By Tracey March
My husband and I are considering investing in a 5-unit multi-family property. In fact, we’re having our realtor write up the offer as I type. The seller has given us all sorts of documents about the property, but the most critical one to our decision-making is the cash-flow analysis.
Knowing how to interpret a cash-flow analysis with a critical eye is a great skill to have, whether you’re thinking about investing in a single-family home or a multi-family property. But if you’re a new rental property investor, you might not know what a cash-flow analysis is.
In a nutshell, the cash-flow analysis estimates how much money you’re going to make or lose after all of your income, expenses, debt servicing, and estimated capital expenditures for your rental property have been taken into account. To figure out the cash-flow analysis, you need to figure out your net operating income, so we’ll start there:
Net Operating Income (NOI)
The formula for figuring net operating income is:
NOI = income – expenses
It’s pretty easy to figure out current net operating income. The seller knows the monthly rental income and expenses and should be able to provide that information easily. Projecting future net operating income is more of a challenge and involves more “educated guesswork.”
- rent: look at other comparable rentals in the area. Is yours priced high or low? Are you going to make improvements which will enable you to increase the rent?
- vacancy rates: many experts suggest a vacancy rate of 8.3% per year, which works out to be one month;
- collection loss: rent that can’t be collected, which is typically .5% to up to 4%, depending on factors such as location, the economy, and the tenants;
- additional income streams: such as laundry facilities or parking fees.
The income section of the cash-flow analysis on the property we’re looking at includes rental income, a vacancy factor of 3% (which seems low), and an “other income” section to cover the coin-operated laundry facilities. If our offer is accepted we’ll ask the seller to verify the vacancy rate by giving us a certified rental history.
- property taxes,
- management fees (if you’re not going to self-manage)
- tenant search and advertising fees
- cleaning, and
- pest control.
The cash-flow analysis for the property we’re looking at lists property taxes at 8.5%, which should be easy to verify on the county tax assessor’s website. Repairs and maintenance are 2.5% and miscellaneous expenses, including insurance, are .66%. Current net operating income on the property is about $30,000 for the year. If we decide to hire a property manager, we’ll need to calculate the estimated property management fees and deduct them from that amount.
Now that you know your NOI you can use it to complete the other critical analysis, your property’s cash flow. The cash-flow analysis is useful because it estimates how much we’ll be clearing or paying each month for the property, after everything has been taken into account. The formula for cash flow is:
NOI – (debt + capital expenditures)
We’ll be taking out a loan to buy the property, so to figure out cash flow we need to plug in the mortgage payment and related debt service we expect to be making. I just googled “mortgage calculator” and plugged in our loan term, loan amount, and interest rate to get our monthly payment.
Capital improvements are another story. In the cash-flow analysis the seller gave us, nothing is set aside for capital improvements, which makes me pause. How much has he spent on capital improvements in the past if he doesn’t include them in the future analysis? The building is an older one. We’re planning on updating all the units, but we have yet to find out about the roof, appliances, HVAC, or other major systems because we haven’t had an inspection yet. So, assuming the seller accepts our offer, we’ll be relying a lot on what shows up in the inspection.
So for now, we’re in a bit of a wait-and-see pattern, and that’s to be expected. Plugging in the numbers we have available, and based on current rents, it looks like we’ll have about a zero cash flow, so the income on the property will be paying for all the associated expenses, including the debt. However, we have nothing set aside for capital expenses. If the seller accepts our offer, we’ll do our due diligence during the feasibility period and have the property inspected to get a handle on what our future capital expenditures are likely to be.
Even if you haven’t been given a cash-flow analysis by the seller, you can try estimating yourself using All Property Management’s rental property investment calculator.
Have you ever bought a rental property? Which documents did you find the most useful in the early pre-offer stage?