There are so many numbers and acronyms used in assessing the current and potential value of a property – Cap Rates, NOI, ROI, LTV ratios, etc. The list goes on and on. While the jargon and acronyms can seem overwhelming at first, it all starts to make sense once you learn the language of real estate investing. Cash flow is as good a place to start as any. Cash flow, after all, is exactly what investors are hoping to achieve. While the concept is a basic one, inexperienced investors are sometimes fooled by property analyses and pro forma statements that tend to overestimate cash flow.
How Do I Calculate My Cash Flow?
On the most fundamental level, Cash Flow = Total Income – Total Expenses.
On a slightly more sophisticated level, Cash Flow = Net Operating Income (net of all operating expenses) – Debt Service (mortgage or other loans).
When utilized correctly, either formula will get you to the number you need, as long as no expense categories are overlooked. When problems arise, it is often because someone either overestimated income, underestimated expenses, or both. That is why experience matters and why new investors are often better off starting as passive investors and leaving the number crunching to professionals.
Expense categories that are often forgotten or misunderstood by novice investors include management fees, tenant improvement costs, vacancy and turnover costs and maintenance issues specific to a property. Every piece of property is unique, with its own set of attributes and requirements.
What Is Pro Forma?
A real estate pro forma statement is a set of calculations estimating costs, expenses and projected returns for a specific investment. The pro forma should offer a cash flow projection based on the best information available. When reviewing a property pro forma, it’s important that the investor undertake a careful review of not only the numbers on the statement, but numbers missing from the statement, as well. Savvy investors know that pro forma review is most useful when accompanied by actual historical data relating to a property. Certified rent rolls, tenant histories and operating statements for at least three years are necessary to verify that the pro forma projections add up and make sense.
Evaluate the Bigger Picture
The goal of every real estate investor is to assemble a portfolio which will, over time, generate positive cash flow and help build wealth. When evaluating a specific property or investment vehicle and looking at cash flow and historical data, investors must also bear in mind their personal goals and have a good understanding of their risk tolerance profile. The perfect investment for one person may result in financial disaster for another. Understanding concepts such as cash flow and owning the ability to assess investments through the prism of personal goals and risk comfort level are key attributes of successful investors.
The best thing about positive cash flow is that it breeds more cash flow. Start investing in real estate when you are young and, at some point down the road, cash flow will not only pay for your living expenses, but will enable you to invest in more properties and generate more cash flow and maybe even retire from your day job at an early age. Instead of working to pay for your assets, put your assets to work taking care of you. That is called financial freedom and it is the ultimate goal of most investors. Why not get started now?
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