On Cash Flow Analysis

The main two metrics for analyzing real estate as an investment are its cash flow and its profitability, and for this week I will focus on cash flow. Simply put, cash flow analysis studies the property’s annual income relative to the price it was acquired for.

The most basic way to assess a property’s cash flow is to look at the Gross Rent Multiplier, or GRM, which is the total of its annual rents divided by the price paid for the property, including cost of any improvements. If we take the example of a property that was purchased for $1,000,000 earning $100,000 per year, you will arrive at a GRM of 10. 

Generally speaking, you will want this number to be as low as possible to indicate a quicker rate of return, but to help normalize their analysis, a savvy investor will compare rent rates per SF for the property they are evaluating against other properties in the analysis or general rental comps in the region to arrive at a more balanced comparison.

The main limitation of using GRM as a metric is that it doesn’t factor in costs such as property taxes, insurance, maintenance, and turnover—namely everything except for the loan payments. These are categorized as Operating Expenses, and these are deducted from the GRM to arrive at the Net Operating Income, or NOI for the Property. As with the rent rates it’s useful when comparing listings to see how they arrived at their stated NOI which is used to calculate the property’s stated Capitalization Rate, which is the measure by which cash flow on a property is measured against not only just other properties but also other forms of investment.

A generally accepted range for Operating Expenses runs between 35% and 42%, but it is not uncommon to see listings with stated expenses as low as 15% or even 10%. This is due to the Seller or their agent basing their totals on understated costs such as using existing property taxes instead of what the property taxes are going to adjust to after it changes hands. Ultimately you will want to rely on actual expense records, but a quick method to equalize properties in your analysis is to deduct a flat 35% for Operating Expenses to arrive at an estimated NOI which gives a more realistic projected Cap Rate.

Using the above $1,000,000 property earning $100,000 in rents and deducting 35% for Operating Expenses gives an estimated NOI of $65,000. Dividing this number by the Purchase Price indicates a Cap Rate of 6.5% for this investment. As a general rule, investors want a higher Cap Rate, but with the caveat that the higher the Cap Rate, the higher the risk and amount of oversight the property will require. 

For the final piece of the puzzle some investors will calculate their Internal Rate of Return, or IRR on the property, by deducting their loan payments from the NOI and dividing that figure by the amount of cash spent, but for purposes of comparing similar investments, a good preliminary Cap Rate analysis will let you know whether the property you’re checking out is worth getting excited about.