Many individuals looking for financial freedom take their shot at real estate investing with the hopes they will create a brighter future for themselves and their families. These investors tend to fall into two popular categories; flippers and holders. “Flippers” look to buy properties at a discounted rate, rehab them (if necessary) and quickly re-sell them. “Holders” look for a longer-term strategy to buy properties for the purpose of renting them out to generate cash flow, sometimes eventually selling the property for a profit. Each approach has its own positive and negative aspects; neither is better than the other. However, some investors are better suited for flipping, while others make better landlords.
In order to become successful, you must look at your investment properties as a business. Understanding how your business makes money is imperative to help it make more. Cash flow and real estate profit are both crucial aspects of a business and are both commonly misunderstood. So, is cash flow the same as profit?
Profit & Cashflow in Real Estate – What’s the Difference?
What is cash flow in real estate? Cash flow refers to the total amount of money being transferred into and out of a business. With real estate investing for cash flow, it is equal to the total cash income minus the total cash expense. With rental properties, the total income might just be the same as total collected rent, but it doesn’t have to be. When analyzing a property for cash flow, it is important to list out all sources of possible income. Some examples of how to increase cash flow in a real estate rental property include application fees, late fees, laundry fees, adding storage and parking, allowing pets and even possibly selling advertising space (depending on the location and type of property you have).
Profit is the positive amount of money that remains after subtracting expenses incurred from revenues generated over a designated period of time. This is one of the core measurements of the viability of a business, and is closely watched by investors and lenders. Profit can also come from monthly cash flow of a rental property, but a smart investor knows it’s best to put the cash back into their business in order to turn a higher profit in the long run.
Generate Positive Cash Flow- Get creative
There are many ways to generate a positive cash flow as a real estate investor; get creative! Be sure to do your due diligence when choosing a property; knowing all costs ahead of time is essential for planning monthly expenses and forecasting cash flow. Cultivating a positive cash flow is the most important way to maintain a profitable investment property.
When looking for the perfect rental property, search for comparable properties in the area to get an idea of revenue and vacancies. Be sure to pick a profitable location rather than something that is convenient for you. A “high-demand” area with a good job market is ideal. College towns also provide amazing investment potential being that there is a high and stable demand for housing, which means less vacancies and usually higher rents. Renovations on a strict budget can be a great way to boost your income potential. Any big or small adjustment to a property can increase the value and rental income. Even something as little as a deep clean and fresh paint job can boost your profits.
Calculating the cash flow on a rental property you are considering will help you decide whether or not to explore that investment opportunity further. Here’s an example. Let’s say you are looking to purchase a two-family property which will rent for $1000 per unit, and let’s assume that rent is your only income on this particular property. You would be responsible for paying $150 per month for water/sewage. Let’s also assume that properties such as these average a 6% annual vacancy and roughly 8% of gross monthly rent will be spent monthly on repairs. The mortgage payment breaks down to $600 a month, with property taxes at $1000 a year and insurance at $800 a year.
Income = $1000 x 2 = $2000 per month.
Monthly Expenses :
- Mortgage: $600
- Taxes: $83.30
- Insurance: $66.67
- Vacancy: $144
- Water/Sewage: $150
- Repairs: $160
$1203.97 per month in expenses
Income – Expenses = Cash Flow
$2000 – $1203.97 = $796.03 per month
You may be looking at this monthly cash-flow as profit, which one day may be a possibility. But, In the beginning, like any business, you should put that “profit” back in to your property. Although you may have put money aside for small contingencies and a small vacancy percentage, you must be prepared! What if after a few months your tenants stop paying their rent? They may decide not to pay, but you must if you plan on keeping that property. If you spend your monthly cash flow rather than holding onto it for the property, where will you come up with the funds to pay your mortgage or other fees? What if you only calculated for minor repairs and next thing you know, the entire plumbing or electrical system needs to be replaced? Expect the unexpected!
In addition, your property must be managed. Are you willing to be the go to person if something breaks and the tenant calls? If not, you must hire a property manager to handle the emergencies and day to day issues that come up. Typically, a good property manager will charge at least 5% of gross rents.
Turning a Profit with your Investment Property
Fix and flip properties are the quickest way to turn a profit as a real estate investor. But, if you aren’t sure what you are doing, it could end up costing you. First things first, make sure you know the ARV (after repair value) of your property. Once you know what your renovated property could sell for, it will be easier for you to work with purchase and rehab numbers. You don’t want to invest more than 65% of the ARV purchasing and rehabbing a property. If you go over this number, you’re more likely to see unforeseen expenses and cost overruns eating into your bottom line.
Be sure you know your local market; ask yourself these questions. Are you in an area with rising prices? How is the school system? What are the demographics? When you are well seasoned on the statistical data regarding your area, you’ll have a better idea of your potential profit margins. These questions will also assist you in the rehab aspect of your property. For example, buying a fix and flip property near a school would more likely than not be sold to a family with younger children. For a property like this, make sure there are enough bedrooms and bathrooms. Keep in mind, with every fix and flip you should be rehabbing the house with your buyers in mind. It doesn’t matter what you would like in your home, what matters is what buyers would like in theirs.
Once your rehab is complete, get your property on the market! Make a list of all your updates. Include everything, even something as little as a new garage door opener. When you create value on your property, put it in a binder and leave it out on the counter. You want everyone who walks into the house to know what you did to make it better! Don’t be greedy about the sale price; sure, you put a lot of time and money into this property to make it the best it could be, but if you overprice your property, you risk holding it for longer than you anticipated, costing you more in the long run.
Calculating potential profits before you move forward with your fix and flip property will assist you when deciding whether you’re working a profitable deal. Here’s an example. Let’s say you are looking to purchase a single-family home for $100,000 that needs $40,000 in rehab and has an estimated ARV of $270,000. In order to complete this flip, you are considering using hard money. For this particular loan, you must put down 20% of the purchase price, which would be $20,000; 80% of the purchase and 100% of the rehab will be covered by the loan. Let’s also assume this is your first flip, and with minimal experience, you qualify for 12% interest and 3 origination points on your 12-month loan. To reach the most accurate number, you should also estimate another 3% of the loan amount for closing costs, factoring in property taxes, home owner’s insurance and utilities. Also, be sure to leave room for contingencies! Let’s look at the breakdown.
- Down Payment: $20,000
- Loan Amount: $120,000
- 12% Interest: $14,400
- Origination Points: $3,600
- Closing Costs: $3,600
- Taxes, Insurance, Water/Sewage: $10,000
- Contingencies: $5,000
$176,600 total expenses
ARV – Total Expenses = Profit
$270,000 – $176,600 = $93,400
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Just Do It!
Sometimes the fear of failing, or even fear of the unknown, paralyzes potential investors. Don’t let this happen to you! Regardless of which type of property you choose to start out with as a real estate investor, do your due diligence. Make a plan. Hope for the best, but prepare for difficulty and complexity. Most importantly, always leave room for contingencies. A properly calculated investment could be exactly what you need in taking the step towards financial freedom!
Keep in mind, nothing good ever comes easy! The man on the top of the mountain didn’t just fall there, and you won’t just fall into success. If you work hard, stay consistent, and give it all you have, you can and will reach your goals! Stay on track, manage your time wisely, and use these calculation examples to formulate your potential profit!
Sound like a deal?