Do you know how to calculate cash flow? If you do, you are already ahead of the game. If not, I urge you to continue reading. Knowing how to calculate free cash flow is of the utmost importance to any aspiring rental property owners, vacation rental or otherwise.
Many of today’s investors have turned to buy and hold strategies to offset the high prices we are currently seeing, and for good reason: it’s entirely possible to recoup much (or all) of the added costs by renting out a property for a short period of time. Vacation rentals, in particular, have seen their prices escalate almost exponentially in the last six years, but I digress. Vacation rentals are no more exempt from the validity of a buy and hold strategy in today’s market than any other rentals. In fact, the right vacation rentals are well worth the consideration of today’s best investors, which begs the question: How can you tell if a vacation rental is worth your time? The answer is simple: cash flow.
If you know how to calculate the cash flow of your vacation rental property, you will have a better than good idea of how well it’s performing. Let me explain.
In its simplest form, cash flow is essentially the amount of money an asset is either bringing in or losing on a monthly basis. Not surprisingly, cash flow can be negative or positive, with every investor favoring the latter for obvious reasons. Positive cash flow, as its name suggests, indicates that an investors assets are liquid and making money. Consequently, negative cash flow suggests an asset is losing more money than it’s bringing in.
As Investopedia so eloquently puts it, “cash flow is the net amount of cash and cash-equivalents being transferred into and out of a business.” Cash flow is, therefore, a great indicator as to how well an asset is performing. Therein lies the single most important reason investors should care about cash flow: it provides an objective look into how an asset is performing from month to month. Not to be confused with something like a capitalization rate, a metric used to estimate an asset’s potential, cash flow is the end result of an investment that has already been made (not an estimation).
Of particular importance, however, cash flow represents liquidity. Positive cash flow suggests an investor will have access to cash, which is what keeps most businesses alive. Not surprisingly, it’s a distinct lack of cash that ruins most businesses, so having access to it can only help.
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For as important as calculating rental property cash flow is to an investor, it’s a relatively simple feat to achieve. In fact, cash flow can be calculated by subtracting all off your expenses from all of your income. What you have left, whether it’s negative or positive, is your cash flow. Or, more specifically:
Understanding how to calculate net cash flow only works if you account for every detail. In addition to the typical expenses you would encounter over the course of owning a vacation rental, there are three things you need to pay special considerations to: Comparable properties, peak season rates and vacancy rates.
Not surprisingly, vacation rentals are inherently subject to seasonal fluctuations. Regardless of the season, vacation rentals serve a distinct purpose: to provide a living space for a distinct place and time of year. That said, vacation rentals tend to have peak seasons. Luxurious mountain cabins, for example, tend to book up in the winter months when skiing becomes its own attraction. On the other hand, beach houses will notice their peak season fill up as the weather gets hotter. Case in point: there’s usually one season that a vacation rental property will experience an uptick in interest. Consequently, the remaining seasons are, well, less busy; there’s an inherent vacancy rate when it comes to vacation rentals, so your cash flow expectations need to account for them.
To get a better idea of what type of cash flow you can expect from your own vacation rental, try looking at nearby comparables. Most vacation rental properties are already part of a community or neighborhood with similar properties within close proximity. Of course, there are exceptions, but you’ll be able to identify a similar property more often than not. In the event you are able to identify a good comparable, see if you can tap into their data. How much is that home renting for? How often is it vacant? Glean as much information from your neighbors as you can, and you’ll be much more likely to realize success.
While simple in nature, understanding how much to charge is a complicated matter that relies on several variables. In fact, there are a number of things you need to consider if you hope to charge the right amount for your rental property. It is worth noting, however, that there’s only one place to start: the value of the home itself. Before you can even think about setting a rental rate, you must first identify how much your home is worth.
Next, you’ll want to take a look at what similar homes in the area are renting for; your rental rate should be a combination of the two. I maintain that the amount you charge in rent should be based on a percentage of your home’s value, but it should also take nearby rents into consideration. “Typically, the rents that landlords charge fall between 0.8% and 1.1% of the home’s value,” according to SmartAsset. A home valued at $250,000, for example, should demand somewhere in the neighborhood of $2,000 and $2,750 in rent.
Unfortunately, there is no simple answer. The true value of a pool is ultimately in the eyes of the beholder. Pools are only as valuable as the amount people are willing to pay for them. Those interested in living in a property with a pool could very easily spend more to have such an amenity at their disposal. Consequently, there are many who view a pool as a negative. New families with young children, for example, may view pools as a threat to their safety, and actually shy away from the prospects of owning a home with a pool. What’s more, the location of a vacation rental will certainly be telling of whether or not a pool adds value. Homes in Palm Springs actually do sell for more money because there is an inherent demand in areas with generally warm temperatures. That said, pools are less valuable in colder climates like Minnesota.
Put simply, the price-to-rent ratio is a tool for conducting real estate evaluations. Or, more specifically, “it is typically calculated as the ratio of home prices to annualized rent in a given location,” according to Investopedia. And for those of you that I have already lost, the price-to-rent ratio is usually used to determine whether it is better to buy or rent in a particular neighborhood. As you may have already guessed, good price-to-rent rations will vary by neighborhood.
If you know how to calculate cash flow and, at the very least, understand the basic concept, you will have a better idea of how to value respective properties. More importantly, however, you’ll give yourself an edge. You see, only those that can anticipate an outcome accurately stand to make success habitual. Therefore, if you know how to calculate operating cash flow, it’s safe to assume you will have an idea of how a property will fare on the rental market. And if that’s the case, you will know whether or not a property is worth investing in. What more could you ask for?