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Positive cash flow by John T. Reed Copyright 2002 by John T. Reed Seminar and home-study course ratings Roughly speaking, there are two ways to get positive cash flow from a rental property: The capitalization rate exceeds the annual loan constant where the loan-to-value ratio is normal (70 to 80%) The loan-to-value ratio is abnormally low (60% or lower) The precise formula is that your loan-to-value ratio multiplied by your annual constant must be lower than your cap rate to get positive cash flow. Capitalization rate The capitalization or cap rate of a rental property is its annual net operating income divided by its price. For example, a \$1,000,000 property with \$60,000 of net operating income per year has a cap rate of \$60,000 Ã· \$1,000,000 = 6%. Net operating income is the gross income minus the operating expenses, but not the mortgage payments. Another way to define cap rate is that it is the cash-on-cash return you get when you have no mortgage on the property. Annual loan constant The annual loan constant is the sum of the annual mortgage payments divided by the mortgage balance. In a 30-year fixed rate mortgage, the annual loan constant is a little higher than the mortgage interest rate at the outset of the mortgage term. For example, the annual constant on a 30-year fixed rate mortgage at 7.25% is 8.14% initially. The shorter the remaining term, the higher the constant. In the case of an adjustable-rate mortgage, the worst-case lifetime cap payments should be used because of the inability to know whether rates will increase after closing. Loan-to-value ratio The loan-to-value ratio is the total mortgages on the property divided by the value of the property. The typical homeowner has an 80 to 90% loan-to-value ratio right after purchasing a house. Example Seattle has an excellent apartment building consultant named Mike Scott (https://www.dsaa.com/). He says that true cap rates in his area were about 7.8% on average in 2001. Such a building with a 30-year, fixed rate 7.25% mortgage would have a slight positive cash flow"”7.8% - 7.52% = .28% of the gross income would be the positive cash flow. Operating-expense ratios The operating-expense ratio of a residential rental property is 45% plus or minus about 2%. That is, the operating expenses"”taxes, management, utilities, insurance, etc."”will consume about 45% of the gross income. That percentage applies all over the U.S. for all types of residential property including those where the owner pays all utilities and those where the tenant pays all utilities. (The more expenses the tenant pays, the lower the rent must be, so the landlord' operating-expense ratio stays the same.) For confirmation, see the annual income-expenses analyses put out by the Institute of Real Estate Management and the National Apartment Association as well as by local apartment association and broker studies. Liar' statements When I attended CCIM courses, the brokers who taught them called the property income-expense statements prepared by sellers "Liar' Statements." That' because they typically show operating expense ratios of around 30% rather than the correct 45%. (Liar' statements also contain