Understanding Cash Flow in Commercial Real Estate Investments

This article dives into the world of commercial real estate (CRE) investment analysis, unpacking a crucial concept: cash flow. We’ll not only explain what it is but also explore how it impacts your potential return on investment (ROI) in CRE.

Demystifying Cash Flow

The term “cash flow” gets thrown around a lot, but in CRE analysis, it has a specific meaning. It’s not simply a property’s total income. Instead, it refers to the money leftover after all operating expenses are paid. While a helpful starting point, a more precise picture is provided by two key metrics: net operating income (NOI) and cash flow before tax (CFBT).

• Net Operating Income (NOI): This figure represents the property’s “operating profit.” It’s calculated by subtracting operating expenses from gross rental income. NOI is crucial because it forms the basis for valuing commercial properties.
  
• Cash Flow Before Tax (CFBT): This metric takes NOI and subtracts debt service payments. It represents the cash available for distribution to investors, often what they consider when they say “cash flow.” For the rest of this article, we’ll use “cash flow” and “CFBT” interchangeably.
  

Positive vs. Negative Cash Flow

Cash flow can be positive or negative, depending on the property’s performance.

• Positive Cash Flow: A positive cash flow signifies that the rental income not only covers operating expenses and debt service but also leaves a surplus for distribution. For instance, if a property generates $100,000 in rent, has $50,000 in operating costs, and $25,000 in debt service, the remaining distributable cash would be $25,000 (positive).
  
• Negative Cash Flow: Negative cash flow means the rental income, minus operating expenses and debt service, results in a negative number. While a short-term negative flow might be acceptable during renovations or lease-up, sustained negativity typically indicates trouble for CRE investments.
  

Cash Flow in Action: A Simplified Example

Let’s illustrate cash flow with a real-estate investor considering a single-tenant, triple-net leased property with 10,000 square feet at $10 per square foot. Here’s a simplified cash flow statement:

Gross Rental Income	$100,000
LESS:  Vacancy	$0
Effective Rental Income	$100,000
Property Taxes	$15,000
Insurance	$10,000
Maintenance	$10,000
Utilities	$15,000
Legal, General, and Admin.	$5,000
Total Operating Expenses	$55,000
Net Operating Income	$45,000
Lender Debt Service	$30,000
Cash Flow Before Tax	$15,000

Why Cash Flow Matters in CRE Investing

The core principle of a CRE investment strategy is the expectation of a return on your investment. Understanding a property’s cash flow is essential because it directly impacts the potential return you could earn, often measured by “cash-on-cash return.”

Factors Affecting Cash Flow

Given the importance of cash flow in CRE performance, understanding the factors that influence it is crucial. Here’s a breakdown of the income and expense sides of the equation:

Income boosters:

• Rents: Rent is the single biggest factor impacting cash flow. Market conditions influence rental income. During strong markets, rent increases can lead to higher cash flow. Conversely, weak markets might necessitate lowering rents to retain tenants.
• Other Income: Rent isn’t the only income source for some properties. Multifamily buildings, for example, might generate additional income from pet fees or parking charges. Implementing such charges, if not already in place, can boost cash flow.

Expense culprits:

