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3 Categories Of Items For Calculating Rental Property Cash Flow
When it comes to investing in rental property, cash flow is undoubtedly the name of the game.
Yet it is something to be reminded of as many new investors enter the world of real estate without clearly defining their investment strategy.
Is it an appreciation play? Or a rental play? Is it a fixer-upper? Or a loser?
Some don’t even think so far and consider that success and profits are a given as soon as they acquire real estate for investment!
If you are still unsure of the most important criteria when evaluating rental property, let’s say this once and for all that cash flow is king.
If for example your acquire a turnkey property ready for move-in, it is critical to work out whether rental will contribute enough positive cash flow to be profitable.
While the biggest expense item is often the mortgage, there are various other items that play a crucial role in determining the amount of cash inflow or outflow you have to work with.
Before going into 3 categories of expenses to keep in mind when tabulating cash flow, it is important to recognize that you are evaluating rental property meant to generate income via rental collections.
I say this because there will be times investments seem to make little financial sense on the surface, yet will clearly generate profits when looked deeper.
For example, a leasehold house might be quickly losing market value as it approaches the final 20 remaining years of it’s life. In this instance, some real estate investors might find it ridiculous to acquire no matter how cheap it is. But if it is in an area that will continue to experience high rental demand, the rental income can usually cover the initial capital with more to spare.
On the other hand, investors who are focused on capital gains will be less afraid of negative cash flow when property value is projected to appreciate greatly over the years.
With that in mind, these are the 3 categories of cash flow items to be meticulous with in order to come up with as specific number as possible.
1) Deductible noncash expenses
The concept of depreciation be difficult to grasp for new investors with little to no accounting background.
Depreciation is an expense concerning the loss of value on assets. In this case, specifically the property.
It is a paper expense that you can include in your financial statements without actually paying it.
This means that the bigger your recorded depreciation, the more you improve your cash flow.
To better illustrate this, let’s say you have $10k in the bank at the financial years after generating $100k in income and $90k in expenses. If you add $4k depreciation expense into your books, your profits will come down to $6k remaining.
$6k will then become your taxable income, yet you actually still have $10k balance in the bank! This in essence, and effectively, improves your cash flow by $4k!
Do talk to a qualified accountant before determining depreciation expenses.
Most assets are legitimately eligible for depreciation including:
However do note that depreciation cannot be deducted from the value of land.
2) Deductible cash expenses
This is the most basic type of cash expense that need little explanation.
These are expense items you incur during the course of doing business and can include things like:
- Mortgage interest payments
- Insurance premiums
- Property taxes
- Utility bills
- Office supplies
- Vehicle installments
- Repairs and maintenance
You might need to check with an accountant familiar with local accounting requirements to determine what items can or cannot be classified as expenses.
Because some expense items are not incurred monthly, one might need to divide the yearly expense by the number of month to determine a projected monthly amount.
This will be required to calculate and forecast monthly cash flow.
3) Non-deductible expenses
Accounting principles can be a riddle that the average person cannot fully understand. Me included.
To have a feel of what non-deductible expenses are, it is best to speak with your accountant.
In essence, these are payments made but are not deductible including:
- Mortgage principal payments
- Initial purchase of equipment
- Written off assets
When in doubt, always check with an accountant. The IRS is not an organization you want to mess with.
Cash flow is ultimately one of the key factors that make an investment in rental property viable or not.
This is why it’s mind-boggling how many investors do not work out the numbers meticulously enough in this area. Some even outright ignore it.
When doing your sums for investment assessment, the more accurate the cash flow you calculate, the easier you can make that decision of whether to invest or not.