Effective investing strategies depend on an investor’s due diligence, and that due diligence depends on an investor’s familiarity with critical metrics.
When investors can accurately measure an asset’s performance using critical financial tools, they gain a deeper insight into that asset’s potential to earn them a return.
Few metrics reveal an asset’s potential as clearly as cash flow. Cash flow tells a compelling story about the investment potential of real estate assets.
Learn what every real estate investor needs to know about cash flow to make better financial decisions.
What Is Cash Flow?
Cash flow measures the amount of cash going into and coming out of a capital asset or business. In a real estate context, cash flow measures the money generated and the expenses incurred by an investment property.
Income-earning capital assets may earn investors a return through the cash they generate. However, an income-earning asset may require prolonged investments to maintain its income-earning function.
You can quantify the dynamic between an asset’s income and expenses required to maintain it by determining the asset’s cash flow.
A net balance determines the final assessment of an asset’s cash flow. Whether the final balance is positive or negative depends on whether more money is going in or more money is coming out.
Cash flow is critical because it alerts investors if their asset brings in more cash than it costs them.
What Is Positive & Negative Cash Flow?
Positive cash flow indicates a net balance where more money is generated by an asset than is spent on it. Alternatively, negative cash flow means an asset’s expenses exceed its generated cash.
At a glance, investors can assess an asset’s performance based on its positive or negative cash flow.
An asset’s positive cash flow is a crucial indicator that it is performing well; it consistently brings in more cash than money expended on it and supplies investors with a steady income stream.
Types of Cash Flow
Cash flow can give more specific information than money coming into and out of an asset. Specialized cash flowmetrics give investors a high-resolution assessment of an asset’s performance.
These are the other essential types of financial measures for cash flow real estate investors should know before assessing a real estate investment’s potential:
- Operating Cash Flow
- Investing Cash Flow
- Financing Cash Flow
Operating Cash Flow
Operating cash flow describes the cash flow generated by a business or asset’s operations. In a real estate context, operating cash flow may refer to income generated by a rental property through monthly income.
Operating cash flow is directly associated with the asset or business, an immediate result of its performance as an asset or company. Positive or negative operating cash flow provides critical insight into the actual operations of a real estate asset.
Investing Cash Flow
Investing cash flow measures in and outgoing cash generated by investments. More often than not, investing cash flow is most helpful in a trading context; this cash flow may measure interest generated by an asset or dividends paid out by a fund.
Investing cash flow can be a crucial metric in a portfolio built upon multiple asset classes, including real estate. For example, trusts like REITs appreciate and pay out dividends like publicly-traded mutual funds from income earned through real estate.
Financing Cash Flow
Financing cash flow refers to inbound and outbound cash from funding measures. An asset or company will likely rely on outside financing to operate.
Because property often presents high financial thresholds, financing is integral to real estate investing. In a real estate context, financing cash flow could refer to the mortgage constant on the property, loans, credit loss, and other capital-raising activities.
What Is Free Cash Flow?
Free cash flow refers to the remaining cash after all the outgoing expenses on operating expenses and capital expenditures for a company or asset have been paid. You can use this surplus cash flow for any number of purposes.
Functionally, free cash flow may be similar to profit, but there are a few key differences between them.
Profit describes the net income reported by an asset or company in a designated period. As it is utilized in an investment context, free cash flow provides subtler information: it indicates the amount of cash on hand at any given time.
Free cash flow measures the net balance of an asset or company from a present standpoint. You can use it to project profitability, growth potential, or future distributions for shareholders.
Net Income vs. Cash Flow
As mentioned, net income is essentially a company’s profits. Net income is related to, but importantly distinct from, cash flow, which measures the cash coming in and going out during operations. Net income is often used at the beginning of cash flow calculations.
In real estate, the difference between net income and cash flow is crucial to understand because of the importance of loan payments in the sector.
The principal portion of a loan payment, which is the money you initially agreed to repay, affects cash flow but not net income. In contrast, the interest portion of a loan payment, which is the cost of borrowing the principle, impacts both cash flow and net income.
What Are the Benefits of Strong Cash Flow Assets in Real Estate?
Cash flow is an integral indicator of a capital asset’s financial health. Strong cash flow investments are crucial to a strong, stable portfolio. Real estate investments present investors with a compelling opportunity to include strong cash flow assets in their portfolios.
- More control over income streams
- Freed income to invest in an asset
- Freed income to invest elsewhere
More Control Over Income Streams
Investors can directly influence real estate cash flow. For example, rental properties possess a mutability in their income stream because the primary source for the income they produce, rental income, is a negotiable number.
Investors are almost guaranteed to gain a positive cash flow on their rental property because rental income must exceed operating expenses.
For example, even during inflationary periods, rental income hedges against rising prices. Furthermore, investors can mitigate operating expenses with opportunities to reduce their taxable income, like depreciation.
Freed Income To Invest in Asset
Robust and positive cash flow from real estate assets means that investors have more income to improve their properties and increase their value. An income property, like residential property, possesses unique features that distinguish it from other asset classes.
Chief among them is the improbability of real estate: as a physical property, the property’s value can be actively improved through renovations.
When properties produce abundant free cash flow, that cash flow can go back into the property and raise its value even further.
The steady income produced by real estate assets provides investors with the means to sustain their held real estate assets and yield even greater returns in the future.
Freed Income To Invest Elsewhere
Free cash flow from real estate assets supplies investors with the additional capital to horizontally expand their portfolio. The strength of a productive portfolio lies in its diversified assets. Including a broader range of assets in a portfolio safeguards it from sudden economic changes.
Capital assets that present investors with the opportunity to expand their portfolio are critical to its stability.
Real estate assets diversify portfolios and sustain investors with the free cash flow to continue making investments to diversify. When investors regularly have cash on hand to make more investments, they can acquire a diversified portfolio that can perform in any economic condition.
The time value of money means that cash now is worth more than it will be in the future; strong cash flow assets puts cash in hand for the present for better investments.
Other Financial Metrics
Cash flow is an essential metric to assess an asset’s potential. Cash flow helps investors understand how an investment can be expected to perform when utilized with other key financial measures.
Consider these additional financial metrics before making a real estate investment:
- Debt coverage ratio
- Cash-on-cash return
- Net present value
- Return on equity
- Capitalization rate
- Internal rate of return
- Net operating income
- Discounted cash flow
- Profitability index
- Gross rent multiplier
How Can You Invest in Real Estate Assets?
Investors have multiple options to acquire real estate. How investors get involved depends on their finances, economic trends, and potential for financing. Here are a few options investors have to access real estate investments:
- Rental properties
- House flipping
- Real estate investment trusts (REITs)
- Private equity funds
- Real estate investment groups (REIGs)
The Bottom Line
The benefits of strong cash flow make real estate a very good asset for a stable, strong portfolio.
While real estate is a huge boon to an investor’s portfolio, as a rule of thumb, most opportunities in the real estate industry have high financial thresholds.