Free Cash Flow ("FCF")
What is Free Cash Flow? 💰
Free Cash Flow, often abbreviated as "FCF", is the cash generated by a real estate investment after all expenses are subtracted from rental income. Understanding free cash flow is important because the safest way to build wealth through real estate is to own cash flowing investment properties.
Let's say you own a house where monthly mortgage principal, interest, taxes and insurance ("PITI") is $2,300. You reserve an additional $200 per month for maintenance based on the property's condition and prior year maintenance expenses. Now, let's say you rent this property for $3,000 per month. Your free cash flow in this example is $500 per month, $6,000 per year.
Next year, you raise your rent to $3,100 per month and your PITI and maintenance budget remains the same. Your free cash flow is now $600 per month, $7,200 per year.
Why is free cash flow important?
Free cash flow is important because owning the property does not reduce your cash balance, it adds to your cash balance. If you own a property that costs $3,500 per month (PITI + maintenance), and only rents for $3,000, then you need to pay out $500 per month or $6,000 per year in order to cover the difference. This is an uncomfortable financial situation to be in, especially if you or your family experiences a loss of income (i.e. job loss).
When does it make sense to invest in real estate that does not cash flow?
Some investors are comfortable investing in real estate with negative cash flow because they expect a market to appreciate. Other investors buy properties with a low % down payment as possible. The lower the down payment, the higher your PITI, the lower your cash flow.