Learning Objectives

By the end of this lesson you will be able to:

• Build a complete rental property cash flow analysis from scratch
• Identify the most commonly missed expenses in investor analyses
• Apply a vacancy and credit loss assumption based on market data
• Stress-test a pro forma against adverse scenarios
• Determine whether a property meets minimum investment criteria before further due diligence

Core Content

The Purpose of Cash Flow Analysis

A pro forma (from Latin: "as a matter of form") is a projected financial statement for an investment property. It shows expected income and expenses to estimate future cash flow.

The goal of a pro forma is not to prove a property is a good investment. The goal is to accurately represent what the property will actually produce. Optimistic assumptions are not projections — they are wishful thinking.

Experienced investors build conservative pro formas. They assume higher vacancy, higher expenses, and lower rents than they hope. If the deal still works under conservative assumptions, it deserves consideration.

Building a Complete Pro Forma

Step 1: Gross Potential Rent (GPR) The maximum annual rent if all units are occupied at 100% for 12 months.

For a duplex with two units renting at $900/month each:

GPR = $900 × 2 × 12 = $21,600/year

Step 2: Vacancy and Credit Loss Vacancy accounts for periods when units are empty. Credit loss accounts for tenants who do not pay.

Typical assumptions: 5–10% of GPR for stable markets, 10–15% for transitional areas.

Vacancy/Credit Loss = $21,600 × 8% = $1,728/year

Step 3: Effective Gross Income (EGI)

EGI = GPR - Vacancy/Credit Loss = $21,600 - $1,728 = $19,872/year

Other income sources (laundry, storage, late fees, pet fees) can be added here if they are contractual and reliable.

Step 4: Operating Expenses

Never omit any of these categories:

NOI = EGI - Operating Expenses = $19,872 - $8,970 = $10,902/year

Step 6: Debt Service For a $180,000 loan (10% down on $200,000 is not realistic for investment; let's use 25% down = $50,000):

Loan: $150,000, 7% interest, 30-year amortization Monthly payment: $998 Annual debt service: $11,976

Step 7: Cash Flow

Cash Flow = NOI - Debt Service = $10,902 - $11,976 = ($1,074)/year

This property does not cash flow with 25% down at 7% in this example. The investor must:

• Negotiate a lower purchase price
• Put more down
• Find a lower interest rate
• Wait for rents to increase before buying
• Pass on this deal

1. Capital Expenditure Reserve (CapEx) — saving for major replacements (roof: $8,000–$15,000 every 20–25 years; HVAC: $5,000–$10,000 every 15–20 years; water heater, appliances). Budget 5% of GPR for older properties, more for properties over 30 years old.

1. Vacancy between tenants — even great landlords have 2–4 weeks of vacancy between tenant turnovers. Budget it.

1. Tenant turnover costs — cleaning, paint, minor repairs, and re-advertising cost $500–$2,000 per turnover.

1. Property management — self-managing is still management. Budget for it so your analysis is honest even if you currently manage yourself.

1. Accounting and legal — CPA fees, lease preparation, and occasional eviction costs are real.

1. HOA fees — common in condominiums. These can significantly affect cash flow and are sometimes increased without warning.

Stress Testing the Pro Forma

A conservative pro forma survives adverse scenarios. Test each property against:

Scenario 1: Higher Vacancy What happens if vacancy is 15% instead of 8%? Does the property still cash flow?

Scenario 2: Rent Decrease If rents fall 10% due to a market correction, what does cash flow look like?

Scenario 3: Interest Rate Increase (Adjustable Rate Mortgages) If you have an ARM and the rate increases 2%, what is the new monthly payment? New cash flow?

Scenario 4: Major Repair If the roof needs replacement in Year 3 ($12,000), do you have the reserves? Is cash flow sufficient to rebuild reserves quickly?

Scenario 5: Extended Vacancy What if one unit sits vacant for 3 months? Can you cover the mortgage from savings or other income?

If the property fails most stress tests, it is not adequately safe for the down payment capital you are risking.

Minimum Investment Criteria

Before proceeding to full due diligence, establish your personal minimum criteria:

• Minimum cash-on-cash return: ___% (common range: 6–10%)
• Minimum DSCR: ___ (commonly 1.20+)
• Maximum GRM: ___ (depends on market)
• Minimum monthly cash flow per unit: $___ (common: $100–$200 per door)

Application

Using a property listing from your target market:

1. Build a complete pro forma using the step-by-step method above
2. Apply conservative assumptions for every expense category
3. Run the three primary stress tests (vacancy, rent decrease, major repair)
4. Does the property meet your minimum criteria? If not, at what purchase price would it qualify?