Appreciation builds real estate wealth, especially with leveraged equity, but experienced real estate investors never neglect the cash flow of the investment. Cash flow isn’t just spending money or passive income — it’s security and risk-management. It’s short-term liquidity. A property or portfolio with negative cash flow faces serious risks, especially if the unexpected happens (which, in real estate, it always does).
Many investors think they have a cash-flow-positive deal or portfolio, but this can be deceptive. Depending on how you put together the numbers, they can lie to you. Savvy investors take the steps to make sure that their investments are truly cash-flow-positive.
Through creative financing and strategic planning, Munoz Ghezlan Capital has helped hundreds of investors achieve a true cash flow rental portfolio. In this article we will describe what this looks like in the real world, and how to avoid the trap of thinking you have a cash flow rental portfolio when you really don’t.
Key Takeaways:
- Many real estate investors think their portfolio is cash-flow-positive (or will be) but critical blind spots like underestimated neglected expenses, portfolio weakness, improper financing, and misuse of metrics can create critical blind spots to negative cash flow.
- Rental cash flow analysis pays extra attention to DSCR (debt service coverage ratio) analysis, with less emphasis placed on the rent-to-value ratio.
- Cash flow is the #1 priority — it is your insulation against emergencies. Even one cash-flow-negative property threatens the entire portfolio.
- Positive cash flow is the result of proper deal selection and conservative rental cash flow analysis, including worst-case-scenario calculations that still produce positive cash flow results.
Why “Cash Flow” Is Often an Illusion
When an investor is mistaken about the positive cash flow of their portfolio, the culprit is almost always one of three circumstances:
- Spreadsheet Optimism. The investor has created income-and-expense projections that paint a rosy picture and don’t leave enough margin for surprises.
- Missing Expenses. Many investors omit critical expenses from their projection — and in some cases even from their cash flow projections, leaving them to think they have more cash flow on paper when in fact they’re in the red.
- “Hot-Hands” Fallacy. Several months of bank account deposits from the property manager may lull the investor into a false sense of security. The fallacy is to assume that a winning streak will continue indefinitely. The name comes from basketball, when a player who makes multiple goals in a row is superstitiously presumed to have “hot hands.” In reality, everyone misses sometimes.
A cash flow rental portfolio is not defined by projections or a small snapshot in time. It is defined by durability, margin, and downside protection.
What “Cash-Flow Positive” Actually Means in Real Life
True cash flow is deceptively simple — it’s easy to understand, and yet easy to miss things. Let’s start with the definition:
All Operating Income
- All Operating Expenses
- All Non-Operating Expenses
- All Capital Expenditures
- All Financing Costs
True Cash Flow
Some of these line items are predictable; others aren’t. Understanding them and planning for them is the key to absorbing shocks, compounding your cash flow, and scaling your portfolio.
Expenses Often Ignored or Underestimated
Expenses that many real estate investors fail to properly plan for include:
- Vacancy. This goes on the income/expense projection. Even in hot markets, vacancy can rear its ugly head at any time.
- Maintenance Reserves. Maintenance expenses are inevitable in real estate, and they tend to land all at once. Without setting aside rent revenue for them, a whole year’s worth of expected cash flow can be erased in one weekend.
- Capital Expenditures. Also called CapEx, these are one-time expenses that relate to the underlying value of the property (renovations, major system upgrades like a new roof or electrical system, etc). CapEx often doesn’t get included in NOI calculations for cap rate calculation, but it still costs money. Investors need to be prepared for lest it eat into cash flow.
- Property Management. Even if you’re self-managing, property management comes with many expenses, like automated tools and outsourced processes. These expenses can be small individually but can add up.
- Insurance Increases. Many investors underestimate how much insurance can increase over time, making their long-term cash flow projections obsolete.
- Property Tax Reassessments. The county appraiser updates your property value estimation every year. Property taxes may increase accordingly, especially after a major renovation. Savvy investors fight their property tax assessments.
- Utilities. Investors who cover some or all utility costs can be surprised how much these rates can increase year over year, or from one tenant to the next.
- HOAs. Homeowner’s associations have the right to levy special assessments. If you don’t want an HOA lien threatening your title, you’re basically at their mercy.
- Admin Costs. Running a business carries a myriad of little expenses that add up, from paperclips to software solutions to attorney and tax prep fees.
If you’re not sure what numbers to project for these expenses, Munoz Ghezlan Capital can help. We are veterans of hundreds of rental cash flow analyses and can give you conservative benchmarks to give you an accurate estimate of the cash flow on your portfolio or your individual deal.
Rental Cash Flow Analysis: The Metrics That Actually Matter
It’s easy to get lost in the numbers on a cash flow analysis. To understand if you really have a cash flow rental portfolio, you need to drill down to the metrics that make the difference:
Gross Rent vs. Net Operating Income
Gross rent alone is meaningless. It only takes on meaning when taken into the context of net operating income (NOI), which is all operating income for the year minus all operating expenses. Even then, many NOI calculations fail to include CapEx.
