The term “cash flow” is widely used, but commonly misunderstood in a commercial real estate context. We want to clear it up.
In this article, we are going to define exactly what cash flow is, how it is calculated, the different types that may be used, and why it matters in the analysis of a commercial investment property. By the end, readers will have a greater understanding of how cash flow impacts the valuation of a commercial rental property and will be able to use this knowledge as part of their own pre-investment due diligence process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of our own pre-investment due diligence process, we invest a significant amount of resources into accurately projecting cash flow for all of our potential acquisitions. If you are an Accredited Investor and would like to learn more about our current commercial property investment opportunities, click here.
What is Cash Flow in Real Estate Investing?
“Cash Flow” is a catch-all term that is typically used to describe the amount of income that a property produces after all operating expenses have been paid. While helpful to provide an indication of a property’s potential profitability, it is overly simplistic. In reality, there are two terms that provide more specific information about potential profitability: Net Operating Income (NOI) and Cash Flow Before Tax.
Net Operating Income is the “operating profit” produced by a property and it is calculated as gross income less operating expenses. NOI is important because it is the number from which commercial property values are derived
Cash Flow Before Tax is calculated as Net Operating Income less debt service. This figure is important because it typically represents the cash that is available to be distributed to investors. Typically, this is what investors mean by the more general “cash flow” term. For the remainder of the article, the terms “cash flow” and “cash flow before tax” are used interchangeably.
Positive Cash Flow vs Negative Cash Flow
Depending on the specifics of an investment property’s performance, cash flow can be positive or negative.
If cash flow is positive, it means that the rental income produced by the property is enough to cover both operating expenses and debt service and still have a positive number left for distributions. For example, if a property produced $100,000 in rental income and had $50,000 in operating costs and $25,000 in debt service, the remaining cash available for distribution would be $25,000 – a positive number.
If cash flow is negative, it means that rental income less operating expenses and debt service results in a negative number. If the rental income for the same property was $100,000, but operating expenses were $80,000 and debt service was $25,000, the resulting cash flow available for distribution is ($5,000). Negative cash flow may be OK for a short period of time while renovations are being completed or while a property is being leased up. But, sustained periods of negative cash flow are usually bad news for commercial real estate investments.
Simplified Cash Flow Statement Example
To illustrate how cash flow is typically calculated, an example is helpful. For simplicity’s sake, assume that a real estaten investor is considering the purchase of a single tenant, triple net leased property with 10,000 square feet that is leased for $10 per square foot. In this scenario, the cash flow statement may look something like this:
|Gross Rental Income||$100,000|
|Effective Rental Income||$100,000|
|Legal, General, and Admin.||$5,000|
|Total Operating Expenses||$55,000|
|Net Operating Income||$45,000|
|Lender Debt Service||$30,000|
|Cash Flow Before Tax||$15,000|
In this scenario, the Net Operating Income of $45,000 is an indication of how profitable the property is from operations. To this metric, a capitalization rate (cap rate) is applied to determine value. Because it is done before debt service, it also provides a handy way for real estate investors to compare the operational profitability of one property to another.
After debt service is paid, the property has $15,000 in cash available before taxes are paid. This number also represents cash available for distribution to investors.
The Importance of Understanding Real Estate Cash Flow
The basic premise of a CRE investment strategy is that an investor is willing to allocate some amount of money to the purchase of a property because they expect that they will earn a return on investment. So, understanding a commercial property’s cash flow is important because it is key to understanding the rate of return that an investor could earn – most commonly measured by a metric known as the “cash on cash return.”
Cash on cash return is calculated as the amount of cash received in a given period divided by the amount of the initial investment/down payment and it is typically measured on an annual basis. For example, if an investor allocates $100,000 to a real estate property and receives $5,000 in distributions in the first year, their cash on cash return is 5%.
Cash flow may also be used to calculate other metrics like Internal Rate of Return (IRR) and equity multiple.
What Factors Impact Cash Flow?
Given the importance of cash flow in the performance of a commercial real estate investment, it is helpful to understand the factors that impact the amount of cash flow a property produces.
On the income side of the ledger, rent is the single most important factor when determining the amount of cash flow a property produces. Since rental income is derived from the amount of contractual rent that a tenant is required to pay, it can go up or down based on market conditions. So, when a tenant’s lease comes up for renewal and the market is strong, it may be possible to raise the rent which can lead to more cash flow. But, if conditions are negative, it may be necessary to lower the rent to keep the tenant from moving to a competing property.
Rent isn’t the only source of income for many properties. In some cases – especially multifamily properties – there may be ancillary charges that must be paid by tenants for things like pets or parking. If an investment property does not charge for these things, starting to do so may be a good way to boost cash flow.
In an ideal scenario, a property is always 100% full with tenants who pay their rent on time. But, this is more the exception than the rule. When a tenant decides to vacate their space, it may take some amount of time to find a new one. During this interim period cash flow may be impacted due to the lost income of not having a rent paying tenant.
Repairs and Maintenance
Repairs and maintenance are routine expenses that are required to keep a property in good operating condition. While necessary, they reduce the amount of cash flow available for distribution. However, repair and maintenance expenses can become especially problematic for cash flow when there are surprises that weren’t planned for. For example, if the entire air handling system breaks down and it is going to cost $20,000 to fix it – there is a significant, unplanned impact to cash flow.
