You’ve probably heard real estate professionals and laymen alike talking cap rates in discussions concerning commercial real estate sales and values. If you have no idea what they’re talking about, don’t worry. While cap rates can be useful they don’t account for one of the greatest benefits of real estate investment: cash flows.
The cash flow model is one of the key tools used by investors to analyze an investment’s profit potential. The 4 components of the cash flow model are:
- Initial investment – The amount of capital that an investor must put down to purchase the property. Investors can pay all cash or finance a portion of the purchase.
- Cash flows from operations during the holding period – The money produced by the investment through rental income. Cash flows can be positive or negative depending on occupancy and operating expenses.
- Cash flow from disposition (sale proceeds) – The amount received after the cost of sale, payment of the mortgage balance (if financed), and taxes.
- Holding period – How long the investor owns the property. This could also be described as how long the investor intends to own the property. Market conditions can change causing property values to increase or decrease, which may cause an investor to reevaluate when to sell.
When this information is known investors can compare investment alternatives and choose the option that provides the highest rate of return (based on their projections).