Investment property cash flow is the oil that keeps the financial engine of rental property running. It should be a top priority whenever you invest your hard earned money in rental property. Cash flow will ultimately determine the level of success you achieve with owning and operating a rental property. So, let’s take a look at why cash flow is “king of the hill” with rental property.
Basically, there are four ways to make money owning rental property:
- Positive Cash Flow
- Market Value Appreciation
- Amortization of the Mortgage, and
- Tax Savings
Positive Cash Flow
At the top of the list is positive cash flow. If the gross effective income of the building (after vacancies and collection losses are factored in) exceeds all of the operating expenses and mortgage payments, then the income that is left over is your positive cash flow. This is the financial foundation that supports your entire investment.
If this number is negative, with expenses and mortgage payments exceeding income, then you will have to take money out of your own pocket each month to support the property. And that my friend, could lead to problems of potential foreclosure on the property. With this threat on the radar screen, it’s easy to see why investment property cash flow is so important!
It’s well known that many rental property investors count heavily on appreciation while placing little emphasis on investment property cash flow. This is really gambling or speculating, on the direction of the real estate market. The fact is that no single person has a crystal ball telling them how much, and how fast, real estate prices will appreciate.
While it is true that history has shown us that real estate appreciates over time, the truth is that no one knows exactly how it will behave in the short term. Appreciation, therefore, should be thought of as “icing on the cake”.
Don’t fall into the trap of investing in rental property by speculating that prices will keep rising. Rarely does it pay to purchase a negative cash flow property with the hopes of selling it quickly at a price high enough that more than compensates for your out of pocket negative cash flow – that’s high stakes gambling my friend!
Amortizing the Mortgage
Amortizing the mortgage simply means paying it down. By lowering the mortgage principal balance, you’ll gain a larger piece of ownership, or equity, in the property. While it is true that the initial years of making regular mortgage payments reduce the principal balance very little, there are ways of speeding up this trend.
Making some additional mortgage payments each year, or taking out a shorter-term or bi-monthly mortgage will amortize the mortgage faster. This principal reduction of the mortgage acts as a nice complement to investment property cash flow.
It’s a shame that investment real estate does not offer the same tax advantages that it did before the Tax Reform Act of 1986, but it still offers some very powerful ways for you to save money on your income taxes. One of the most significant ways of lowering your income taxes is through “depreciation” of the property. The tax code allows rental property owners to deduct from their income an annual amount of depreciation of their rental property. This accounts for the property “wearing out”.
Depreciation for residential income property can be taken for up to 27.5 years of ownership. The tax savings realized from depreciation can be substantial, and is an added bonus that complements investment property cash flow.
The bottom line is that cash flow is king. It takes time and effort to build it – it’s no different than building a regular business. The surest way to build cash flow is through buying neglected property cheaply, making improvements yourself (sweat equity), and then managing its rental cash flow conservatively.
When buying a neglected property, never offer a price based on any projected rents that either a real estate agent or seller specifies. If you cannot purchase the property based on its existing rents (which should be verified), then it’s best to walk away from the deal.