So how do you calculate positive cash flow on a real estate investment? Are you saying that cash flow is the difference between your monthly rent amount and your mortgage payment? If so, the fault is yours.
Managing a rental property entails more expenses in addition to paying the mortgage. Most banks use 75% of the monthly rent amount as a guide for what they think is a better indication of what will actually lead to the bottom line. For example, if your monthly rent is $ 1,000 per month, they will say you have $ 750 per month of income.
So where does that other 25% go? Well, it goes to maintenance, vacancy, administration, taxes, insurance, legal, accounting and the other expenses that you would make to run a business, and don’t be fooled; real estate investing IS a business.
There is a calculation that is often used in commercial real estate investing that some of us have adapted to the world of residential real estate investing: net operating income.
The net operating income calculations involved determine what the property’s actual income is (not including the mortgage payment).
So if you had a rental income of $ 1,000 per month and subtracted taxes, insurance, a reasonable estimate of the effect of vacancies, maintenance, and management, the number you have left is your net operating income for that property.
If we calculate this number first, we can use a financial calculator to determine the maximum amount of debt a property can bear with that monthly payment and the interest rate at which we can borrow.
If the amount we can borrow is greater than the purchase price (minus what we are willing to use as a down payment), then we can honestly say that the property appears to have positive cash flow. If it is lower than the purchase price, then we know that we have to deposit more money or that we have negative cash flow which is actually, in my opinion, like making a down payment over time.
Therefore, the next time you do your investment property analysis, I encourage you to do your own net operating income calculation to determine the cash flow of the potential real estate transaction.