Keep in mind that debt service (mortgage payments, loan payments, etc) is not an operating expense, since investors can choose how much debt they assume. They can’t always choose whether or not they buy insurance, whether or a refrigerator breaks down, etc.
Market Rent vs. Achieved Rent
Many investors fixate on the market rent of their property, represented by comparables (which may be faulty) or digital calculation tools (which may be even more off base). At the end of the day, the rental value of a property is nothing more or less than what a tenant is willing to pay for it. The only truly accurate rental KPI is the contract rent on an executed lease.
Operating Expense Ratio (OER)
Because expenses can be hard to predict, many investors (and lenders) rely on a benchmark called the operating expense ratio — an estimation of what percentage of the gross rent will be taken up by expenses.
35-45% of the gross income is a common and relatively conservative ratio. Motivated but liberal investors may underwrite an OER of 30% or lower. The last several years of income statements may even show an OER below 30%. However, conservative investors consider these “lucky years.” The previous landlord may have been neglectful, or miscounting the expenses. It’s usually not wise to assume that such low expense ratios will continue forever.
If you really want to put your projections through their paces, consider adding to your rental cash flow analysis an OER of 50% — half of your income taken up by operating expenses. See if your cash flow projects still look appealing under the worst-case scenario.
Stress-Tested Cash Flow
Conservative investors try to knock their cash flow projections down and see if they get back up again. If you want a cash flow rental portfolio, consider throwing the following tests at your rental cash flow analysis:
- 10% rent drop
- 1-2 months of vacancy
- Spikes in property taxes or insurance
The Rent-to-Value Ratio: Why It Still Matters (When Used Correctly)
The rent-to-value ratio has a long history in rental cash flow analysis. It can be a useful tool, but it can also be a liability if investors misuse it.
What the Rent-to-Value Ratio Is
The calculation for the rent-to-value ratio is as follows:
Rent-To-Value = One Month’s Rent ÷ Property Value
Naturally this is going to produce a number greater than zero but far less than 1. The most popular way to interpret this equation is the “1% Rule.” If the equation results in a number greater than 1%, it is likely to be cash-flow-positive.
For example, if a property has a value of $500,000, it is likely to be cash-flow-positive if it can command $5,000 in gross rent.
Why the Ratio Still Works as a Filter
The rent-to-value ratio is still useful as a screening tool. You can use it early in the acquisition process (i.e. before you have made an offer) to weed out properties that are unlikely to produce positive cash flow and not worth the time it would take for a detailed rental cash flow analysis.
Where Investors Go Wrong
However, it is a very imprecise tool for calculating the actual cash flow of a rental property. Yet some investors use this as the only metric to decide whether or not to offer on or acquire a deal. Some even neglect proper cash flow analysis when they own the property — they just look at their rent-to-value ratio and use it to estimate whether or not they are in the green. This is seldom an accurate assessment.
DSCR Calculation: Cash Flow Through the Lender’s Eyes
If you really want one number that assesses the cash flow potential of a real estate investment, the debt service coverage ratio (DSCR) is a much better metric than the rent-to-value ratio. By calculating your DSCR, you are thinking like a lender, who may be the only party as (or more) invested in your positive cash flow than you are.
What DSCR Actually Measures
Debt service coverage ratio measures the ability of the NOI to cover its debt service (mortgage payment, any other associated loan payments). The number is either greater than, equal to, or less than 1. Greater than or equal to one, and the investor is expected to be able to afford the debt service from net rental income alone. Less than 1, and the investor is expected not to be able to afford the debt service from the net rental income alone.
However, the DSCR can indirectly indicate the cash flow potential of the property. Any amount above 1 is an estimate of the percentage of NOI the landlord can expect to keep as cash flow. Any amount below 1 is an estimate of the amount the investor will have to dip into outside cash reserves to pay the mortgage, making the investment a cash-flow liability.
Walk Through a Simple DSCR Calculation
The DSCR calculation as follows:
DSCR = NOI ÷ Annual Debt Service
Suppose a property has an actual (or estimated) NOI of $40,000 and a monthly mortgage payment of $3,000. 12 months of debt service ($3,000 x 12) is $36,000. $40,000 divided by $36,000 is 1.11. That’s the DSCR. It is greater than 1, which a lender will like.
However, that extra 0.11 tells us something. It tells us that the investor is likely to pocket 11% of the NOI as cash flow.
Why DSCR Is a Reality Check
DSCR calculation is a reality check because, when done properly, it includes every expense the investor will incur on that particular deal, including calculations either sometimes don’t or never do get factored into NOI — particularly the debt service the investor is considering, as well as reserves for CapEx.
Financing Structure: The Silent Killer of Cash Flow
The ability to borrow money to buy or rehab real estate is usually good news, but many good deals fail due to bad financing. Your financing can become a cash flow liability for many reasons, including:
- Rate Sensitivity. You may perform your rental cash flow analysis when interest rates are low, but there is always a chance interest rates could increase when it’s time to lock your rate. When that happens, you may already have money invested in the deal in the form of inspection fees, loan application fees, and non-refundable deposits. It’s best to throw a higher-than-expected interest rate at your analysis to see if it can survive a drastic interest rate move.
