In the world of real estate, there are several metrics that can help gauge the health of a real estate investment. In addition to net operating income (“NOI”), understanding cash flow is a key measure allowing owners and managers of real estate to track the health of their property and provide projected returns to their investors.
What is “cash flow”?
In real estate, sometimes cash flow may be referred to as FFO or funds from operations. This is the amount of excess or distributable funds available after all payments have been made for operating expenses, mortgage principal and interest, and capital expenditures.
In the most basic of terms, cash flow is measuring the net amount of cash and cash equivalents going in and out of a property. Foundationally, it is what would be inflows (revenues) less outflows (expenses). In most circumstances, it would be equal to a profit and loss statement. However, with real estate investments, there is an added complexity due to a variety of different balance sheet items.
Cash flow can be impacted by many different factors including whether rents are received in a timely manner, vacancies, operational expenses, and extraordinary items (like a backed-up sewer line or property damage). Even through careful planning and budgeting, unexpected issues can really make it challenging.
Investing in real property requires diligent tracking of all inflows and outflows. And because it is more than just income and expenses it is important to know accounting basics to maximize available cash. When providing outside investors with projected investment distribution schedules, having a thorough and comprehensive knowledge of the fundamentals will help validate and affirm an investor’s investment decision.
How is cash flow different from NOI?
Experienced real estate investors know that they can get a more comprehensive view of their financial position through visibility into their cash flow situation. Unfortunately, many new real estate investors tend to confuse NOI and cash flow. But there is a big difference.
Net operating income is the bottom-line number for a property that is calculated by subtracting property revenues from the property’s operating expenses. Examples of revenue include rents, additional rents, sales overages, vending or payphone revenue, late fees, and revenues associated with other ancillary income (e.g., events, licenses, promotions, advertising). Operating expenses will include insurance, taxes, maintenance, repairs, utilities, security, management fees and administration, and other similar items.
Operating expenses do not include leasing expenses, capital / tenant improvements, legal fees associated with lease administration (defaults or lease negotiation), mortgage or note payments, depreciation, amortization, and escrow (or impound) account payments.
Cash flow will include items normally found on a balance sheet: outflows will include mortgage principal paydown, escrow account payments, capital / tenant improvements, leasing commissions, security deposit payouts, etc., while inflows may reflect reimbursements from lenders for impounds, security deposit receipts, interest or notes receivable payments, and even proceeds from refinancing the property.
Budgeting for cash flow
It is said that property managers live and die by their budgets and most property managers only look at hitting their NOI targets. For organizations looking to report to their investors, budgeting for cash flow and delivering on those stated goals is important for investor confidence. Providing clear and concise guidance is imperative for both investor confidence and relationships.
Only by breaking down the components of ALL inflows and ALL outflows can a property operator get a clear picture of their position. It is necessary to review all potential sources of receipts, not just income, including security deposit receipts, reimbursements from insurance and taxing authorities, and escrow accounts. Many real estate owners fail to recognize that they need to budget for all outgoing funds, not just expenses, including payment of security deposits to tenants whose leases are expiring, payments of principal and escrow accounts, capital improvements, and fees and charges related to non-operational items.
A budget is both a guideline and goal for achieving one’s investment objectives. By budgeting for cash flow, property owners will have greater transparency into the sustainability of their properties.
What’s the bottom line?
Starting with a thorough budget and using that as a guideline, property owners can easily track their cash flows against their projections. Using a budget is also their goal – what is the number at the end of the month, quarter, or year that we want to achieve?
It is advisable to check on their cash flows on a monthly basis. This may seem cumbersome, but by using a state-of-the-art financial management system, it is as easy as a click of a button to get an in-depth picture of your position, and get a variance report of your actual to your budget.
There are no benchmarks that can tell you how you are doing; this is something that must be determined by your team. But, by having a budget in place, you have the ability to judge how your property is doing based on your annual assumptions.
Some months may be a negative number, but the overall health of your property and your portfolio is determined by careful planning and thorough tracking of all inflows and outflows. NOI may be what one uses to calculate property value, but it is the cashflow that one counts on to determine property sustainability.
And if your cash flow isn’t up to your expectations, there are a few steps you can take:
Seek out the advice of an accountant who can help guide you through your rental portfolio and give you insight on where you can make changes, or maybe even invest in additional properties.
Leverage a property management software, such as Re-Leased, to help you analyze your expenses. Understand what can be cut or reduced or see if you should be increasing your rent.
Better cash flow management starts with your accounting numbers in one place. Xero connects to your bank and enables your data to flow in automatically, so you can reconcile transactions with ease. In addition, Xero helps automate tedious tasks, saving you time while giving you an accurate picture of your financial health.