Cash flow is why most real estate investors make an investment in rental properties. Whether to get a steady stream of it on a monthly basis or a lump sum of it when the property appreciates in value and gets sold (or both); the proverbial real estate investing adage is true: real estate investors buy the revenue investment real estate generates.
In this article I will show you how to compute rental property cash flows.
But just for the record, bear in mind that cash flows are always regarded in one of two ways: those collected before taxes-that is without any regard for the investor’s federal income taxes-and those that are collected after Uncle Sam takes his share.
This is why you regularly will see cash flows labeled as (CFBT) and (CFAT) in real estate analysis reports. The designation simply indicates whether or not it is revenue before or after tax consideration.
Though serious investors are commonly more interested in (CFAT) because it presents a more concise picture on the profitability of an investment property opportunity directly applicable to the investor, we will discuss both.
CFBT
Cash flow before taxes is somewhat straightforward. It is the property’s net operating income (gross income collected less operating expenses) less debt service and capital additions (i.e., cost for a new roof) plus loan proceeds (i.e., funds obtained from a second mortgage to pay for the new roof) plus interest earned (i.e., interest earned on revenues collected).
Net Operating Income
less Debt Service
less Capital Additions
plus Loan Proceeds
plus Interest Earned
= Cash Flow Before Taxes
For example, say a rental property generates a gross operating income of $200,000 (total rental income less vacancy allowance), operating expenses of $80,000, and requires the investor to make an annual mortgage payment of $100,000 (the debt service). For simplicity we’ll assume no capital additions or additional loan proceeds and no interest earned. Here’s the result.
$200,000 (gross operating income)
-80,000 (operating expenses)
-100,000 (debt service)
=20,000 (CFBT)
CFAT
Cash flow after taxes is a bit more complex because it requires a calculation for taxable income followed by a computation for tax liability (or loss) which in turn is subtracted from CFBT. Again, for simplicity sake, I will show you the schema for both but we will simply assume that the result is a tax liability of $7,000 for our illustration. There are three steps to arrive at the result.
STEP 1:
Net Operating Income
less Interest Expense (mortgages)
less Amortized Points (mortgages)
less Depreciation (real property and capital additions)
plus Interest Earned
= Taxable Income
STEP 2:
Taxable Income
x Marginal Tax Rate (the investors combined federal and state income tax rate)
= Tax Liability (or savings)
STEP 3:
CFBT
less Tax Liability
= CFAT
RESULT:
$20,000
-7,000
= 13,000
In this case, remember we assumed that the investor had a tax liability, therefore it was subtracted from the cash flow before taxes to arrive at our result; had it been a tax savings, however, it would have been added instead.
Fair enough. Just keep in mind that for your real estate analysis to accurately forecast rental property cash flows you must be sure to use realistic financial data. It won’t benefit your real estate investing objectives to include income and operating expense data that the property is not likely to produce.
