Cash Flow Simulation for Investors

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If you're considering investing in real estate rental property, there is a lot of research to do.

Real estate investors must have basic valuation skills to make buy, sell, or hold decisions. Along with my experience and knowledge, and by using spreadsheet tools I can produce an adequate valuation on most income-producing real estate. This would include commercial real estate, and residential real estate purchased as residential rental property.

Valuing real estate using cash flow or capitalization methods is similar to valuing stocks or bonds. The only difference is that cash flows are derived from leasing space as opposed to selling products and services. I can help you weed through prospective investment opportunities.

Some other opportunities in the real estate market involves finding properties that have been incorrectly valued by the market. This often means managing a property to a level that surpasses market expectations. A valuation should provide one's estimate of the true income-producing potential of a property.

Properties are valued by discounting net cash flow or the cash available to owners after all expenses have been deducted from leasing income. Valuing a property involves estimating all the rental revenues and then deducting all expenses required to execute and maintain those leases.

All income estimates come directly from leases.All rent and contractual increases in rent (escalations) will be spelled out in the leases, as well as options for space and rent concessions.

• Full-service leases
• Net leases
• Triple-net (NNN) leases

In full-service leases, tenants do not pay anything in addition to rent. In net leases, tenants usually pay their portion of the increase in expenses for the period after they move into the property. In triple-net leases, the tenant pays a pro-rata share of all property expenses. Need help? Contact Bobby Now!

Whether buying or selling, we produce a valuation model accurate enough to assist in the decision-making process.

Owning cash flow properties is really owning a simple business without having to manage the day-to-day operations. And like any business, the owner must still understand the numbers in order to ensure that the investment is performing well, and know what corrective action to take if it is not.

Comparing the cash flow of investment properties is difficult, even for experienced real estate investors.   You may have seen a version of these alluring marketing pitches:

    “$3,000 Annual Cash Flow!” 
    “Get Positive Cash Flow With No Money Down!” 

    “31% Cash-on-Cash ROI!”

But common sense tells us that things that sound too good to be true often aren’t.  How is a real estate investor to know?  A little basic knowledge and some due diligence up front will go a long way in answering this question. Need help? Contact Bobby Now!

  Some due diligence guidelines:

Gross rents (GSI):  Use caution when acquiring properties that have not been leased to a tenant. If you plan to purchase an un-rented property, validate the estimated rent.

Vacancy allowance:  Vacancy rate is a function of many factors, including how often a tenant fails to pay rent, the condition of a home, how long it takes to get a property back in rentable condition after a tenant leaves, how high the asking rent is relative to market conditions, the demand for rental property, the length of the lease, etc.   

Property management:  For single family homes, property management costs 8 – 12% of the actual rents collected.  Markets with higher rents tend to have lower property management fees on a percentage basis.  For properties that are self-managed, this cost is much lower. Good property management is the key to minimizing the vacancy rate.

 Property taxes:  Taxes and tax assessment methodologies vary widely between states and counties within states.  Call the county tax assessor’s office where the property of interest is located to learn how taxes are assessed and collected, and get an estimate for the property in which you are interested. 

Insurance:  Lenders will require that a home carry hazard insurance, sometimes called landlord insurance.  Ask for a quote from your insurance company.  Insurers will want to know how much coverage is desired, the amount of the deductible, and what special coverages are needed.   Special coverage types may include general liability, loss of rents, flood insurance (if the home is in a flood zone), etc. 

Repair and maintenance allowance:  This is one of the most overlooked expense categories, and it can vary widely from year to year.  A recently renovated or a newer home will usually have lower annual repair costs, on the order of 5% of GOI.  Homes that have not been renovated or have significant deferred maintenance pending, such as a roof needing replacement, may experience 10% and up. Need Help?  Contact Bobby Now!

A home inspection will help you understand the condition of the home that you are buying, as all homes require preventive maintenance, repairs and cleaning.

Utilities/other:  Include utility estimates if any utilities are landlord-paid.  In most circumstances, the tenant is responsible for paying the utilities.  Other expenses might include applicable homeowner association (HOA) fees, landlord-paid yard care, etc.

Principal and interest:  This is usually the largest expense category, and is a function of the size of the mortgage, interest rate, and amortization period.  Cash flow is improved by putting a larger amount down and borrowing less. If you need a lender to learn about current interest rates and about buying down (lowering) the interest rate by paying points, it would be my pleasure to refer you to one of my top lenders.

Interpreting Cash Flow

An investment metric related to cash flow which is commonly misunderstood is cash return on investment (ROI), sometimes called cash-on-cash ROI.  Cash ROI is the annual before tax cash flow (BTCF) divided by the total initial out-of-pocket cash investment in the property.  The initial cash investment is the sum of the down payment, closing costs, and the cost of initial upgrades to the property, if any. 

Importantly however, negative cash flow does not necessarily mean the investment is a poor one.  If the cash flow is negative and the investor can afford it, it may be worthwhile if the expected appreciation is exceptional.

Many sellers include depreciation benefits in their cash flow calculations in an attempt to derive after-tax cash flow (ATCF), as it makes the cash flow numbers look better. Consequently it is recommended that cash flow be compared on a before-tax basis excluding depreciation.  This will provide an undistorted picture of the comparable performance of one property to the next. 

In the end, it is critical when comparing cash flow on investment properties to measure cash flow in an accurate and consistent manner so that comparisons are made “apples to apples”.   After factoring in appreciation and pay down of the loan, I can help you make an informed, lower risk decision when purchasing investment property that will deliver exceptional returns.  Need Help?  Contact Bobby Now!

**A special thanks to James Kimmons**