Understanding passive income in the real estate realm starts with understanding cash flow. Cash flow is not only one of the primary drivers of building wealth via real estate investing, but also a common pitfall. In short, understanding cash flow and properly forecasting it is often the make or break between a great investment and money pit.
Ever heard a real estate investor talk about collecting “mailbox money?” Mailbox money is exactly what it sounds like — money that shows up in your mailbox on a monthly basis without having to do much of anything. In personal finance, “mailbox money” is one kind of passive income.
Passive income — unlike the active income you earn at your 9 to 5 — is income for which you have to do very little work. It’s a necessary concept to understand because passive income, along with appreciation, are the cornerstones to building wealth through real estate investing.
At its simplest, cash flow is the net amount of cash moving in or out of a business at a specific point in time. Just like in all businesses, the long-term rental property business has cash moving in (in the form of rents collected, fees charged, etc.) and cash moving out (in the form of property management fees paid, repairs done, etc.).
In finance, a company’s net cash flow is defined at the sum of three separate cash flow measurements: cash flow from operations, cash flow from financing, and cash flow from investing. In real estate, we can simplify that down to the following formula:
Cash Flow =
NOI - Debt Servicing - CapEx
And more specifically,
Cash Flow =
(Revenue - OpEx) - Debt Servicing - CapEx
Cash flow is one of the many ways to evaluate the profitability of an investment. Generally speaking, higher cash flows imply more lucrative, less risky investments. A business has positive cash flow if the money going out is less than the money coming in - here, the net cash flow calculation will yield a positive number. A business will have negative cash flow if the money going out is more than the money coming in - here, the net cash flow calculation will yield a negative number.
All this said, it’s important to remember that cash flow is a snapshot-in-time type of measurement - it only tells us how much money is moving in or out of our business at a given moment in time. This means it’s possible to have negative cash flows and still have a great investment property.
Say, for instance, you purchase a property but it’s a fixer upper - you got the property at a great price but you’ll need to put in $100K before it can be rented out. Well, technically, the investment you just made has a negative cash flow. Why? The $100K you used to fix up the property counts as capital expenditure and, since you haven’t collected a dime of rent yet, your cash flow is equal to -$100K.
But this negative cash flow doesn’t mean this wasn’t a good investment. It just means that you got a great deal on a property that required an up-front investment that you’ll be able to get a return on over time via the higher rents you’ll now be able to charge your tenants. This is an example of forced appreciation - you’re renovating to increase the rent and the overall value of the property.