Understanding Cash Flow: Net vs. Free & Why It’s Important to Know the Difference
Growing up, my uncle always told me “cash is king”. And I agree with that which is why our real estate investing niche is buy and hold properties that s cash flow.
The term “cash flow” is tossed around a lot when it comes to real estate investing and it seems every investor uses it differently making it hard to really compare apples to apples when looking at deals.
Generally speaking, cash flow is the amount of money left over after deducting your expenses from the income of the property. So if a property produces $2,000 a month in income (rent) and your fixed expenses (mortgage, taxes, insurance etc.) are $1,500 then it would seem that this sample property would cash flow $500 a month.
Damn! This figurative property sounds like a good deal!
But let’s hold up a minute.
We’re in this real estate game to make some money, right? When the water heater breaks, I don’t want to pay for that out of my own pocket. When the property sits vacant for a month between tenants, where am I finding the cash to pay for the mortgage and insurance that month? I’m not foregoing happy hour with my friends because we had to fix a toilet this week.
To make sure a deal is truly a good deal, we have to account for ALL possible expenses. We must save money each month for reserves. So when we need to replace the roof, we have enough money in reserves to pay for it, and I can go about my life without taking a personal hit. Happy hour here I come!
Net Cash Flow vs. Free Cash Flow
When I’m analyzing a deal or am talking about cash flow, I’m referring to FREE cash flow not NET cash flow.
So what’s the difference between NET cash flow (NCF) and FREE cash flow (FCF)?
Basically, for me and the purpose of this blog, net cash flow is the amount of money left after deducting expenses that actually occurred.
NCF = Income (Rents) – Expenses (Mortgage, Taxes, Insurance, Property Management [if you use one], Utilities [if you pay them], and any other expense that ACTUALLY occurred during this billing month. So if you paid to have the lawn mowed, that would be included.
Free cash flow is the money left after deducting a percentage of all possible expenses. So you’re accounting for possible costs that may occur down the line.
FCF = Income (Rents) – Expenses (Mortgage, Taxes, Insurance,Property Management [if you use one], Utilities [if you pay them], and any other expense that ACTUALLY occurred during this billing month.) – an anticipated % for Vacancy, Capital Expenditures, and Repairs.
Free cash flow is profit. It’s money that the shareholders, aka you the property owner, can keep, save, buy a yacht, buy sushi, donate to a good cause, do whatever with. If you don’t account for and save money for a possible vacancy, or to replace the roof, then one day, you will be hit with a hard expense that you must personally pay for because you never set aside a percentage of the income each month for reserves.
We love reserves. We’re not risk takers, remember?
For you visual learners out there, here’s a fun infographic to help further explain.
Let’s Sum It Up
When analyzing a deal you want to be positive free cash flow, not just positive net cash flow.
Still reading? Wow, look at you! For that, I’ll give you an actual analysis with real numbers below. Let’s analyze a property and calculate both NCF and FCF together.
For numbers sake, let’s look at a $100,000 single family home.
Here are the details of the property.
Purchase Price– $100,000
Mortgage (with 20% down at 5%)- $429.46/month
Potential Rent- $1,300/month
$1,300 (Income) – $939.46 (Fixed Expenses) = $360.54
Over $350 cash flow on a $100,000 property sounds like a steal! Now let’s look at it using free cash flow.
$1,300 (Income) – $939.46 (Fixed Expenses) – $312 (Reserves) = $48.54
Barely profiting only $50 is not a good deal. That’s only a 2.54% cash on cash return assuming you did zero in renovations. You can do better in the stock market at this point.
You see, not accounting for potential costs can severely affect your bottom line and destroy your free cash flow.
So remember my friends, free cash flow is king.