How your financial life is going to change in the next few years, depending on where you are and what you do. Since 2018, cash flow real estate has been the overwhelmingly most important financial metric for any building owner or investor to understand and thrive under. 2019 is no different, but that doesn't make it any easier.

As everything slows down due to slower spending rates and as interest rates continue to slowly rise up across the nation, cash flow will be a key factor in deciding who comes out ahead versus who falls behind financially moving forward for all US real estate investors (REI) alike.

What Is Cash Flow?

The definition of cash flow is very simple. It is the difference between your income (including rent, mortgage payments, etc.) and your expenses (mortgage payment, taxes, insurance, HOA dues). The greater the difference the better! Using an example will help you understand why cash flow matters.

This could happen for a property that was purchased at $500,000 with a tenant paying $1,500/month in rent. Both of these examples will yield the same net amount on a month-to-month basis. However, on an annual basis,, there is an enormous difference in terms of net equity growth.

The example deals with only a single purchase but spreads over a lifetime of deals- where all the different income, expense, and property management scenarios are dealt with. This spreadsheet has cash flow calculations over hundreds of different investment scenarios involving monthly and annual income, expense and property expenses. All scenarios have been tested and verified against actual real-world properties (including some mistakes I made).

Cash Flow = (Income - expense) / purchase price

So why is cash flow real estate so important to real estate investors?

Because it directly impacts your ability to grow one of the most important financial metrics in real estate-net equity. Net equity is simply the difference between what your property is worth and what you owe on it (the mortgage).

The greater the net equity the more wealth you have created and the more opportunities for other investments become available. This is because you can use your equity as leverage for other transactions like pay down debt, make additional investments or just retire/consolidate future years of expenses.

Mortgage Payment = Mortgage Payment - Cash Flow = Net Equity.

Cash Flow is what makes up net equity for property investors.

Net equity is the difference between your mortgage's principal balance and the cash that goes in it each year, right? So if you have a negative cash flow, you have to borrow money to make up for it. And if your mortgage payment is more than your cash flow, then you borrow too much! What good is a house if you can’t afford to make payments?

There are two types of cash flow: positive and negative. These are represented by the green and red bars seen in the example above. The key to understanding cash flow is to understand that it is highly dependent on both income and expenses (the yellow section). For every dollar of net income that you make, more money comes into your pocket each month. Likewise, for every dollar of expense you have, it reduces the amount of money you have leftover at the end of each month.

Positive Cash Flow Real Estate

When you are able to earn more than your expenses, then you have a positive cash flow. This is represented by a red bar with a larger amount of red than green (the differences between income and expenses). This is good news for building owners because it means that you are able to cover your expenses without having to borrow. You are able to put money in your pocket each month, which means you can invest and retire more.

Negative Cash Flow Real Estate

When expenses exceed income, then you have a negative cash flow. This is represented by a red bar with a smaller amount of red (the differences between income and expenses) than green. This is bad news for building owners because it means that you will have to borrow money from one source or another in order to make up the difference each month. This can create huge problems such as paying interest, payday loan fees, etc.

However, if you borrow from a bank or by taking on a loan with your property, then it is not so bad because as long as you pay back the money with interest, then you made money. The interest that you pay back is actually interest on your income- which is pretty good. What is considered bad about borrowing money for a negative cash flow deal is that there are other costs involved in the transaction- such as points and fees- that may be unexpected.

In addition, the problem with borrowing money, in general, is that it requires some sort of action to be taken on your part. In other words, you can only do this if you actually have the money or have permission to take out a loan.

Tax Advantages Of Positive Cash Flow

It should be clear by now that positive cash flow deals are much better than negative cash flow deals. That is because negative cash flow deals require some sort of action to be taken in order for you to continue receiving money. In some cases, it may be necessary to take out a loan. But in most cases, you do not have to do anything. This gets back to the point of positive cash flow deals because you do not have to borrow any money for a positive cash flow deal. That means that when you are able to earn more than your expenses, then you are able to just keep receiving income without having any expense on the monthly or annual level (negative cash flow). Positive cash flow deals are great because they allow you to continue making money with no cost or action required on your part!

