Every month I write about my Alternative Income, which is a measure of “passive-ish” cash flow. For a long time, I was completely confused about how to value our real estate accidental “empire”. The three properties don’t make money each month, which is to say that make any cash flow. Usually real estate investors are looking to make money each month (have positive cash flow).

We’re not typical, because our real estate was mostly accidental. My wife and I bought independently near the market highs and then we moved across the country for different career opportunities. Selling at a loss wasn’t a good option, so we became landlords and refinanced them with a double HARP refinance opting for 15-year fixed mortgages (better rates – yay!) at market lows in 2012. We added another property around 2011. These aren’t big expensive properties… they are condos worth around $500,000 in total.

It seems fairly easy to say, “zero cash flow property is worth $0.” However, my goal is to measure progress in growing cash flow. It doesn’t feel very good to say that they are $0, but then magically become worth $3000 a month when the mortgages are paid off. That’s too Boolean even for the computer scientist in me. It’s really a perception problem:

“It’s all about the exposure, the lens I told her. The angles were all wrong now.”

Paramore – Brick By Brick which is great financial advice!

We could do either of the following and get cash flow out of them:

- Refinance the remaining principle into 30 year fixed mortgages. This lowers the monthly costs and we could pocket several hundred dollars a month.
- Sell the property with the most equity and payoff 1.5 properties. We aren’t going to sell a property just to make the math work better when I calculate cash flow. Also, paying off half a property doesn’t lead to better cash flow number.

The angles were all wrong because neither of them is a very realistic scenario. In fact, they are very unrealistic. Neither of them really assessed the progress we were making to owning them outright.

**The “Right” Formula to Calculate the Cash Flow Value of Cash Flowless Real Estate**

I don’t know if there’s a “right” formula, but I created what I feel is right for our situation. I’d love your thoughts on this, especially if you are into real estate investing.

The formula is:

(EquityInAllProperties/TotalValueOfProperties) * ((MonthlyEstimatedZillowRent + MonthlyActualRent)/2)

Let’s make that a little prettier:

(This is my first time trying to format a formula for the web, so I apologize if it isn’t as good as it could be. I only promised it would be a little prettier.)

The left side of the equation is meant to calculate the percentage of equity you own. When you first buy, you might put down 20%. Over time the hope is that this grows to 100% and you own the property completely. I calculate the value of the properties using Zillow, but use whatever you feel comfortable with. That’s the denominator. You can subtract the amount you have outstanding from your mortgage statement from that total value calculation to get the equity you have in the properties (the numerator.)

The right side of the equation is meant to calculate the monthly rent that you’ll be getting from all the properties. I average the Zillow expected rent because we give some great tenants a bit of a discount. It makes me feel a little better about the numbers to know that we can and will likely raise the rent to market levels eventually. You could, of course, skip this. For us the numbers are close to the same anyway, so it isn’t a big difference.

As a real life example, we own 43.1% of the total value in our properties. It’s up 36.4% from earlier this year. This is due to the value of the properties increasing as well as the mortgages getting paid down. Our expected rents from all the properties (factoring Zillow) is $3225.

Essentially, the left side tells you how much of the pie you own. The right side tells you the size of the pie. Multiply them together and you get a number representing the amount of virtual cash flow you own. Over time both numbers will grow. That makes tracking the progress of this number.

**You’ll want to take out HOAs, taxes, insurance, and some reasonable amount for maintenance, etc.** As commenter Jaime below mentions, it could be more or less than 25% of your cash flow. I think I’ve estimated it to be closer to 20% of what I project, but 25% is a good safe number. I like to take it out of the right side of the equation, but the order of operations doesn’t matter mathematically.

## MLM Corner

I thought I’d test out something a little different today and cover multi-level marketing in a section called MLM Corner. The goal is raise visibility of how such companies operate. I’m getting a lot of feedback from you that MLMs are crowding your Facebook and you are sick of it. I’ve covered quite a few such as Youngevity, It Works, and Le-Vel. Typically MLM Corner will highlight other perspectives of MLM from around the web.

I’d like to kick it off with MLMs and Me from Oakes’ of Righteousness. Rachel walks the reader through the cold recruitment (not sales) pitch from a friend who hadn’t talked to her in two years. She covers a lot of MLM in a fairly brief personal story. If you are interested in this kind of thing, it is worth reading (and sharing.)

thebadmoose says

I think your cashflow should be accounted as $0. Your income statement would show the net cashflow as zero. Then you recognize the increased equity, from making the monthly payment, on your balance sheet. I’m not an accountant so I may be off base.

Lazy Man says

I think you are right as far as accounting goes. However, I’m trying to create a tool that recognizes that there’s some value there. I find it helpful for measuring and motivation.

I do recognize the equity in my net worth accounting.

Jaime says

Hi LazyMan,

I will recommend putting in bold the following “HOAs, taxes, insurance, and some reasonable amount for maintenance” I am pretty they can at least take more than 25% of your cashflow.

Thanks for sharing you opinions.

Jaime

Lazy Man says

Thanks Jaime. I took your suggestion to bold that and while I was there, I cleaned it up a bit.