Utilities expenses are those associated with power, water, and sometimes other things like trash pickup. They are normal for the operations of a property and reduce cash flow so property owners are incentivized to reduce them where possible.
Operating expenses are those normal and routine expenses required to operate a property on a day to day basis. They include things like legal and administrative expenses, property management, or landscaping. Because these reduce cash flow, property owners must find a balance between keeping the property in good operating condition and minimizing these costs to the extent possible.
Missed Rent & Property Vacancy
Missed rent can reduce cash flow in two ways, First, the lost income can cause cash flow to be less than expected. But, missed rent can frequently trigger other expenses – like legal – that are required to collect the missed or late rent. So, in a way this is a double whammy for cash flow.
Property management costs are those associated with the day to day management of a property for things like collecting rent, making repairs, or leasing the space to new tenants. Property management costs can be paid to a third party manager or they can be reduced by self-managing the property.
Property taxes are fees that must be paid to local municipalities for the use of common amenities like roads, water, and sewer. They reduce cash flow and can rise significantly when a property is sold to a new owner (based on the purchase price). For this reason, they must be accounted for when buying a property.
Every property needs insurance to protect themselves from financial loss in the event of theft or damage from a natural disaster like a hurricane. The policy premium reduces cash flow, but is necessary to prevent a major, unexpected expense.
To summarize, any sort of income that a property produces, either from rent or other means can increase cash flow. While any expense can reduce it. With this in mind, there are a number of strategies that investors can employ to increase cash flow.
How Can Investors Increase Cash Flow?
There are three ways that investors can increase the amount of cash flow a property produces: increase income, decrease expenses, or both. Below are some techniques that are commonly employed to increase a property’s cash flow.
Whether due to inflation or favorable market conditions, the long term trend for rents is usually up. So, when a tenant’s lease comes up for renewal, property owners should review market conditions and raise rents if possible. In addition, they may add a clause to the lease that calls for periodic rent increases at regular intervals over the term of the lease. For example, it could be 3% annually.
Encourage Long Term Tenants
In many cases, it may be worth it to charge slightly lower rent in the short term in exchange for a long term lease commitment. For example, a property owner could charge $10 PSF for a 5-year lease, but may be willing to go down to $8.50 if the tenant signs a 10-year lease. It may actually lower cash flow in the short term, but periodic rent increases and the long term nature of the lease means that it will provides stability over time and reduces costs associated with tenant turnover – hopefully a net increase for cash flow.
Appeal Property Taxes
Typically, property taxes are based on an assessment of the market value of a property. So, in a down market, investors can save money by appealing their property tax bill and asking for a reduction. In some cases, they may even hire a third party service to help with this. The property tax savings can increase cash flow.
In a so-called value-add investment strategy, a property is purchased for a good price and capital is invested into renovations and improvements with the hope of increasing rent and/or reducing vacancy. Either way, cash flow can increase.
Although it may require some investment upfront, conducting preventative maintenance on major systems like air handling, electrical, and plumbing can save a significant amount of money down the road by preventing a major, surprise expense – thus increasing cash flow.
Perhaps one of the most popular ways to increase cash flow is to develop new revenue streams beyond just rent. For example a multifamily property could add application fees, install vending machines, convert unused space into rentable storage lockers, or charge additional rent for tenants with pets.
Or, in the types of real estate deals that we specialize in, we may buy a shopping center and then develop the outparcels and rent them to banks or quick service restaurants to generate more revenue.
Manage Operating Expenses
Increasing cash flow isn’t just about increasing revenue. It can also be about reducing expenses. For example, we have our own in house property management team so we typically insource this responsibility, driving cost savings and improved cash flow for our investors. Or, it may be wise to renegotiate service contracts for things like landscaping and maintenance or to invest in technology that will allow for a smaller onsite team.
As this section describes, there are a number of ways that commercial real estate investors can increase cash flow. The key is to be creative and fair so as to not overcharge tenants.
What is The 1% Rule When Determining Cash Flow in Real Estate?
Analyzing a commercial property can be incredibly time consuming. So, investors sometimes face a difficult choice. Do they want to invest the time to build a detailed cash flow model only to find out they aren’t interested in the property? Or, can they do a quick test to determine if there is enough interest to do a more detailed analysis. The 1% rule is the answer to the second question.
The 1% rule states that a property’s monthly rent should be at least 1% of its purchase price in order for the property to break even. So, if a property has a $1,000,000 purchase price, it should generate at least $10,000 in monthly rent to break even. If it generates this amount or more, this may be a positive indication that it is worth proceeding to more detailed analysis.
Summary of Commercial Real Estate Cash Flow
The term “cash flow” is commonly used to describe the amount of money produced by a property. But, this is a general term that ignores some of the more important nuances in commercial real estate analysis. Net Operating Income and Cash Flow Before Taxes are the more specific terms used.
Net Operating Income is the specific term used to describe the amount of income produced by a property on an operating basis. It is calculated as gross income less operating expenses.
Cash Flow Available Before Taxes is Net Operating Income less debt service and it represents the money that is available to distribute to investors each month or year.
Given its importance in determining returns, investors are strongly incentivized to maximize the amount of cash flow a property produces. Some ways to do this could be to increase rent, decrease expenses, or both.
Interested In Learning More?
First National Realty Partners uses its expertise to find world-class properties and multi-tenanted assets below intrinsic value. Our strategy and due diligence help us secure long-term returns for our partners and one of the key components of our success is properly managing a property’s cash flow.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.