One of the most misunderstood and commonly mistaken terminologies in real estate is cash flow. Every person and every business requires cash flow in order to survive. The question to ask is: what kind of cash flow are we talking about?
When I first started real estate investing, I remember this scenario as a perfect example of how a novice can misunderstand the principles of cash flow and land up in big trouble a few months later. Here’s the story:
We received a call from a business associate just starting out in real estate. He called to run the numbers by us to make sure the deal was as good as it looked on paper. He was buying a pre-sale condo and there was huge cash flow: a thousand dollars a month. We let him gush about the deal in order to vent his emotional fervor. This was red flag number one. Emotions never dictate a deal: only fundamentals. He was going to make a lot of money. Or so he thought … until we started asking him some clarifying questions.
What type of cash flow is the thousand dollars? Is it gross income, effective gross, NOI or net? Gross Income is the rent. Effective Gross Income is rent plus other income such as laundry and parking and less vacancy allowance. NOI, an acronym for Net Operating Income, is gross rent less operating expenses. Net Cash Flow is NOI less debt service. Debt service is your mortgage payment. Net Cash Flow is the bottom line and for me, this must be positive cash flow.
What is positive cash flow? This is the continuous flow of money over and above expenses and debt service that is deposited into your account every month just like a pay cheque. Positive cash flow equals freedom.
Less than five minutes later, we figured out quickly that our friend had neglected to deduct strata fees, property taxes, utilities, repairs and maintenance, factor in a vacancy allowance and – most importantly – his mortgage payments.
From a author_link perspective, the deal was a money drain. He would have been subsidizing the condo about $500 per month. This comes to $6,000 out of pocket expenses a year later. He didn’t have the fortitude to flip the property a year later.
Cash flow is intimately related to expenses. Both cash flow and expenses need to be managed and strategized. Some provinces have rent caps. Alberta has no rent caps which makes it an attractive place to buy investment property. Even so, the market dictates the rent amount. In an uptrending market, rents should always be managed up.
What are two types of expenses: operating and capital. These are some of the fixed operating costs associated with properties:
• Property taxes
• Property insurance
• Property management
• Utilities: water and sewer
• Utilities: electricity and oil & gas
• Repairs and maintenance
• Maintenance service contracts
• Refuse removal
• Vacancy allowance
• Bank charges
• Contingency allowance
A mortgage is not an operating expense. This is a debt service.
These are some of the capital costs associated with properties:
• Hot water tank
• Roof repair or replacement
• Appliance replacement
• Carpet replacement
• Electrical system upgrade
• Fire code upgrade
Capital expenses are capitalized. You cannot deduct 100% of these expenses all at once. This means that only an allowable percentage of the capital expense can be deducted each year similar to the capital cost allowance deductions for automobile deductions.
Owners of multi-family dwellings have a choice between creating an operating or capital expense. How? Suite by suite repairs and maintenance such as replacing the carpet and painting can be expensed. Replacing the carpet throughout the building and common areas or painting the entire building is a capital expense. These decisions are made in conjunction with our Bookkeeper and Chartered Accountant.
One of the most important calculations is the investor’s bottom line: their Cash-on-Cash Return. This is calculated using the Net Cash Flow per year and divided by the actual cash investment. Although this is not a true reflection of their total return on investment, it is a very powerful and compelling reason for investors to participate in your investment.
The next time you encounter cash flow issues, you have your clarifying questions to determine what type of cash flow you’re dealing with.