One of the two biggest mistakes new real estate investors make is purchasing a rental property on emotion and not doing a proper cash flow analysis. Some new investors just want to rush in because they have heard owning real estate will make them wealthy.

  However, probably the biggest mistake new investors make is doing too much analyzing (analysis-paralysis) and never gaining the confidence needed to make the actual purchase of a property. Thus, new investors miss opportunities, or worse get frustrated and quit.

  To be successful, you need to seek a middle ground between the two extremes. You need to create a system of analyzing cash flow, quickly be able to understand the story the numbers are telling you, and know that you do not need to be 100% accurate. All you are looking for is a property that will generate positive annual cash flow and will have a reasonable appreciation rate over time. Wealth comes with accumulating many of these cash-flow positive properties.

  The first step in analyzing a property's cash flow is having the right tools - a cash flow model. At the very least, your cash flow model needs to be able to calculate annual net cash flow after income taxes, cash-on-cash return, and return on investment every year over a number of years.

  Annual net cash flow takes into consideration your gross rental income less expenses, vacancies, mortgage payments, capital improvements and and income taxes. This number tells you the annual net cash generated from your investment. Dividing your annual net cash flow by your initial investment (purchase price less debt) gives you the cash-on-cash percentage return. This return ratio shows you how your money is working for you... much like you would view a certificate of deposit at your bank.

  The other significant number in real estate investing that affects your return is appreciation. Appreciation is not a cash flow item until the property is sold. Therefore, you need to understand how this future cash in-flow affects your overall rate of return. One of the ways to do this is to use an internal rate of return (IRR) calculation. The two main differences between IRR & cash-on-cash are that IRR takes into account appreciation and time-value of money.

  Which is more important, cash-on-cash or IRR? Well since I am a CPA, this is where I get to say "it depends". The general rule is that the longer you plan to own a property, then the more you want to focus on the cash-on-cash return.

  This ratio makes you focus on the annual return on your investment and helps you compare investments. In other words, I would rather purchase a property with a higher cash-on-cash return that generates less cash flow than a property that generates a lot of cash flow but has a poor cash-on-cash return. A low cash-oncash return means I am tying up my cash to generate a poor return.

  The shorter the holding period, the more you want to focus on the IRR. In this case, appreciation will be a realized cash flow item sooner and thus has more of an impact. I generally give more weight to IRR than both cash flow and cash-on-cash when my intended holding period is three years or less.

  One of the more frequent questions I get is which goal should my clients be setting.

  Obviously that is a personal choice, but I recommend that you remain flexible and be willing to let the property tell you what you should do... in other words, let the opportunity dictate your strategy.

  And of course, the only way to know which opportunity is presenting itself is to have a good cash flow model that quickly and easily paints the property's financial performance.

(c) Copyright 2004, All Rights Reserved.

Douglas Rutherford, CPA is the founder and CEO of RentalSoftware.com LLC whose main product is the Landlord's Cash Flow Analyzer. The software is designed to help landlords compute cash flow, profitability and the rate-of-return on their rental property investments. Income taxes are a critical component of calculating cash flow in making real estate investment decisions.

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