Big-D says

I don’t know exactly what you are trying to do (I understand the math, just not what you are attempting to realize by it). Your monthly cash flow from your rentals is a simple calculation – rent minus expenses (which should be positive). Your equity should not be on your cash flow as it is not cash, it is unrealized gains, like non-cashed-in investments or unpaid but expected dividends. Cash flow deals with how much money you have in hand, and not how much potential you have. Net Worth deals with the hypotheticals of your entire portfolio. They measure two separate things. It is like using a hammer for a screw driver, it just doesn’t work (unless you are Jeremy Clarkson).

Lazy Man says

Big D,

I see what you are saying and maybe it is like using a hammer for a screwdriver. However, my alternative income reports are measured in terms of screwdrivers. So for better or worse, I have to deal with screwdrivers. So why not pretend that I could sell the hammer or barter for a screwdriver.

I’m not trying to create a true accounting cash flow statement. I don’t do that because it requires budgeting (not a fan and I’m much too Lazy). So maybe it’s an alternative or potential cash flow.

I’m also not trying to create a net worth as $1 million dollars (for example) doesn’t give you any hypothetical monthly income. You can’t use the safe withdrawal rate from equity in a rental property. You need to use rent. What if you had $900K of your $1 million net worth in your primary residence? You aren’t going to be generating much income off of the remaining $100K.

I’m trying to create a motivational tool that measures the journey toward the day in 2017 when the mortgages are paid off and the full cash flow potential is realized.

Big-D says

If you are looking for the future “revenue” to be reported in the current that is different than what you have reported. Revenue “fun money” is the amount of money that you have to use on a monthly basis. So it is calculated as rent taken in, minus the expenses (the 25% Jamie mentioned, the cost of mortgage, etc.)

Profit from sale is your new “infusion” when you sell the properties (which is (Sale $ – equity – fees)/(1-tax rate)).

If you are looking to mix the two, that would be cash or investment planning. So saying that in 2027 you are going to get an infusion of cash (from profit) but the preceding yearly payments are fun money (from revenue). It would look something like this.

cash planning:

2017 – $1000

2018 – $1000

2019 – $1000

2020 – $1000

2021 – $1000

2022 – $1000

2023 – $1000

2024 – $1000

2025 – $1000

2026 – $1000

2027 – $1000 + $900,000k in profit from sale.

Lazy Man says

Well if I calculated rent minuses expenses, it would be $0 for the next 10 years and then be $3200 (or whatever the rents adjust to then). That’s precisely what I’m trying to avoid… an all-or-nothing analysis that doesn’t show growth on a monthly basis. Profit from sale could work, but that’s not really my goal with these properties ever. The goal is to hold on to them as an income stream.

Big-D says

okay .. you are now making me pull out my MBA financial management classes. *blows on fingers*

If you want to determine in current day numbers what your future income will be, you have to do some reverse mortgage (or reverse interest) analysis. So lets say in 10 years you are going to make $3200 a month, and you estimate you are going to have 3% year over year inflation. PV=FV(1+i)^-n, where PV = ?, FV = $3200, i = 0.03, n = 10. That means in today’s dollars, you will have $2381.10 in today’s dollars you will expect to earn. You can place this as expected income and change it as time changes (year 7, year 9, etc). Since it is all formulaic, you can change the numbers how you want.

Lazy Man says

I hadn’t thought of that. Of course I never took financial classes, but I was aware of the formula. This looks to be pretty good, but I find it hard to explain to the average person.

I’m not sure if this passes the smell test for mortgages. It seems weird to say that an asset that I only own 43% of is worth 74% of it’s future value. Also rents should roughly keep track with inflation, so “i” should be zero, right? That doesn’t work out well as my PV would be the same as the FV.

Brian - Rental Mindset says

That’s definitely a new idea, I haven’t heard of that analysis before.

For people who want to pay off their properties to get a massive cash flow in the future, I suggest they treat it as a discounted cash flow analysis. Actually run the cash flow numbers and see how it looks over however long you plan to own the property.

You are right though – it is pretty boolean. There is no difference in cash flow when you have 20% of the property paid off vs 80%. The same mortgage will have the same monthly payment. So while it is important to calculate your equity value, I think your formula might mislead you into thinking you get more cash flow as your equity grows.

That’s why I run my numbers independently and add them all up. Cash flow return. Equity return (paying down the mortgage and appreciation). Tax benefits. I treat it as a discounted cash flow, looking at the returns every 6 months: https://rentalmindset.com/6-months-9596-dollars-rental-property-portfolio-update/

Lazy Man says

Thanks for looking at this.

I’m a much too lazy to do a full cashflow analysis. I’d have to separate the transactions and I’m not sure there’s no much value in all that work. It’s a little like budgeting down to the last cent… at some point you just keep track of the big picture.

So this analysis is designed to help me keep track of the big picture with minimal data. I don’t really use it for cash flow as I recognize that it is cash flowless.

Brian - Rental Mindset says

An easier compromise is just looking at what you put on your tax return at the end of the year. That will provide a good idea of the cash flow and tax benefits. Then you can look at your mortgage statement and Zillow for the appreciation side of things. Project that forward each year until your 15 year mortgage is paid off.

Lazy Man says

This is a great suggestion for most people. Unfortunately, I routinely have to go with extensions due to a number of complexities. Also, my goal is to do something that can be updated monthly for my alternative income report (which is openly full of kludges.) I do like this for an annual update though.