Cash Flow (CF)
AKA Meet the key to your financial independence and go with the flow
In this article:
- property investment cash flow explanation
- importance of CF
- types of CF
- CF income and expense definition
- SWORP TIP!
Cash flow. Two words that sound almost like a shamanistic incantation. Trust me, go ahead and repeat it a few times. Probably the most graphic metric and one of the most powerful topics in the real estate business - literally a money flux. Cash flow is the easiest concept to understand and calculate if you keep track of your incomes and expenses (as you do, of course). Cash flow is simply the amount of income property is generating, after expenses.
A proper evaluation of your investment performance shouldn’t concentrate merely on revenues and expenses, but on cash flow equally. Keeping track of a bank statement does not mean controlling a property's cash flow. To manage a property’s expenses and revenues effectively, you need to anticipate impending cash shortages before such a situation occurs. It is easier to keep an eye on the payment of receipted invoices and other obligations when they need to be paid. You can plan to develop a business and invest that won't break your neck due to a lack of funds. Information on sufficient cash flow is also necessary when repaying loans and meeting banks' terms and conditions.
For any kind of investment, cash flow is the life-giving sap that continually nourishes your business - and you. The more cash flow, the better the returns. It helps you pay off your mortgage, it pays your bills. If properly taken care of, it becomes a resource to reinvest, best case scenario to a point of financial independence.
Nevertheless, the thing about cash flow’s magic is its elusiveness. You have to be prepared for many variables, as each property generates a different cash flow even under similar circumstances. Mistakes are inevitable. The most important is to learn from them and evolve.
Lack thereof results in the death of your property business. The fact is that among the reasons why businesses bankrupt, insufficient cash flow is the most common. In case the cash flow turns negative, it tends to follow you for ages. In other words, the effort and time devoted to managing cash flow are more than worthwhile.
Cash flow equals passive income. It's the income generated when rental returns exceed monthly expenses. Some property investors call cash flow “mailbox money”, referring to the fact that cash flow epitomizes a monthly income that doesn’t require working nine to five.
Before learning CF calculation, note that there are two types of cash flow: gross and net. Both are calculated differently.
- Gross Cash Flow (GCF)
GCF is the gross income you get from collecting rents and other fees you charge your tenants (including parking fees, late payment fees, etc.). Basically, any income generated off of your rental is gross cash flow.
- Net Cash Flow (NCF)
NCF is the cash that you have at your disposal at the end of the month after you deduct all the expenses and bills associated with the property or unit from rental income. In other words, NCF is GCF minus expenses. Ideally, your net cash flow will be positive, but there may be some cases where the net cash flow shows a negative balance, i.e. for unexpected repairs, insolvent tenants, or incurred vacancies.
Gross cash flow is suitable for a quick determination if a property is worth investing in, but naturally, the GCF is a mere signpost. For the most part, as an investor, you must be concerned about the net cash flow - an indicator of profit making.
Now let’s take a closer look at the net cash flow calculation. The gist is knowing all applicable expenses of the investment property and being realistic about it so that you get the most accurate estimate possible.
Expenses to consider:
- Property management fees (if applicable)
- Legal fees
- Garbage disposal
- Utilities (if applicable)
- Advertising and promotion
- Mortgage installment, insurance, and interest
Note that in the case of cash flow, mortgage installments are also considered expenses, so include them. Nevertheless, it is always better to overestimate the expenses than underestimate and then experience a rude awakening.