How does Real Estate generate Cash Flow?

May 31, 2020

If you are considering investing in a real estate syndication you might be thinking that it sounds a little too good to be true.  You’re not alone, I get questioned about this from nearly everyone I speak to.

Many investors are surprised, skeptical and impressed when they first learn about the potential massive and steady cash flow they could receive through passively investing in real estate syndication.

The best way to deal with this surprise and skepticism is to understand where the cash flow comes from and how it makes its way from the rents collected to your pocket.  That is exactly what we will cover in this post.

Cash Flow Distributions

Typically, within the first few months after closing, you can expect to start receiving monthly cash flow distributions.  These distributions will be a percentage of your cash invested.  This is your  new stream of passive income!

But how in the world is it possible that this cash flow stream can be so much higher than a dividend stock and actually appreciate in value for a substantial capital gain as well? Where does the money really come from? 

Where Cash Flow Comes From

Every investment property, no matter the size or number of tenants, is an asset that generates income as well as expenses. Let’s talk about how an apartment complex generates income, the expenses they incur, and how cash flow is calculated.

Gross Potential Income

In the case of an apartment building, the main source of income is the rent that the tenants pay each month. 

As an example, let’s say the average rent in a 100-unit building is $800 per month. this means the gross potential income is $80,000 per month, which comes out to $960,000 per year. 

Monthly Gross Potential Income

100 units x $800 each = $80,000 per month

Annual Gross Potential Income

$80,000 per month x 12 months = $960,000 per year

Now, before you get over excited, remember this is Gross Potential. The keyword is POTENTIAL. This assumes every unit is rented for every month (no vacancy) and there are no delinquencies (failure to pay)  with no deals, or discounts like “first month’s rent free!” (concessions).

Net Rental Income

Vacancy costs, loss to lease, and concessions decrease the potential income, and once they are removed, you’re left with something called net rental income

Assuming only 10% of the units are vacant (i.e., in a 100 apartment complex, only 10 are empty), at $800 a month, the monthly vacancy cost would be $8,000.

Vacancy Cost

10 units vacant x $800 in lost rent per unit = $8,000 vacancy cost per month

If the vacancy rate remains constant throughout the year, the annual vacancy cost would be $96,000.

$8,000 per month x 12 months = $96,000 per year

Net Rental Income

Remember, to get the net rental income, we must take the gross potential income (the total income if all units were filled) and subtract out the vacancy cost.

$960,000 annual gross potential income – $96,000 annual vacancy cost = $864,000 annual net rental income

Operating Expenses

Don’t forget, there are business expenses too.  Just as in any business, real estate has expenses that must be considered.

Operating expenses like maintenance, repairs, property management, cleaning, landscaping, utilities, legal and bank fees, pest control, etc. have to be paid. No two apartment buildings have the same needs or the same expense structure.

Let’s presume that total projected monthly operating expenses equal $38,000, which works out to $456,000 per year. The sponsor team would work toward reducing these expenses over time, but we’ll use this figure as a starting point.

Annual Operating Expenses

$38,000 monthly operating expenses x 12 months = $456,000 annual operating expenses

Net Operating Income (NOI)

NOI or Net Operating Income is what’s left from the net rental income after operating expenses are removed.

$864,000 net rental income – $456,000 operating expenses = $408,000 NOI

If you’re a little confused at this point it’s okay! There are a lot of numbers here and potentially some new terms.  Refer to the Real Estate Terms reference guide if you need to. The important thing to remember is that you want the NOI to be a positive number and as high as possible.  This means the asset has the potential to generate a profit.  Thus creating  the cash cash flow for distributions.  This is why we got into real estate investing, right? 

Mortgage Payments

Next, let’s talk about the mortgage. As with any property purchase, you’ve got to pay the lender back. Just like in a single-family home purchase, to get a loan on a commercial property you need to provide a down payment (equity) and a loan amount (debt) – usually around 25% down (equity) and 75% leveraged  (debt).  That means, the investors typically raise 25% and the bank provides the rest.  The loan would need to be paid back through monthly principal and interest payments.

In this case, let’s say the group owes $20,000 each month (which is $240,000 per year) in mortgage payments.

Annual Mortgage Payments

$20,000 monthly mortgage x 12 months = $240,000 annual mortgage payments

Cash Flow / Cash on Cash Returns

Now that we have subtracted the expenses from the income, we arrive at our cash flow for the first year. 

Keep in mind that a number of factors can change in subsequent years as the sponsor team optimizes the income and expenses of the property.  The business plan will detail this, so you may expect  that the  cash flow figures will increase over time, though this is not guaranteed.

First-Year Total Cash Flow

$408,000 NOI – $240,000 mortgage = $168,000 first-year total cash flow

This amount is then split up, according to the agreed-upon structure for the deal. Assuming this deal uses an 80/20 deal structure, 80% of the profits go to the investors (i.e., the limited partners), and 20% goes to the sponsor team (i.e., the general partners).

First Year Cash Flow to Investors

$168,000 first-year cash flow x 80% = $134,400 first-year cash flow to investors

Depending on your level of investment, you would get a share of that cash flow each month, in the form of a distribution check or direct deposit.

Your Monthly Cash Flow Distribution Checks

If you’d invested $100,000 into this deal, you might expect a $667 check each month, which works out to $8,628 for the year (8.6% cash on cash return).   Remember, the capital gains resulting from disposition of the property come on top.  However, these are not guaranteed.

Recap – how real estate generates massive monthly cash flow

So there you have it. The monthly cash flow that arrives in your bank account originates from the rent that the tenants pay. After deducting the expenses, the mortgage, the taxes, and the insurance, we have money to make disbursements to the owners / investors.

Is this passive income guaranteed? Absolutely not. 

However, now that you have a better understanding of where the cash flow in a real estate syndication comes from, you should be able to more thoroughly understand and vet the figures you see in the pro forma and investment summary, which will lead you to make wiser investing decisions.