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October 4, 2024, BY Paul Tanso
As a seasoned real estate investor, I’ve learned plenty along the way, and I want to pay it forward by sharing the knowledge I’ve gained. One key lesson I’ve learned is how crucial underwriting is when investing in multifamily real estate.
What is Cash Flow?
In real estate investing, cash flow refers to the amount of money left over after all property expenses have been paid. This includes operating costs like maintenance, property management, taxes, and mortgage payments. The goal for every investor should be to have positive cash flow, meaning your rental income exceeds your expenses.
Understanding cash flow is critical because it determines whether your investment property is financially sustainable. It’s the difference between staying profitable or taking a loss each month.
Cash Flow Formula:
The basic cash flow formula is:
Cash Flow = Total Rental Income - Total Expenses
This simple formula helps investors assess if a property will generate income or lose money each month. For instance, if your monthly rental income is $10,000 and your total expenses are $8,500, your cash flow is $1,500.
My approach: cash flow
Underwriting is the foundation of a solid business plan.
Stick to the fundamentals: Don’t compromise on core investing principles.
Cash flow from day one: Only buy assets that generate income immediately to ensure long-term stability.
When I first started, I bought a 4-unit building without much underwriting knowledge. I didn’t even know what underwriting was! But the beauty of real estate investing is that anyone can learn, and I quickly realized the importance of understanding the financial details behind each deal.
Why Cash Flow Matters in Real Estate
In real estate, cash flow is key to building long-term wealth. Investors often use cash flow as a measure of how stable an investment is. A property with positive cash flow can help you pay off debts, reinvest in other properties, and build equity over time. However, properties with negative cash flow could drain your resources, especially if you’re unable to raise rents or reduce expenses.
Cash Flow vs Profit: What’s the Difference?
Many new investors confuse cash flow with profit. While both are important, they’re not the same. Profit refers to the total money you make after selling a property, while cash flow is the monthly income you receive from renting it out. Positive cash flow helps keep the property profitable in the short term, while profit is a long-term goal.
My Business Plan: Prioritizing Cash Flow
For most of my investments, my plan is simple: buy at a price where the property cash flows from day one, then stabilize and improve the property, increase income, refinance with a cash-out within 3 to 5 years, re-invest the money into another property to repeat the process. I plan to hold properties for many years, but I also believe there’s a time to sell and harvest returns.
I stick to a few core principles:
The asset must cash flow from day one.
I aim for a 10% return on my initial investment in the first year.
There must be room for rent growth within the first two years, so I target properties with rents below market value.
New Lead: Example of Cash Flow Analysis
Recently, I found a pocket listing—a property not listed publicly. This gave me a competitive advantage, but I had to move quickly and perform my own underwriting before making an offer. I analyzed the deal using Key Performance Indicators (KPIs) like cap rate, debt coverage ratio, and cash-on-cash return to assess its potential.
The building was a 12-unit property with nine 2-bed and three 1-bed apartments. Although there weren’t immediate value-add opportunities, the potential to raise rents was significant. The asking price was $1,900,000.
Financial Breakdown
Here’s how the numbers looked:
Asking price: $1,900,000
Gross potential annual income: $171,000
Operating expenses: $88,605
Net operating income (NOI): $100,000
Cap rate: 5.3%
Annual cash flow: -$17,521
Let’s break down these numbers:
Gross Potential Annual Income: This is the total amount of rent I could collect from all the tenants over a year if every unit were rented all the time with no vacancies. For this 12-unit building, that adds up to $171,000.
Operating Expenses: These include everything it costs to maintain the building, such as taxes, insurance, maintenance, and utilities. In this case, the expenses come to $88,605 annually.
Net Operating Income (NOI): This is the total income left after subtracting all operating expenses from the gross potential income. For this property, it leaves me with $100,000. NOI is key because it shows how much profit the property generates before paying the mortgage.
Cap Rate: The capitalization rate, or cap rate, is a percentage that shows how much return I’m getting based on the purchase price. For this deal, the cap rate was 5.3%. I typically reserve this low of a cap rate for brand new, high-end buildings (Class A properties). But this building was a 100-year-old wood frame property in a middle-tier area (Class C+/B-). This was a red flag for me, as the cap rate didn’t match the property type or condition.
Annual Cash Flow: Based on the initial numbers, the property was losing money. The annual cash flow came out to -$17,521, meaning I would lose about $1,460 a month unless I could raise rents. Raising rents takes time and won’t generate positive cash flow right away.
Since the property loses money based on these numbers, my business plan would require me to raise rents from an average of $1,250 to close to $1600 per unit over 2-3 years. I typically avoid situations where my hard work and risk benefit someone else, but I saw potential. The market rent for 2-bed units in this area ranges from $1,450 to $1,800. I targeted $1,600 by the end of year two to reach my goal of a 10% cash-on-cash return.
Managing to Profit
A well-researched pro forma is critical to making or breaking your deal. You need to know your market, understand historical data for expenses like utilities, maintenance, and interest rates, and forecast how they will impact your deal in 3 to 5 years.
In this case, I projected the total annual rent income to grow to $242,500 by year two, with an exit cap rate of 6.5%, which would increase the property’s value to $1.99M and generate $38,246 in annual cash flow. While the potential looked good, I had to consider the risks: What if rent prices drop, or the job market falters? Always have a Plan B, and stress test your deal before making an offer.
How to Improve Cash Flow in Real Estate
If your property isn’t cash-flowing as expected, there are ways to improve it:
Raise Rents: If market conditions allow, increasing rent is one of the simplest ways to boost cash flow.
Reduce Expenses: Lowering costs like utilities, maintenance, and property management fees can help improve your monthly cash flow.
Increase Occupancy: Filling vacancies quickly ensures you’re maximizing rental income.
By focusing on these areas, you can improve your cash flow and build a more financially stable portfolio.
Conclusion
Thoroughly underwriting a real estate deal is critical to long-term success. Making conservative judgments about rent increases, occupancy rates, and other key factors ensures that your investment is built on a solid foundation. Overestimating income or underestimating expenses can lead to significant financial strain, especially in an unpredictable market.
The goal is always to ensure positive cash flow from day one. A property that generates income immediately provides stability and allows you to navigate market fluctuations more comfortably. By sticking to core principles—like conservative projections and a focus on cash flow—you’ll position yourself for sustainable growth and greater profitability over time.
This need for thorough underwriting and financial clarity is exactly why I’m developing DealGen—to eliminate the chaos of spreadsheets, calculators, and paperwork. DealGen is designed to simplify the entire deal process, allowing investors to perform complex underwriting quickly and efficiently. With DealGen, you can streamline your deal flow, make informed decisions faster, and focus on what matters most—growing your portfolio.
Try DealGen for 14 days free and see how it can transform your investment process and help you focus on making smarter, faster, and more profitable decisions.
Terms to Know
In real estate investing, there are some important terms that can help you better understand the process. Here’s a breakdown of a few key concepts, including how “underwriting” has two meanings depending on the context.
What is Underwriting?
Underwriting is the process where a company, like a bank or insurance provider, looks at how risky it would be to lend you money or offer insurance. They review your financial background, such as income, debts, and credit score, to decide if they should approve the loan or policy, and under what terms.
What is Underwriting in Real Estate?
Underwriting as Property Analysis
Multifamily Real Estate Investing
What is a Pocket Listing?
Infinite ROI with Negative Cash Flow
KPI (Key Performance Indicator)
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