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Lets Talk About Cash Flow...
What Is Cash Flow?
Cash flow is the amount of money left over after all expenses and debt has been paid. Let’s take a look at a basic example with some easy numbers. You buy a property and the mortgage costs you $600 per month and the expenses cost you $400 per month for a total of $1000 per month. You rent the property out and collect $1,200 in rental income per month. In this case, you would be left with $200 of cash flow per month. At the end of the year, you would be left with $2,400 in cash flow.
How To Properly Calculate Cash Flow
The are a lot of different formulas and ways to measure how good or bad an investment is when it comes to real estate. Cash flow is a very simple thing to calculate but it is often calculated wrong due to the absence of a few expenses. As I mentioned above cash flow = income - expenses but many people calculate this number using only the most basic of expenses. Maintenance, vacancy, capex(capital expenditures), and property management costs are some of the most common expenses left out by beginner investors. At first glance, a property might look like a great investment opportunity but once ALL expenses are factored in that can change very quickly. Setting aside money for some of the expenses that are commonly forgotten can decrease or eliminate your cash flow completely. The investment opportunity that once looked like a home run doesn’t look so sweet anymore. Let’s take a look at just how fast things can take a turn when cash flow isn’t properly calculated. You have a rental that you bought in the heart of winter and when you bought it the property had just been remodeled and it looks great. The property went through a full gut rehab but the one downside was that roof was a little bit on the old side. You successfully rented the property for the first two years and the day after the lease ends a roof leak presents itself on the ceiling of one of the bedrooms. The roof and drywall repair cost $11,000 and took two weeks to be completed and another two weeks to get a tenant in the property due to people not being as motivated to move in the heart of winter. Not only do you have an $11,000 repair to come out of pocket for but you also have an entire month of vacancy that you had to eat the cost of. This example shows why factoring in ALL expenses when calculating your cash flow is crucial. If those expenses are factored in upfront then you can eat those costs and still hit your desired return.
Why Is Cash Flow Important?
Cash flow is important because it is a defensive mechanism. Cash flow gives the property the ability to support itself meaning that you don't have to come out of pocket every month to pay for a portion of it. If you experience a financial hardship and your properties do not cash flow then you could potentially be forced to liquidate due to the inability to float them. Let’s say you have four properties and they are all cash flow negative $250 per month for a total of $1,000 and you lose your job. Would you be able to float $1,000 in payments per month? What if the roof leaks at the same time and you didn’t have the proper reserves set in place because the cash flow was calculated incorrectly? How long could you go before you had to liquidate? Even if you only had $50 or $100 of cash flow after all expenses were correctly calculated you would be in a much better position.
Cash Flow VS. Appreciation
Should you buy for cash flow or should you buy for appreciation? Typically cash flow or at least higher returns of cash flow are easier to achieve in lower-quality neighborhoods. Due to the high prices of the Greater Sacramento market, it is hard to cashflow in many areas but it is achievable if you know where to look. But the question is should you invest in the areas that are easier to achieve higher returns of cash flow or should you take a lower return in exchange for a better neighborhood? My rule is that if you would not feel comfortable doing a Craigslist transaction at 8 pm there you shouldn’t invest in that area. More desirable neighborhoods will appreciate at a faster rate which I believe is a great reason to invest in those neighborhoods over the neighborhoods that produce a little more cash flow. I would gladly trade a couple of thousand dollars of cash flow for thousands more in yearly appreciation, a higher quality asset, and a higher quality neighborhood.
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