Cash flow analysis, from gross income to cash flow
Before buying an income property, an investor builds an operating statement: a one-year picture of what the property brings in and what it costs to run. The exam tests the order of the steps more than anything else. Memorize this ladder.
| Step | Line | How to get it |
|---|---|---|
| 1 | Potential gross income (PGI) | Every unit rented all year at market rent |
| 2 | − Vacancy and collection loss | Rent lost to empty units and tenants who do not pay |
| 3 | + Other income | Laundry, parking, vending, late fees |
| 4 | = Effective gross income (EGI) | What the property realistically collects |
| 5 | − Operating expenses | The cost of running the property |
| 6 | = Net operating income (NOI) | Income from the property itself, before any loan |
| 7 | − Debt service | The annual mortgage payments, principal and interest |
| 8 | = Before-tax cash flow (BTCF) | Cash left for the owner before income taxes |
Some textbooks list other income in step 1 instead of step 3. Read each problem carefully to see whether the vacancy rate applies to rent only or to all income.
Potential gross income
PGI assumes 100% occupancy for the full year. For an apartment building, multiply the number of units by monthly rent by 12. Watch for problems that give a monthly figure; annualize before you do anything else.
Vacancy and collection loss
No building stays full forever, and some tenants do not pay. Investors estimate this loss, usually as a percentage of PGI. A 5% allowance on $158,400 of PGI is $7,920.
Operating expenses
Operating expenses are the ongoing costs of keeping the property running:
- Fixed expenses that do not change with occupancy, such as property taxes and hazard insurance.
- Variable expenses that rise and fall with use, such as utilities paid by the owner, repairs, and management fees.
- Reserves for replacement, money set aside each year for items that wear out, such as roofs and appliances.
Not operating expenses:
- Debt service. The mortgage payment depends on how the buyer finances the deal, not on how the building performs. NOI is always measured before debt service so that two buyers with different loans see the same NOI.
- Depreciation. It is a tax deduction, not a cash expense. (Unit 18.)
- The owner's income taxes.
Net operating income
NOI is the single most important number in income property analysis. Lenders compare it with the loan payment, and appraisers divide it by a capitalization rate to estimate value (Unit 16). Lenders often express the comparison as a debt service coverage ratio: NOI divided by annual debt service. A ratio above 1.0 means the property earns more than the loan payment.
Before-tax cash flow
Subtract the annual debt service from NOI and you have the cash the owner actually puts in their pocket before income taxes. This is the number the investor cares about most from year to year. It is also called cash throw-off.
A full example
A 12-unit building rents for $1,100 a unit per month. The owner allows 5% for vacancy and collection loss and collects $2,400 a year from the laundry room. Operating expenses are $58,000 and the annual mortgage payments total $62,000.
- PGI: 12 × $1,100 × 12 = $158,400
- Vacancy and collection loss: $158,400 × 0.05 = $7,920
- EGI: $158,400 − $7,920 + $2,400 = $152,880
- NOI: $152,880 − $58,000 = $94,880
- BTCF: $94,880 − $62,000 = $32,880
The most common mistake is subtracting the mortgage payment as an operating expense. If you do that, you get the cash flow figure and call it NOI.