Positive cash flow analysis plays a central role in determining whether a particular property will generate enough profit for it to be a worthwhile investment. A simple formula is used to accurately calculate this amount; the annual debts must be subtracted from the net operating income and the resulting figure represents the cash flow. This tool is useful for both assessing properties currently owned and those which one is contemplating buying.
Questions for Cash Flow Analysis
There are some very important questions that need to be answered regarding real estate investments, and more specifically cash flow analysis, to create a clear picture of the whether or not it will yield enough cash flow to suit your investment objectives:
- how much money needs to be invested
- when does it need to be invested
- how much money does it produce
- when will this money come out
There are also some key terms any investor must have an understanding of when involved in real estate investment. One such term is the “holding period”, this refers to the amount of time which has passed since the owner acquired the investment, in the case of property it begins when the contract of sale is drawn up. Profit is typically assumed to be gained at the end of each year of ownership.
Annual cash flow of the property can either be positive or negative and are calculated by deducting the amount of debt and expenses from the gross income it generates before taxes are deducted. Every investor wants this to be positive, as this indicates a profit, whereas if it is negative this means that it is more of a liability than an asset and is costing more than it brings in.
Calculating Cash Flow
The basic process used to calculate an investment property’s cash flow is carried out as follows. The actual monthly rental rate of the building or in the case where it is not rented, a going market-rate for such a property can suffice, needs to be multiplied by twelve which is the annual rental income. The amount of money lost due to vacancies must then be subtracted, which results in the EGI or “effective gross income”.
Now sum up all operating expenses incurred to run the building, such as management, repairs and maintenance, insurance, and property taxes, and any other recurring expenses but not the financing. This number must then be subtracted from the EGI and the result is called the NOI or “net operating income”.
Next, the amount of the loan payment must be multiplied by twelve to give the figure for the ADS or “annual debt service”, if only in prospecting stage, an estimated amount can also be used in this respect. The ADS must then be subtracted from the NOI which will produce either a positive or negative figure representing the flow of cash.
Creating a projection model of this type is referred to as a “real estate proforma”. Investors often rely on this forecast to help them make wise decisions when it comes to choosing properties to purchase, and also it can help indicate to them when selling a previously acquired property is the best choice.