bills - water, sewer, gas, electric (at least two years of monthly statements or a recap report from the provider showing usage and cost)
- Property tax bills for the past three years
- Litigation history - details of any past or pending litigation (if none, then affidavit from owner)
- Property tax appeal status, if any
Important questions to ask:
- What are the current rents, according to the lease and rental agreements?
- Are these market rents?
- How long do these agreements run?
- Are the tenants prompt payers?
- When was the last rent increase?
- If there is a property manager, what do his records show as collected rents?
Vacancy & Uncollected Rents
- What is the current vacancy factor for the property?
- What is the current market or sub market vacancy factor?
- What is a reasonable forecast for future vacancies?
- Is the property competitive, or does it need to be upgraded?
- Are the laundry and vending machines owned by (a) the property owner or (b) an outside vendor?
- If owned by the seller, how long will the machines last, and how much will it cost to replace them?
- If owned by a vendor, what are the contract terms?
- Are there late fees on rent payments?
- Is an application fee charged?
Important items to include in calculating operating expenses:
- Management fees
- Property insurance
- Utilities (Who pays (owner or tenant)? Are the utilities separate, master or sub-metered?)
- Apartment make ready and prep
- Cleaning and maintenance
- Leasing commissions
- Legal and other professional fees
- Services (garbage, gardening, pest, pool, landscaping, etc.)
When considering the external physical conditions of a target property, it is wise to secure the services of a licensed inspection service. Depending on the nature of the physical attributes of the property, the following items should be considered:
- Engineering inspection and survey
- Environmental inspection (areas of concern include asbestos, lead paint, testing of underground tanks, wetlands)
- Type of roof (Consider the number of layers of roofing material installed and identify evidence of damage)
- Assess leaks or moisture damage inside the structure (both roof and basement)
- Drainage system should direct water ways from the structure
- External electrical connections and boxes
- Condition of chimneys. (If the chimneys are masonry, are there signs of loose mortar? If the chimneys are metal, are there signs of rust or corrosion?)
- Cracks in sidewalks or driveways that are large enough to present a tripping hazard
- Condition of any retaining walls (Are there signs of movement?)
- Major cracks, bulges, or other visible signs of settlement in the foundation
- Have handrails been installed where needed?
When considering the internal conditions of a particular piece of improved real estate, consider:
- Are ground-fault breakers installed at bathrooms, kitchens, outside and other wet locations?
- Age of heating system (Is it equipped with modern safety controls? When it was last serviced?)
- Age of water heater (Is there a properly installed temperature and pressure relief valve?)
- Are interior floors level?
- Carbon monoxide alarms and smoke deectors installed/tested
- Signs of rust, corrosion or scorching around heating unit
- Sufficient source of outside air provided to the heating system
- Condition of piping or ductwork
- Cracks or bulges at the interior finish surfaces
- Do doors or windows bind in their openings? Are the openings out of square?
- Is there any earth/wood contact in the crawl space or basement
- If there sufficient fireproof barrier to utility rooms and garage?
- Is there sufficient electrical service?
- Is structure insulated?
- Was urea-formaldehyde or asbestos-containing insulation used on the property?
- Property serviced by private water or sewer systems
- Main water shut-off valve operational and accessible
- Is there a main sewer clean-out?
- Is there sufficient water pressure?
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This information is presented for educational purposes only and is intended to provide a broad overview of basic investment property analysis. Readers are urged to seek independent legal/tax guidance on each transaction as circumstances often change and can affect the validity of the investment analysis. I am not engaged in providing legal or tax advice. Nothing contained in this information shall be construed as providing such service. Every investor should always seek the advice of his or her tax and/or legal advisors regarding his or her specific situation.
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