Tell Me the Difference: Cash Flow vs. Profit
For some investors, the concept of cash flow and profit are blurred. This is understandable; there is frequently a link between the two, and a lack of cash flow often means that more funds are going into real estate projects than is possible to get out of them. And when cash flows have completely dried up, there is a strong chance you’re losing money on your investments, not profiting.
However, cash flow and profits are not the same thing and conflating the two can cause issues for your perspective on the success of real estate investments. If you understand the distinction between these two popular financial benchmarks, your position as a real estate investor will be more likely to succeed.
Defining Cash Flow
Cash flow refers to the actual transfer of funds into and out of a business. For example, if you sell a property for $450,000, the receipt of $450,000 into your bank account is cash flow.
From an accounting standpoint, cash flow can be categorized as investing activity, financing activity, and operating activity. Investing activity refers to things like dividends earned on investment accounts, while financing activity can include interest paid on a loan borrowed from the bank. Operating activities encompass all of the day to day expenses that contribute to normal business operations, like purchasing equipment.
As a real estate investor, these categories are less important than they would be for a large business that generates a statement of cash flows in accordance with accounting rules, but understanding the basics can help with comprehension of cash movements.
In essence, whenever money is credited or debited in your bank account, it is a normal cash flow movement.
Quantifying Cash Flow
To gain an overall understanding of your cash flow activities, it’s important to quantify all sources of cash inflows and cash outflows. Sources of cash inflows can include things like:
- Rental income
- Proceeds from property sales
- Laundry fees
- Maintenance fees
- Application fees
- Late fees
- Pet fees
- Dividends on investments
On the flip side, cash outflows can include:
- Mortgage payments (including interest)
- Property taxes
- Maintenance and repair costs
- Down payments on new purchases of property
- Costs of upgrades
In general, those who serve as landlords tend to have more income streams than those who solely flip properties. But not all income streams contribute to profit (since some of the income streams will be offset by related expenses).
An important exercise in real estate investing is accounting for all of the cash inflows and outflows.
Understanding the Implications of Cash Flow
While cash flow and profit are different concepts, cash flow can be an indicator of success.
Far too many investors assume that negative cash flow is always a sign of a problem, but in the early days, this may not be true. For example, in the first year or two of owning and renting out a property, limited cash is more par for the course than a red flag as there may be frontloading of certain repairs and upgrades. In addition, cash flow does not take into account appreciation on property values (which will contribute to profit upon the sale of the property).
However, it is a problem if cash flow is consistently inadequate to meet obligations; for example, if you’re not making enough on rent to pay your mortgage and maintenance obligations, your negative cash flow may indicate that it is time to reconsider your strategies and evaluate the feasibility of an exit plan.
Cash flow isn’t the only sign to look for, but when interpreted in context, it can contribute to a better view of the overall picture.
Maximizing Cash Flows
Cash flows don’t always equal adequate profits, but having cash on hand is a big part of running your property investment strategy without digging a hole from which you can’t crawl out. Making moves to maximize inflows can contribute toward higher profits and a bigger safety net in managing your operations.
Say, for example, you have a two-unit home and rent each unit for $1,600. Your mortgage is only $2,400 due to the amount of equity you were able to put in at the time of purchase, but utilities cost another $300, taxes an additional $100, and repairs and maintenance run around 5% of your rental income on a monthly basis. Suddenly, that $3,200 of rental revenue (cash inflow) is offset by $2,920 of cash outflows, and the $280 surplus could easily be wiped out with a few smaller emergencies back to back, particularly when elements like vacancy rates are taken into account.
How to proceed in this situation can be managed in a number of ways, including increasing rent to a manageable level without exceeding area averages, providing for the tenants to pay utilities rather than paying out of pocket, or taking on more repairs and maintenance projects yourself to cut costs. The choice you make will be circumstantial, but when cash is tight, it’s time to make tough decisions to leverage potential upsides. As an investor, it’s up to you to strategize and plan accordingly, and finding the right balance between appropriate demand and enough cash isn’t always easy.