What's great about positive cashflow deals is that they provide a way for investors to retire/consolidate expenses and begin their investment cycle again. If you cut your expenses and earn more than enough to cover them without having to borrow, then you can then put that money into more income-producing properties. This is considered rollover equity and rolling over cash flow.

Cash Flow Metrics

There are various metrics used to measure the cash flow of a real estate deal. The best cash flow metric is net income (NI). Net income is simply your income minus your expenses. You can calculate your NI by adding up the total of all of your monthly recurring cash flows and subtracting the total of all of your monthly recurring expenses.

Net Income = Total Income - Total Expense

This is a great metric because it measures how much money comes in each month compared to how much money goes out. If you have a high net income, then you are able to retire/consolidate more expenses or make additional investments than if you had a low net income. If you have a high net income but low expenses, then you can make some investment that will yield a good return that will increase your cash flow.

Cash Flow = Net Income + Cash Flow from Non-Recurring Sources

Cash flow from non-recurring sources is what the money is coming in from. These sources include money that comes in for free or at a discount compared to your normal pricing model (inventory, trade-ins, etc.) and is not dependent on your income. This includes your previous investments and the returns that they earned which may not have resumed producing any more cash.

If you have good cash flow from non-recurring sources, then you can cut down your expenses or start investing in other income properties. Cash Flow = Net Income + Non-Recurring Investments (Non-Recurring Cash Flow).

This is similar to positive cash flow real estate except these are investments that have already been made and do not generate any additional income. This may include a refinance on an existing property, deals that are not performing as they should, and more. The key difference between cash flow from non-recurring investments and positive cash flow is that your cash flow will be negative for the first year.

Cash Flow = NET INCOME + (Non-Recurring Investments - Close Deals/Invest)

This is similar to positive cash flow in that it is just a combination of your non-recurring investments minus the deals you have closed. However, if you have a negative cash flow, then this is the formula you would use to calculate your negative cash flow. This formula should not be used unless you are trying to calculate the negative cash flow for a year when there was an abnormally high or low expense or income. The total must be positive at the beginning of each month and then steadily decreases in value until it hits zero.

Some building owners make the mistake of borrowing money from a bank to cover their expenses. The problem with this is that the bank will charge you interest on the amount that you borrowed, so it is not actually free money. Some building owners think they are getting a good deal by doing this, but their cash flow stays at zero. Banks are very good at selecting bad deals for loans. If your cash flow does not increase after you have done this, then it can be time to renegotiate with the bank or do something different.

Recurring Expenses vs Non-Recurring Expenses

There are two types of expenses: recurring and non-recurring expenses. Both are important to take into consideration when calculating your cash flow, but non-recurring expenses are more important than recurring expenses. Recurring expenses include insurance, property taxes/assessments, and any payments that you have to make every month. On the other hand, non-recurring expenses include specific one-time costs.

For example:

Cash Flow from Non-Recurring Sources When calculating your cash flow from non-recurring sources, it is important to recognize the difference between a good source of income and a bad source of income.

Good Source:

Any extra money that you receive from an investment or deal that is not a part of your normal business. This would include things like:

Bad Source:

Any extra money that you receive from an investment or deal that is a part of your normal business. For example, if you buy a property and then sell it immediately for a profit, then the profit is not considered a good source of cash flow. The property was part of your ordinary investment portfolio, so the profit should be included in your closing costs (when calculating positive cash flow). This is because it was basically free money for you to make and not related to any of the work that you did in order to gain profit.

The amount of the cash flow is equal to your net income plus the cash flow from non-recurring sources minus what you pay to service your debt. This formula is the same one used for positive cash flow. To calculate negative cash flow, you would simply subtract the negative amount of your recurring expenses from your net income.

Net Income x 1 - Cash Flow From Non-Recurring Sources = Negative Cash Flow.

You should consider using this formula for all of your calculations so that you can compare all of them against each other and see which formulas give you the biggest wins.

For more information, you can visit Real Estate Calculators.