Monday, March 7, 2011

Cashflow: The Foundation of Investing

Last week we learned about CADA, the 4 advantages of investing in real estate.  We've covered the D, depreciation.  Now it's time to cover the C, Cashflow. 

Cashflow is the first letter in the acronym because it provides the foundation of the investment.  If you don't have your home rented, you will inevitably pay the mortgage yourself or be foreclosed on.  So that's why it is so important to know what your rent and mortgage prior to making offers on homes.

Here's the simple formula for cashflow: Rent - Mortgage = Cashflow.  Simple, right?  You take in the rent by the fifth, pay the mortgage by the 16th, and what you have left is your cashflow.  Store some money aside for maintenance as well as vacancy and you are good to go.  Let's go into each variable of the formula...

Rent- find out what a property will rent for before you make the offer!  How, you ask?  Ask your real estate agent, ask property management companies, compare it to homes that you already own that are rented, and best of attention to every street of the subdivision and call all the "For Rent" signs you see to find out current market rents.  Won't these other homes be your competition once you've bought and rehabbed your home?  I do this every time; guaranteed.

Mortgage- your mortgage payment is normally composed of 4 things: principal and interest (based off your loan amount, interest rate, and terms), taxes, and insurance.  How do you figure out what this will be prior to buying a home?  To find out principal and interest, google "Financial Calculator," or get an app to do it for you.  My favorite app is "CalcsFree."  Find out the taxes from the county website ( or  Insurance?  Just call your insurance company and have them give you a quote or compare it to your personal residence and guesstimate. 

So here's an example of how to calculate cashflow that I did on a real live home that I made an offer on recently: Rent- $1050.  (I have one comp @ $1095 that I've seen...).  Mortgage- $100K @ 5% over 30 years = $536.  Taxes + Insurance = $164 / mt.  Total Cashflow is $1050 - $700 = $350.  $350 is an excellent cashflow because you're making $4200 / year before maintenance and vacancy expenses.  A good rule of thumb in today's market is to use a debt service ratio ( or 1.4  So if your rent divided by mortgage is > 1.4, it's a solid deal.

A good quote from some of my favorite authors, the Real Estate Guys (, "Cashflow controls mortgages; mortgages control properties!"  So keep the cash flowing your way and have fun investing!


  1. Paul, this is a great analysis. Simple, but covering most of the important details. I have one question. You often say "before maintenance and vacancy expenses." Can you comment on your experience with vacancy on your homes? How about maintenance costs?

  2. Paul, Great articles! Glad I found these. You mention debt service ratio. Can you spell out your numbers used for calculating that on this exact example? Good article!

  3. Ben,
    I did a quick calculation given Paul's formula (Cashflow divided by Mortgage) and got a 1.95.
    That far exceeds the 1.4 he suggests.
    Paul, do you know what that 1.4 means? What is it guarding against? Why is that number a way to evaluate debt?

  4. John- a healthy allowance for vacancy would be 1 month per year or 1/12 = 8%. This allows 2 weeks for rehab and 2 weeks for showings and screening of new applicants. My vacancy is much less than this of course but that's a conservative estimate. Also, depending on the situation, the tenant's security deposit can be used to cover vacancy if they violate the lease by their departure.

  5. Ben- Debt service ratio is RENT / MORTGAGE. So $1000 / $700 = 1.4.

  6. Jay- 1.4 means you can cover about 4 mortgage payments with about the months of rent. This indicates the liquidity of your cashflow; so it's guarding against vacancy. It's a way to conservatively account for how much rent a home will generate vs. the mortgage. For instance, if I asked you which of these 2 homes were a riskier investment, which would you say: Home #1: Rents for $800 w/ a Mortgage of $400. Home #2: Rents for $1000 w/ a Mortgage of $800. Home #2 poses a riskier investment because of the amount of the mortgage payment in comparison to the rent. It gives the home a lower debt service ratio.