Profit is more of a concept than the tangible results that cash flow provides but is an essential part of evaluating the effectiveness of a real estate investment opportunity. Simply put, profit – or, for those experiencing a poor investment decision, loss – refers to the difference between revenue and expenses for a given period of time.
Take, for example, a fix and flip in which you originally paid $475,000 for the property, invested $50,000 in repairs, and sold for $575,000. In this scenario, regardless of the cash you receive for the sale – say, for example, any cash was immediately diverted to paying down an existing mortgage – you still generated a profit of $50,000, net of any expenses that went into the sales process.
In the prior example of the two-unit rental property, the $280 surplus in cash each month that we calculated above is effectively the monthly profit, but a more accurate assessment of the profitability of the investment would also take into account the amount of the down payment at the time of purchase, the property appreciation that will be realized at the time of a sale, and the possibility that rent will increase over the years even while the mortgage payment remains constant (or the mortgage is paid off).
These examples illustrate that cash flows can affect profits, but that profits encompass more than just cash flow and it is important to examine both metrics for a fuller understanding of the performance of your investments. And analyzing these metrics on your prior investment decisions can help you learn from past mistakes before your next investment.
Turning a profit is an important part of real estate investing, but getting to that point can take time, experience, and education. Maximizing the money you earn from your fix and flips, for example, isn’t as easy as just buying a house, making a few simple fixes, and listing it for more than you paid.
Before making a purchase, it’s important to consider after-repair value, or ARV. ARV refers to the value of a property after repairs, and this metric is indicative of the price at which you can expect to sell a property once the major pain points are remedied. It’s important to understand that the amount of money you put into a property doesn’t necessarily have any relation to the amount you can list it for once it’s up to par; to a large degree, the value of the house stands regardless of whether you got a good deal on replacement windows. A good rule of thumb is to make 65% of the ARV the maximum aggregate amount you’ll spend on purchasing and rehabbing a property to give yourself an adequate buffer.
Before making a purchase, keep these kinds of questions in mind:
- What is the current state of the area you are considering, and how is the city or neighborhood trending?
- What is the behavior of area prices – are they stable, volatile, rising, or falling?
- Are area schools strong and are families or high wage earners going to be likely to move into the area?
- What is the average income in the neighborhood?
- Is the population growing or shrinking?
- How is the job market for those moving into the area?
In addition to conducting your due diligence on the neighborhood, you need to consider the other components that play into calculating a profit. Unless you’re exceptionally handy, you’ll likely need to partner with plumbers, electricians, contractors, and even property inspectors to make sure you’re making the right upgrades without cutting corners. While relationships over time can keep these costs lower than working with a revolving door of vendors, the expenses required to handle the fixing part of a fix and flip go beyond simple supply charges. You should also consider the cost of taking out a mortgage if applicable as well as closing costs, taxes, and insurance. That’s why a maximum investment of 65% of an estimated ARV is highly encouraged – should the costs of necessary renovations or expenses associated with closing spiral out of control, there will still be a safety net in place to ensure at least a little profit.
In essence, real estate should never be a gamble. When you neglect due diligence in favor of moving quickly on something you think could be a sure thing, you run the risk of ruining your chance for profits before you even get started. All the cash flow in the world can’t necessarily guarantee making a profit in the long run, so the more emphasis you put on sustainable profits, the better.
Putting It All Together
For many investors, significant cash flow tends to accompany profits, but conflating the two can be a big issue, particularly under circumstances like a fix and flip where cash outflows are frontloaded and a cash inflow only occurs upon the sale of a property, or in a rental property situation where a modest net cash flow may be offset by property appreciation. By familiarizing yourself with common financial metrics and terms, it’s easier to run and analyze your operations in a proper way.
Scott Clift is a licensed real estate broker with Westpark Loans. He has been in the real estate industry since 1994. His team of seasoned professionals specialize in providing real estate loans for investors and other self-employed individuals. When you are ready to invest in real estate, call Westpark Loans to secure your financing at (844) 574-LOAN or by visiting westparkloans.com.