Rental Cash Flow

Rental cash flow is the money a rental property puts in the owner's pocket over a period after everything the property costs has been paid, including the mortgage. It is built by starting with the gross scheduled rent, the rent the property would collect if fully occupied and everyone paid; subtracting vacancy and credit loss to reach effective gross income; subtracting the operating expenses of running the property to reach net operating income; and then subtracting debt service, the principal and interest on any loan. What remains is pre-tax cash flow.

No agency or standards body defines the figure, which distinguishes it from the two measures it is most often confused with. Net operating income has an established meaning in appraisal and is the numerator of a capitalization rate; taxable rental income is defined by the Internal Revenue Code. Rental cash flow sits between and outside both: it is an ordinary arithmetic result whose value depends entirely on how completely the person computing it lists the costs.

Cash-on-cash return is the ratio built directly on it: annual pre-tax cash flow divided by the cash the owner actually put in, meaning the down payment plus closing costs plus any money spent to get the property rentable. Where a cap rate describes the building, cash-on-cash return describes the owner's own position, because the financing that a cap rate deliberately excludes is exactly what this ratio includes.

The most common error is subtracting only the mortgage payment from the rent. That calculation omits three separate things, each of which is real. The first is vacancy and credit loss: a property is not occupied every month of every year, and some rent that is owed is never collected. The second is the operating expenses, which include property taxes, insurance, management, routine maintenance, any utilities the owner pays, and association dues. The third is reserves for capital expenditure, the roof and the furnace and the water heater that fail on a schedule of their own and are not a monthly bill until the month they arrive. A calculation that treats a good month as the typical month is not optimistic, it is incomplete.

It is not net operating income, and the difference is one line. Net operating income stops before financing. That is deliberate, because a cap rate is meant to describe the property rather than the buyer, and two buyers of the same building at the same price have different loans. Rental cash flow carries on and subtracts the debt service, which makes it specific to one owner's financing. This is why a property with an attractive cap rate can still produce no cash: if the borrowing cost is above the property's own yield, the debt takes more than the property produces.

It is not taxable rental income either, and the two can point in opposite directions in the same year. For tax, depreciation is deducted, and mortgage interest is deducted while the principal portion of the payment is not. For cash flow, the whole mortgage payment leaves the bank account and depreciation never does. So a property that produced positive cash can report a taxable loss, and a property near the end of its depreciation schedule can report taxable income larger than the cash it generated. Neither result is an error; they are different questions, and the answer to one is not evidence about the other.

The ratio built on it, cash-on-cash return, is sensitive to leverage in both directions. Dividing annual cash flow by cash invested gives a percentage that rises with borrowing when the loan costs less than the property yields and falls, all the way through zero, when it costs more. That is the same mechanism that makes a cap rate silent about the buyer, seen from the other side: the cap rate refuses to look at the loan, and cash-on-cash return looks at almost nothing else. Neither number is complete alone.

Two honest cautions about the figure. It is pre-tax, so it says nothing about what the owner keeps after the return is filed. And it is a single-year snapshot of a business whose costs arrive unevenly: a year with no turnover and no capital repair produces a flattering figure, and the average of several years is a better description of the property than the best of them.

Work down the page in four steps and do not skip a line because it did not occur this year. Start with gross scheduled rent, every unit's market rent for twelve months as if fully occupied and fully collected. Subtract vacancy and credit loss, a percentage of gross rent reflecting turnover and non-payment, and the remainder is effective gross income. Subtract operating expenses, meaning property taxes, insurance, management, maintenance, owner-paid utilities, association dues and a reserve for capital expenditure, and the remainder is net operating income. Subtract debt service, twelve months of principal and interest, and the remainder is pre-tax rental cash flow.

A hypothetical example. A rental house is bought for $360,000 with $90,000 down, $7,200 of closing costs and $6,800 of repairs before the first tenant, so the cash invested is $104,000 and the loan is $270,000 at 7 percent over 30 years.

Gross scheduled rent is $3,000 a month, or $36,000 a year. Vacancy and credit loss at 6 percent is $2,160, leaving effective gross income of $33,840. Operating expenses are property taxes $4,320, insurance $1,560, management $2,880, maintenance $2,160, capital reserves $1,800 and association dues $600, totaling $13,320. Net operating income is therefore $20,520, and the capitalization rate is 5.70 percent ($20,520 divided by $360,000).

The mortgage payment is $1,796.32 a month, or $21,555.80 a year. Pre-tax rental cash flow is negative $1,035.80 ($20,520 minus $21,555.80), and cash-on-cash return is negative 1.0 percent on the $104,000 invested. The property yields 5.70 percent and the money to buy it costs 7 percent, so the loan takes more than the building produces.

Now the naive version, for contrast. Rent of $36,000 minus the mortgage of $21,555.80 is $14,444.20, which looks like a comfortable result. The gap between that and the real figure is exactly $15,480, which is the $2,160 of vacancy plus the $13,320 of operating expenses. Nothing was hidden; those two lines were simply left out.

And the same property bought for cash. With no loan, the owner's cash invested is $360,000 plus $7,200 plus $6,800, or $374,000, and the annual cash flow is the full net operating income of $20,520, a cash-on-cash return of 5.49 percent. Same building, same rent, same expenses, and a result that moves from negative 1.0 percent to positive 5.49 percent purely on the financing.

Pros

• It answers the question an owner actually has, which is whether the property produces money rather than what the building is theoretically worth.
• Because it includes debt service, it captures the effect of financing, which a cap rate deliberately excludes.
• Divided by cash invested it becomes cash-on-cash return, which is directly comparable against the return on any other use of the same money.
• Building the figure forces every cost line onto the page, which is where most of the value in the exercise is.

Cons

• It has no standard definition, so two people can compute it honestly and get different answers depending on which costs they included.
• Reserves for capital expenditure are the easiest line to omit and the one that most flatters the result.
• It is a single-year figure for a business with lumpy costs, so a quiet year reads far better than the property deserves.
• It is pre-tax, and the after-tax result can differ substantially because depreciation and the principal portion of the payment are treated in opposite ways.
• A seller's stated figure is an estimate the seller prepared, and the expense line is the easiest number in any listing to understate.