• Tenant Turnover: Ideally, a property would always be fully occupied with tenants paying rent on time. However, tenant vacancies are inevitable. During these vacancy periods, cash flow suffers due to lost rental income.
• Repairs & Maintenance: Routine repairs and maintenance are necessary to keep a property in good condition. While unavoidable, they reduce the amount of cash available for distribution. Unexpected repairs, like a failing HVAC system, can significantly impact cash flow.
• Utilities: Utility expenses for power, water, and trash removal are standard operating costs for properties. Property owners are incentivized to reduce these expenses whenever possible to improve cash flow.
• Operating Expenses: These are the everyday costs required to run a property, including legal fees, property management, and landscaping. Striking a balance between maintaining the property and minimizing these expenses is key for maximizing cash flow.
• Missed Rent & Vacancy: Missed rent creates a double whammy for cash flow. The lost income itself hurts, but it can also lead to additional expenses like legal fees to collect the missed rent.
• Property Management: Property management costs encompass day-to-day tasks like rent collection, repairs, and tenant leasing. These costs can be reduced by self-managing the property or using a third-party manager with competitive rates.
• Property Taxes: Property taxes are fees paid to local municipalities for public services. These taxes reduce cash flow and can increase significantly upon property sale due to the new purchase price. Factoring property taxes into the initial purchase decision is crucial.
• Insurance: Every property needs insurance protection against theft or natural disasters. While insurance premiums reduce cash flow, they are essential to prevent major, unexpected expenses.

In essence, any income a property generates, from rent or other sources, increases cash flow. Conversely, any expense reduces it. With this understanding, investors can employ various strategies to maximize cash flow.

Strategies to Increase Cash Flow

There are three main approaches to boosting a property’s cash flow: increasing income, reducing expenses, or a combination of both. Here are some commonly used techniques:

• Rent Increases: Over time, rents generally trend upwards due to inflation or favorable market conditions. When a lease renews, property owners should analyze market conditions and raise rents if possible. Including a rent escalation clause in the lease for periodic increases throughout the lease term can also be beneficial.
• Encouraging Long-Term Tenants: Sometimes, offering slightly lower rent in exchange for a longer lease commitment can be advantageous. For example, an owner might accept $8.50 per square foot for a 10-year lease instead of $10 for a 5-year lease. While this might decrease cash flow slightly in the short term, the long-term stability and reduced tenant turnover costs can benefit cash flow over time.
• Property Tax Appeals: Property taxes are typically based on a property’s assessed market value. In down markets, investors can potentially save money by appealing their property tax bill and requesting a reduction. Consider hiring a third-party service to assist with this process, as the property tax savings can directly increase cash flow.
• Value-Add Renovations: A value-add investment strategy involves purchasing a property at a good price and then investing capital in renovations and improvements. The goal is to increase rent and/or decrease vacancy rates, ultimately leading to higher cash flow.
• Preventative Maintenance: While it requires upfront investment, preventative maintenance on critical systems like electrical, plumbing, and HVAC can save significant money down the road by preventing major, unexpected repairs. This translates to improved cash flow.
• Generating Additional Revenue: Developing new revenue streams beyond just rent is a popular strategy to increase cash flow. Multifamily properties, for example, could implement application fees, vending machines, rentable storage lockers, or pet rent. In a commercial setting, an investor might develop unused outparcels in a shopping center and lease them to generate additional income.
• Managing Operating Expenses: Cash flow improvement isn’t just about increasing revenue; it’s also about reducing expenses. An in-house property management team can potentially cut costs and improve cash flow. Additionally, renegotiating service contracts for maintenance and landscaping or investing in technology to streamline operations with a smaller on-site team can be explored.

The 1% Rule: A Quick Cash Flow Assessment

Analyzing commercial properties can be time-consuming. Investors often face a dilemma: invest significant time building a detailed cash flow model only to find the property isn’t a good fit, or conduct a quick test to see if further analysis is worthwhile? The 1% rule offers a solution.

The 1% rule suggests that a property’s monthly rent should be at least 1% of its purchase price to break even. For example, a property with a $1,000,000 purchase price should generate at least $10,000 in monthly rent to break even. If it meets or exceeds this threshold, it might be worth further, more detailed analysis. It’s important to remember that the 1% rule is a basic guide and shouldn’t be the sole factor in investment decisions.

Conclusion

Understanding cash flow is a fundamental skill for commercial real estate investors. By analyzing NOI, CFBT, and the factors impacting them, investors can make informed decisions about potential CRE investments. Remember, maximizing cash flow is key to achieving a strong return on investment in the exciting world of commercial real estate.