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Resources Methods for forecasting cash flow

Methods for forecasting cash flow

By the editorial team at Story by J.P. Morgan

Q: How can I forecast my cash flow?

A: Keeping track of your cash flow can help you measure success in the short term, as well as provide you a clear picture of what lies ahead for future investments. Various factors can affect whether forecasting cash flow will be a simple or complex process.

The type of method you use to determine your cash flow should depend on how you plan to use the information, as well how easily you can access your financial data. For example, if you’re trying to ballpark your monthly cash flow, you may consider the standard method of income minus expenditures. However, if you’re looking at potential investment opportunities or you want a more accurate number, you may want to consider other methods.

Standard method

For a broad view of cash flow, you can compare your expenses and financing costs to your income. To use the standard method to determine your existing cash flow, subtract your total expenses from your total income. Eric Bao, Director of Commercial Real Estate Research at Moody's Analytics, also refers to this as the “direct cash flow approach, where you only record cash inflows and outflows as they occur.”

While this method is fairly straightforward, it’s important to keep in mind income can be difficult to establish due to inconsistencies like missed rent payments. And expenses can be complex; you’ll likely have to consider factors such as administrative costs, property taxes, repairs, and vacancy rates.

In addition, Bao points out there are limitations to the standard method. “You don't necessarily take into account anything that hasn't happened yet,” he says. For example, it doesn’t factor in debt or unforeseen circumstances that can affect your income and expenses.

Leveraging additional data

Property owners can drill down into their data to try to get a more accurate assessment of their income. Christian Henkel, a Senior Director at Moody's Analytics specializing in commercial real estate, says, “You need to look at what is the actual rent that's generated, and maybe potential rent that could be generated if units weren't vacant. But then there has to be some allowance for vacant space, or for credit losses when people can't make their payments or make full payments.”

Next, there are expenditures. “Now you're looking at different operating expenses. What are the both fixed and variable operating expenses to keep the revenue stream flowing? You have to pay insurance. You have to pay taxes. Basically, what are the things that need to be paid, ultimately, to keep that revenue stream coming in?” Henkel says.

While managing all this data may seem challenging, going through the process is important because you can ultimately use the information to make better decisions about your finances.

Looking at comparable properties

What benchmarks can you use to determine the health of your cash flow? Comparable properties can be a great resource. “Ultimately, what you're wanting to do is get a comparative analysis to learn things like, ‘Am I charging enough rent?’ Or ‘is the income that's coming in sufficient?’,” Henkel says.

Identifying a comparable building’s cash flow can also be a great way to assess if a potential property is a good investment.

“Because multifamily properties tend to be more homogenous, it's relatively easy for you to find comps, Bao says. “Location is the most important thing when you're selecting comps. You don't want to use properties in different neighborhoods as the benchmark. […] You should also consider things like property size, the age of the property, and number of units.”

Cap rate

Your cap rate is a calculation that helps determine your property’s potential cash flow. Cap rate is the property’s net operating income divided by its current value. It helps estimate the rate of return you can expect on your investment based on how much income the property will generate. For example, low purchase price and higher rent can increase your cap rate, while low rent and high maintenance costs can decrease it.

What is a good cap rate? According to Bao, “What [Moody’s] has seen recently from the markets is the market cap rate tends to be around 6%. It's kind of low, but that's because of the environment, and the cap rates are generally quite low, partially because of the low interest rates. So 6% return is around the national average. But if you were an owner in a gateway market like New York or San Francisco, you might be expecting something lower because these markets are very hot, and the returns tend to be lower as a result."

Managing your cash flow

Calculating cash flow can require a lot of data. Once you’ve gathered the data, it’s a matter of analyzing it properly. Of course, you can always bring in help. Henkel points out that there are companies that can help you assess and analyze data, but you can also use subscription services.

The keys to selecting the right cash flow method for your property are to consider how far into the future you want to look, know what data you have at your disposal, and understand your financial needs. By evaluating these factors, along with the time and resources you have available, you can access an accurate picture of your cash flow and ultimately improve decision-making.

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