Guides

Building Real Estate Cash Flow

Cash flow from an income property generally starts with gross rental income and works down through a series of deductions to reach the actual cash left in an investor's pocket each month or year. Gross potential rent, meaning the rent achievable if the property were one hundred percent occupied at market rates, is generally reduced by a vacancy and credit loss factor to reflect realistic occupancy, producing effective gross income. From there, operating expenses, generally including property taxes, insurance, utilities not paid by tenants, repairs and maintenance, property management fees, and reserves for future capital expenditures, are generally subtracted to arrive at net operating income, commonly called NOI, which is the standard measure used to value and compare income properties independent of financing. Debt service, meaning the principal and interest payments on any loan used to acquire the property, is then generally subtracted from NOI to reach cash flow before taxes, which is generally the figure most investors think of informally as their cash flow. The lease structure a property uses generally has a direct effect on how predictable that cash flow is. Under a triple net, or NNN, lease, the tenant generally pays real estate taxes, insurance, and maintenance costs directly or reimburses the landlord for them, which generally shrinks the landlord's exposure to rising operating costs and makes cash flow more stable and forecastable across the lease term, compared to a gross lease structure where the landlord generally absorbs those cost increases directly against NOI. Multifamily and other property types with shorter lease terms and higher turnover generally carry more cash flow variability, since vacancy, turnover related repairs, and periodic capital expenditures tend to be less predictable than a long term net lease with a single stable tenant. Tax treatment also generally affects the after-tax cash flow an investor actually keeps. A Section 1031 exchange does not directly increase a property's operating cash flow, but by deferring capital gains tax and depreciation recapture that would otherwise be paid at sale, it generally preserves a larger amount of principal to reinvest into a new income-producing property, which in turn generally supports a larger base of cash-flowing real estate than would be available after paying tax on an outright sale. San Diego, CA investors modeling cash flow on a potential replacement property should generally request a trailing twelve month operating statement and a current rent roll before finalizing an identification, since actual historical performance generally reveals expense patterns that a simple pro forma projection can miss. Educational content only. This is not tax, legal, or investment advice.