Understanding Cash Flow: The Foundation of Rental Property Success

Cash flow is what is left after everything

Cash flow is the money that remains after vacancy, operating expenses, and debt service are all paid. It is not gross rent minus the mortgage. Owners who subtract only the mortgage from rent consistently overestimate returns by 30 to 40 percent, because they have not priced vacancy, management, maintenance, or reserves.

The four lines beginners skip

Vacancy, capital expenditures, management, and turnover are the lines that turn a paper winner into a cash drain. Even self-managing owners should charge management to the property, because your time has a price and one day you will hire it out.

• Vacancy: 5-8% of gross rent in stable markets.
• Capital reserves: 5-10% of gross rent, or a per-component sinking fund.
• Management: 8-10% of collected rent plus a leasing portion.
• Maintenance: 5-10% of gross rent depending on building age.

Model the bad quarter, not the average month

Year one often has no turnover, so steady-state cash flow looks strong. Plan for one turn per unit every two to three years and rerun the deal with rent down 10 percent and one capital event in year one. If it survives that, the property is defensible.