- Refinancing Risk. Many deals rely on a plan to refinance to work. The debt may be short-term and carry penalties for extension. Even if that isn’t the case, there’s always a chance that the refinance will not be approved or that rates could spike, making the refi-based rental cash flow analysis obsolete.
- Expiration of Teaser Periods. Investors who agree to an interest-only or adjustable-rate period often underestimate how the increase in debt service will impact their cash flow. This alone can take you from positive to negative overnight.
One of the biggest services Munoz Ghezlan Capital offers its partners is helping them pick a financing structure that will preserve their cash flow without unpleasant surprises down the road.
Portfolio-Level Cash Flow vs. Property-Level Cash Flow
Cash flow is one ballgame when it’s one property, but a different ballgame when we expand to the portfolio level. With multiple properties, overall portfolio cash flow can mask weakness in one property.
The fact that cash flow from one property can cover a deficit at another property is not a smart strategy — siphoning income from the stronger property makes the portfolio weaker overall. If an emergency expense arises at the strong portfolio, it has less cash flow to absorb it. Meanwhile, an emergency expense is just as likely to arise from a weak property within the portfolio. Both could even strike at the same time.
A cash flow rental portfolio is only stable when every property in the portfolio is cash-flow-positive. Other sins of overall portfolio health include:
- Geographic Diversification. It’s easy to fall into the comfort zone of a specific neighborhood, zip code, or town. You know the tenants, you know the expenses, you know the local politics. However, undiversified geography puts your portfolio at risk. If the area all your rentals reside in takes a downturn, your cash flow could end up taking a large hit.
- Expense Diversification. While it may be tempting to choose the same insurance carrier or contractor every time, at the portfolio level this actually adds extra risk. A drastic increase or inconsistency in one vendor can affect the entire portfolio.
- Staggered Debt Maturities. If all of your debt on every property comes due at the same time, it could lead to a debt service spike that kills the overall portfolio. It might be wise to agree to a longer or shorter debt term based on the maturity date of your other outstanding debt liabilities.
- Multiple Rent Drivers. If your entire tenant base depends on one employer, one school, or one demographic trend, your whole portfolio is lashed to that rent driver. Conservative investors introduce multiple tenant drivers into their portfolio so weakness or decline in one area doesn’t affect every rental they own.
Why Appreciation and Tax Benefits Don’t Fix Bad Cash Flow
Investors eager to expand their portfolio come up with many justifications to accept weak, marginal, or even negative cash flow. These justifications rarely hold up to scrutiny. Common rationalizations for cash flow weakness include:
- “I’ll make it up on appreciation.” Appreciation is a major wealth-builder, but until you sell or refinance it is unrealized and may come with its own tax liabilities. There will be no appreciation at all if insufficient cash flow puts the deal at risk of default on debt before that appreciation has the chance to materialize.
- “Tax write-offs will cover the losses.” Real estate investment carries many tax advantages, but tax write-offs reduce taxes, not losses. The losses on a cash-flow-negative property almost always outweigh the tax savings. Even for the most ardent opponents of Uncle Sam, a dollar sunk on a struggling property is not worth $0.20 saved on taxes.
- “The cash flow will appear when the rents go up.” Rent increases are never guaranteed. Positive cash flow is the minimum requirement to make sure the property can stay afloat in the event that market rents decrease (which can and does happen).
What a Truly Cash-Flow-Positive Portfolio Looks Like
True cash-flow-positive portfolios have certain elements in common. Signs to keep in mind as you evaluate your current portfolio (or the portfolio you intend to build) include:
- Conservative Underwriting. Try your best to defeat your deal in the rental cash flow analysis phase. Keep adding or increasing liabilities and see if the deal still holds up. Better to have pleasant surprises than unpleasant ones.
- Margin Above Expenses and Debt. The higher your DSCR is above 1 on all properties, the more likely you are to be cash-flow-positive under every foreseeable circumstance.
- Surplus Cash Flow After Reserves. Investors with longevity don’t pocket every dollar of rent in excess of that month’s expenses. They set aside ample portions of the surplus to funds for repairs, CapEx, and portfolio-level reserves. If there’s still cash left over, the portfolio is in good shape.
- Financing Aligned With Income Stability. No unpredictable spikes in debt service loom in the future that aren’t wholly justified by plausible increases in income due to repositioning.
Bottom Line
Real estate comes with many benefits, but cash flow is the #1 priority. Tax savings may be satisfying and appreciation may eventually grow your wealth faster, but cash flow is oxygen for a deal — it keeps the deal alive long enough for benefits like appreciation and tax savings to even kick in.
Munoz Ghezlan Capital is a team of cash flow experts. Whether your current portfolio needs a cash flow rescue, or you want to build a portfolio from the start that is set up for positive cash flow, schedule a complimentary strategy call with a Munoz Ghezlan cash flow expert today. We can help you not only with the financing, but the fundamentals of building a cash flow rental portfolio.
