Rich Dad Education Blog

Cash Flow
Cash flow is the amount of free or net cash left over at the end of every month after debt service and operating expenses are deducted from the income generated by the rental of an investment property. Although debt service and operating expenses are both expenses that have to be paid, they are looked at differently when we are talking valuations. Debt service is considered a temporary expense that can be paid off at any point in time. Debt service is paid out of the net operating income (NOI); NOI is not what is left after paying debt service. Operating expenses are considered to be permanent expenses; these expenses will have to be paid or allowances made for, whether the property is owned free-and-clear or is encumbered by mortgages. Expenses (such as vacancy, management fees, repairs and maintenance, property taxes, insurance, etc.) are a few of the expenses that fall into this category.

Cash flow can be looked at and estimated several ways, a few of which are:
• The One Percent Rule
• Gross Rent Multiplier (GRM)
• Cap Rate

One Percent Rule
The One Percent Rule says that one needs one percent of the purchase price of the property as monthly rental income in order to break even. For example, a $100,000 property must bring in $1,000 per month in rent in order to cover operating expenses and debt service.
If this $100,000 property brings in $800 per month in rent, it would be expected to be $200 per month negative in cash flow; conversely, if the property brings in $1,200 per month in rent, it would be expected to be $200 per month positive in cash flow.

I use a rule of thumb that in general, the more positive the cash flow from the One Percent Rule, the more management and maintenance intensive (or lower income), the property is likely to be.

Gross Rent Multiplier (GRM)
The GRM is an evaluation method that has widely fallen out of use, though I do still see it used on MLS listings, usually incorrectly. For this reason, it is necessary for an investor to be aware of what the GRM is and how to interpret it.
The GRM is a multiplier, so it’s a number, not a percentage or dollar amount. The formula is:

GRM = Purchase Price ÷ Gross Annual Rent (GAR or GSI)

This means that if an investor could keep all the rents received, the investor would recover his cost of capital in (X) years.

For example:
A $100,000 investment property that rents for $1,000 per month, or $12,000 per year, would be calculated like this:

$100,000 ÷ $12,000 = 8.3 GRM

If the investor could keep the property occupied 100 percent of the time and could keep 100 percent of the rental income generated, the property would pay for itself in 8.3 years.

Realistic? Hardly, but it is a way to value a property.

My rule of thumb is the lower the GRM, the lower the quality of the property probably is. All things equal, I would expect a property with a GRM of four to be of lesser quality than a property with a GRM of eight.

Cap Rate
I have heard much discussion and debate about the capitalization rate, or cap rate, and what it really is. It is actually very simple to define as long as one understands that the assumption when talking about the cap rate is that you are paying cash for the property.

The formula for calculating the cap rate is:
NOI ÷ Purchase Price = Cap Rate

Suppose you have $100,000 in your hand and you are debating on where to invest it. If you take that $100,000 and put it in a savings account at the bank, what would you get for that? Two or three percent perhaps? Well, that two or three percent is the cap rate of the savings account.

Assume the savings account returns two percent; the calculation would look like this:

$2,000 ÷ $100,000 = 2.0%

The $2,000 is the NOI and $100,000 is the purchase price or the deposit in this case.

By putting your $100,000 into the purchase of the property and not financing a dime, assume the gross annual rents (GAR) are $12,000 and the operating expense ratio is 45%, so the net operating income (NOI) would then be $6,600, or 55 percent of the NOI.

The calculation would look like this:

$6,600 ÷ $100,000 = 6.6% Cap Rate

Again, the assumption is that you would be paying cash for the property. As not many people are able to pay cash, the cap rate is not a valuation model, but rather another way to analyze a property in which one is interested.

My rule of thumb concerning the cap rate is that, all things equal, the higher the cap rate, the lower the quality of the property.

What the cap rate does not take into account is the equity you create going into the deal or any future appreciation the property may have.

