What is cash flow?
Cash flow is the foundation of any successful investment strategy, especially if you’re just starting out.
Cash flow simply refers to the rent you take in that exceeds the costs of operating and owning a property – much like running a business.
Real estate investment is not a passive form of investing. Each property you purchase is like a small business with revenue and expenses – both of which you have an opportunity to affect as the landlord.
When you buy stock or bonds, there’s nothing you can do to increase the income you receive from them - the success or failure of your investments depends on those companies’ business strategies.
But with your property you can work on both sides of the equation. Starting out with a business mindset will help new investors find and analyze potential income properties that support their overall business plan.
Become a geographical specialist
The first step in developing your own business strategy is to identify economically strong areas to invest in. After you’ve found good investment cities select one or two areas (preferably ones close to you) and limit your investments to just those areas.
Many novices buy real estate anywhere they find a deal. The major problem with that strategy is that investing takes a lot of research to do it properly. So every time they buy in a new community, they either spend too much time getting to know the city’s local economy and real estate market, or they don’t spend enough time, which leads to lost revenue and opportunities.
So when you become a geographical specialist you’re not only saving time, you’re also saving money. Sticking to places you know helps you to make deals faster because you know what the tenant profile of the area is, what the property management costs are on average, and how much rent you can get for different property types.
The cash-zone formula
For real estate investors looking for positive cash flow properties, the cash-zone formula (cash flow formula or cash flow calculation) is a good rule of thumb for calculating cash flow:
The cash flow formula = (gross annual rent/purchase price) x 100 = cash flow zone percentage.
For example, you are looking to purchase a property for $200,000 and you’ll be getting $1,500 a month in rent. When you divide the gross annual rent of $18,000 by the purchase price of $200,000, multiplied by 100 you should end up with nine per cent. That’s a clear indication that the property is worth looking into further because any properties that fall between eight and 10 per cent should generate positive cash flow. Any properties over 10 are guaranteed to, while anything under eight typically won’t.
Investors sometimes fall in love with a property and convince themselves that they can make it work, even when the numbers don’t add up, but the rule takes all the guesswork and emotions out of making an investment decisions. And it saves time.
Investors cannot sift through thousands oflistings doing detailed financial examinations on each, when the next day there’ll be hundreds of new ones posted on the Internet. So the cash-zone formula simply helps investors narrow their property search down to those properties that are really worth looking into, while leaving the more extensive number-crunching for when you’re getting serious about buying.
Remember, when you’re looking for properties, it pays to find ones that provide additional opportunities to generate cash flow. For instance, say that $200,000 property we were talking about earlier is a single-detached unit with a detached garage. If you could rent out the basement for $600 a month and the garage for $200 a month, you could be getting as much as $2,300. Now, if you redo the cash-zone formula, you should have roughly 14 per cent, which guarantees the property will generate positive cash flow. However, finding a property like this is admittedly rare.
In fact, the reality is that roughly 90 per cent of the properties in the country won’t fall into the cash-zone range. Because this is the case, it demonstrates that it’s even more important for you to be actively involved in a specific real estate market so you can find deals on positive cash flow properties as soon as they become available.
Once you’ve identified a potential income property, you need to calculate the expenses and the net cash flow your property will produce. Have a checklist to go over for every property to reduce the risk of forgetting an expense which can shrink your cash flow.
Even if you hate math this is the most crucial step in determining if the property in question is worth purchasing.
Money for a rainy day
In addition to all the typical costs associated with purchasing and owning a home, such as the mortgage payment and the utilities, real estate investors will need to factor in money for repairs, maintenance and vacancies.
To prepare for vacancies, you should use the vacancy rate for your area provided by the Canada Mortgage and Housing Corporation to determine the percentage of your monthly rent to hold in reserve. For example, if the vacancy rate is five per cent, you should save five per cent of your monthly rent and hold it in a reserve account to cover a potential vacancy.
Second, you must factor in repairs and maintenance. Typically, you should deduct another five per cent from your monthly rent and hold it in reserve to pay for repairs.
While having to put money out on repairs is unfortunate, it would be even be more unfortunate if you were left scrambling for cash in the event something breaks.
Preparedness includes developing the mentality of a property investor, not a speculator, and doing your homework so that your property selection is based on facts not hearsay. By understanding what you’re getting into and being ready to do the work required to be successful, you’re already half way there.
Costs to factor in
Don’t forget you need to budget for more than just the utilities and the mortgage. Also factor in the:
Staying power fund
Repairs and renovations
Land transfer tax
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