Cash flows are life blood to real estate investment property. Real estate investors purchase income, and every prudent real estate investor makes real estate investing decisions based upon the income stream of rental property.

Cash flows are defined as those annual streams received from the renting of space during the holding period and the value of the reversion (usually sale price less mortgage balance and taxes due) at termination of the investment.

Annual cash flow results from rental activity, and as we will see in the following discussion, can be measured in a variety of standardized ways. Each provides the real estate investor a measure of a property’s productivity and should be understood by anyone seriously engaged in real estate investing.

1. Gross Scheduled Income (GSI) is the full anticipated amount of rental income without reductions from any sources. It is the best case scenario, rental income as if the building were 100% occupied.
2. Vacancies and Bad Debts are reductions in GSI resulting from vacancies, nonpayment of rent, or the inability to place the property in service for any reason.
3. Effective Gross Income (EGI) is GSI reduced by the forecast vacancy factor.
4. Gross Operating Income (GOI) is EGI plus other income items not subject to vacancies and bad debts such as laundry income.
5. Operating Expenses include those costs associated with keeping a property in service such as routine maintenance and repair, utilities, property taxes, insurance, and management fees, among others. Payment of debt service (principal and interest payments), income taxes owed by the investor as a result of owning the subject investment, and allowances for depreciation is not an operating expense.
6. Net Operating Income (NOI) is calculated on an annual basis by subtracting operating expenses from gross operating income and is an extremely valuable measure of cash flow. Namely, NOI is the return expected from a property for any given annual period as if it was wholly owned (no debt) and before taxes and depreciation are considered.
7. Cash Flow Before Tax (CFBT) is cash available before consideration of taxes, and is simply NOI minus debt service. This measure of cash flow is important in the world of real estate investing because it provides the return available after the debt has been serviced, but before the effect of tax (shelter) has been considered.
8. Cash Flow After Tax (CFAT) is a measure of spendable cash from the investment, and is calculated as CFBT minus taxes, which requires a separate tax calculation to determine taxable income from annual operating cash flow. To do this, the following are subtracted from NOI: interest on the loan, an allocation for depreciation (cost recovery), and allocable amortization expense. This figure times the investor’s marginal tax bracket equals tax payable.

One of the benefits of real estate investing is the return on investment due to tax shelter.

These are paper losses the IRS allows you to deduct from the taxable income you receive from the real estate investment property. Namely, when you own an investment property, the IRS gives you an annual depreciation allowance to deduct against your income.

How do you determine your annual depreciation allowance? One of the methods you can use is your property tax bill. Look for two components:

1. The assessed value of the improvements (the structures on the land)
2. The total assessed value of the entire property

Since it is ratio we are looking for (not the actual dollar amount shown on the tax bill), use these numbers to get the percentage for the value of the improvements. Here is the calculation:

Assessed improvement value / Total assessed value = % value of improvements

Next, use the percentage you get from that calculation to determine the amount of improvements as follows:

% value of improvements x price = depreciable improvements

The IRS rarely challenges this method of determining depreciation, but proceed with caution. The ratio from your tax bill is not always accurate; and if not, your deduction could be unfairly limited.

Please feel free to preview a proforma income statement created by our real estate investing software that shows how depreciation allowance can affect your annual cash flow.

By Blake Edwards

Editors note: The following article with advice for real estate investors was submitted by one of our real estate investment software customers. Hopefully the content will be helpful to those who have been thinking about making a real estate investment.

If you’ve ever dreamed of becoming a real estate investor, you’re not alone; being a real estate investor is not really that hard. There are realistic and practical ways to get started as a real estate investor regardless of your experience level or the amount of cash you have on hand–sometimes you do not need any money down.

First, it’s worthwhile to make yourself a real estate investor business plan. If you start out with a professional attitude, using a real estate investor business plan, you’ll be well on your way to achieving success as a real estate investor.

Commercial real estate investing can be done by even the most average and non-average of people- a little motivation and willingness to learn, and you can easily be on your way to being a very successful, profitable commercial real estate investor.

Here are a couple of tips:

1. Seek out a successful commercial real estate investor whom you can study, model after and even adopt as a mentor.
2. Having legal help is one of the most important aspects of commercial real estate investments.
3. Avoid negative cash flow. Choose a property that does not eat away your working capital on a regular basis.
4. Interview real estate agents and learn from them, but don’t sign any agreements that will limit your search for bargain properties.

On the whole, real estate investing can be an extremely profitable investment niche, but know this: most real estate investors spend an average of five years running their business before they ever see a good income. So be patient. Wealthy real estate investors are not born overnight.