Equity Going Into the Deal
Another way for you to make your money is by creating as much equity as possible going in to the deal. Simply put, if the property is worth or “comps-out” at $100,000, and you can purchase the property for $70,000, then you have $30,000 or 30 percent equity going into the deal. To know how much equity you have going in, you have to establish the current market value of the property. This is typically done by looking at sold comps. You could also have the property appraised, but I feel that checking sold comps is sufficient initially. In the current market environment, I prefer sold comps that are no more than three months old, and I prefer to have an equity position of at least 30 percent.

Appreciation
Appreciation is the long-term way to build wealth in real estate. Over time, assets that an investor purchases tend to increase in value, a process commonly known as appreciation. The nice thing about appreciation is that it compounds. What this means is that a property appreciating at three percent annually is not only increasing in value from its purchase price, but the market value is actually three percent higher than it was the year before.

Here is an example:
Assumptions - $100,000 Purchase Price and 3% Appreciation.

Property is worth:
At the end of year 1 = $103,000
At the end of year 2 = $106,090
At the end of year 3 = $109,273
At the end of year 4 = $112,551
At the end of year 5 = $115,927

As you can see, just by holding the property for five years, the market has created $15,927 of wealth.

Take the previous example we used in which a property is acquired for $70,000, giving the purchaser $30,000 of equity going in. Using the same assumptions of appreciation, at the end of the five-year period, the owner would have $45,927 of wealth accumulated.

Depreciation
There are a couple of types of depreciation. One type is where fundamental value of an asset is lost due to deterioration or changes in the market; another is used for tax purposes. The later is what we, as real estate investors and business owners, are going to discuss.
So what is depreciation and how does it relate to real estate investment? Depreciation really falls under the cash flow discussion but I wanted to break it out separately, as I typically do not rely on depreciation to make decisions concerning whether or not I buy, though it is an important factor to consider in the overall process.

When an individual opens a business, that person typically has to buy assets, computers, vehicles, and many other necessities to make the business run. The IRS allows these capital expenditures to be tax deductible for business owners, but does not allow them to deduct the entire cost of some of these capital expenditures in the year of the purchase. Rather, the capital expenditures are categorized into the appropriate asset classes, as defined by the IRS, such as three-year assets, five-year assets, etc. Residential real estate investments have been designated as a 27½-year asset class. The IRS allows the business owner to deduct the pro rata portion of the asset over the life of the asset class.

For real estate, the IRS typically allows one to deduct 75 percent of your basis over the period of 27½ years. They do not consider land to be a depreciable asset. Only the improvements made or built upon on the land are depreciable; the other 25 percent of your basis is allocated to the land.

Using the $100,000 property that was acquired for $70,000 from the previous example:

Fair Market Value $100,000
Purchase Price $70,000
Amount to be Depreciated $52,500 ($70,000 * .75)
Annual Depreciation Expense $1,909

How does this relate to cash flow? The $1,909 annual depreciation expense is considered a phantom expense because it is an expense you can use against the income received from the property, even if your property shows a loss.

As you can see, the ability to depreciate the asset and deduct that expense against the income from the asset is one of the great benefits of owning residential real estate. Unfortunately, what the IRS gives, they also tend to take away. Though the IRS allowed you to deduct much of the cost of the asset over a period of time, when you sell the asset, you have to give it back. Let’s say you owned this property for 10 years and deducted depreciation for that 10-year period:

$1,909 * 10 = $19,090 Accumulated Depreciation Expense

You, the business, will have to now show that $19,090 as income in the year of sale.

All of these factors should be taken into consideration before an investor makes the decision to purchase any property. Of course, there is far more due diligence to be conducted before making a final decision to pursue a deal, but the ideas mentioned in this article are among the first things to analyze and take into account. If a deal does not make sense based upon these criteria, it is unlikely that it would withstand further scrutiny. Use the information in this article to create a solid starting point from which you can make a decision, and go from there!