February 16, 2009

Cash Flow Investors

For any business to be successful it must produce cash flow sufficient to cover expenses and generate profits. The amount of cash flow generated by real estate is often dependant on the amount of the down payment. For example, an investor that pays for the property without taking out any mortgage will generate cash flow except in times of vacancy. A $200,000, three bedroom, 2 bath home that leases for $1200 per month will generate cash flow less amounts set aside each month for property taxes and maintenance.

Most investors, however, will want to take advantage of the principles of leverage which accelerates the cash-on-cash return on investment. Cash flow investors want each property to generate a positive cash flow when expenses are deducted from monthly rental income. The amount of cash flow is determined by the amount of the deposit, interest rate, and the period of the loan.

For example, a $200,000 home with a 10% downpayment ($20,000), $1100 in annual property taxes, $450 annual insurance policy, 30 year amortization, and an interest rate of 6.0% would have a mortgage payment of $1208.00. If the rent is $1200 per month less a 10% management fee, the investor’s cash flow would be $1,200 - $120 = $1080. In order to pay the mortgage of $1208, the investor would need to supplement with other cash flow or reserves the monthly payment each month. If there was a vacancy or maintenance to be done, the deficit would be even greater.

Cash flow investors want to make sure that each property produces sufficient cash flow so that if rental rates decline, vacancies occur, or if maintenance is required, then they still have cash flow to cover those expenses without drawing money from other sources. The way they do that is increase the downpayment to reduce the monthly mortgage payment and to use insurances (property and home warranties) to control maintenance expenses. By increasing the downpayment to 20% ($40,000) the monthly mortgage payment reduces to $1,089. Increasing the downpayment to 30% ($60,000) the mortgage payment reduces to $969.00.

Cash flow investing is the safest form of real estate investment because it anticipates market fluctuations and plans for cash flow accordingly. It also uses leverage to increase the rate of return on cash over paying 100% for a property. Without cash flow, a real estate investment can take away from personal resources. For example, in the case of illness, if there was a prolonged period on not being able to work, the cash flow investor would be able to maintain their properties independently.

Posted By: Steve Randall