Real estate investors can use the free cash flow formula to evaluate and analyze their property’s performance and financial health.
Free cash flow is a vital indicator of your investment’s financial health and whether it’s desirable to investors. However, most investors admit to not understanding the concept and how to calculate it.
In today’s article, we’re going to look at the free cash flow formula and why it’s important for real estate investors like you to understand it.
Free Cash Flow Definition
Free Cash Flow (FCF) refers to the amount of money an investor is left with after deducting property expenses and payments. Property expenses include recurring expenses, such as property taxes, insurance, and mortgage payments. There are also one-time payments, such as home inspection fees and closing costs.
In simpler terms, FCF is the money left for an investor to use whichever way they deem fit.
Investors may calculate their FCF for various reasons. The most common reason is to guide vital business decisions, such as ascertaining whether the investment has enough money to diversify their portfolio or renovate the property to attract more ideal tenants.
Smart investors also use FCF calculations to nab or check for accounting fraud. This is because FCF numbers aren’t as easy to manipulate as other accounting numbers, such as net income and earnings per share.
As you can already tell at this point, FCF calculations are essential to calculate your investment’s financial health and performance. You can determine whether your current capital situation will help you meet your business goals and settle your business liabilities.
Related: How to Analyze Real Estate Deals in 5 Steps
Is Free Cash Flow Synonymous With Cash Flow?
Many people tend to get confused and think these two terms mean the same thing. Well, they don’t.
Generally, cash flow refers to the amount of money flowing in and out of your investment. A cash flow statement is a detailed overview of the property’s inflows and outflows.
Read our guide on cash flow for rental properties to understand this topic further.
On the other hand, free cash flow is more detailed because it calculates the amount of money that an investor has left after taking out property payments and operating expenses. Free cash flow reflects the amount of money you can spend on your investment’s growth.
Types of Free Cash Flow
As we’ve seen, free cash flow is essential in helping you understand how much money you can spend on expanding your property or investing in other areas. However, there are a few variations of free cash flow that help investors understand their financial situations better.
Here are the common types of free cash flow:
Levered Free Cash Flow
Also referred to as free cash flow to equity (FCFE), it is a type of free cash flow that factors in the loans or debt balances that an investment property has. In most cases, investors will use the levered free cash flow formula to determine the amount left once external financial payments have been made.
The free cash flow to equity formula is as below:
FCFE = Income from Operating Activities – Capital Expenditures (CapEx) + Net Debt Issued (Repair)
Unlevered Free Cash Flow
This type of free cash flow is also known as the free cash flow to the firm (FCFF). The unlevered free cash flow formula is used to determine the amount of free cash flow your investment would have if it had no external debts to pay.
You can say this free cash flow is hypothetical as it helps you determine the investment’s ability to generate income. In short, it’s another way to determine its value.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Investors use the free cash flow formula from EBITDA to measure their property’s financial performance, monitor the cash flow, and analyze the profitability of their investment’s operations before accounting for the tax rates, capital expenditure, and non-cash expenses.
What Is the Free Cash Flow Formula?
Going by the description, the generic free cash flow formula is:
FCF = Income from Operations – Capital Expenditures (CapEx)
To understand this formula, we need to break it down further. You can follow the steps below to arrive at your FCF. Note that you can derive the numbers from your financial statements, such as balance sheets and income statements.
- Calculate the total amount of cash from operations – Add your rental property’s net income to the cash from expenses. From the figure you get, subtract the property’s non-cash net working capital. This could include accounts receivable, accounts payable, or inventory. The amount you get is your cash from operations.
- Calculate your capital expenditures – Firstly, you need to determine your expenses related to acquiring your investment property and other long-term tangible assets from the previous and current year. Subtract the previous year’s expenses from the current year’s. After that, add the depreciation and amortization numbers. The figure you get is your capital expenditures.
- Calculate your free cash flow – From the free cash flow formula we provided above, you can now subtract the figure from step 2 from the figure you got in step 1. The number you arrive at is your free cash flow.
What Counts as Good Free Cash Flow?
While most investors may interpret a low free cash flow to mean that the investment is failing, that’s not always the case. Even investments experiencing great financial health may experience a dip in their free cash flow when aggressively pursuing growth. This is because big moves, such as buying a new property or remodeling an old investment, usually subtract from the bottom line, though temporarily.
The key here is to look beyond the numbers. There’s no standard number that fits all investments. Good free cash flow is relative. For example, if you’ve owned the rental property for decades and are still generating a steady flow of income, you will have a more consistent free cash flow. On the other hand, if you’re constantly re-investing to diversify your portfolio, you will have a lower free cash flow figure.
Related: How to Achieve a Positive Cash Flow in Real Estate?
Pros and Cons of Calculating Free Cash Flow
Let’s look at the benefits and possible limitations of calculating your cash flow.
Pros of Calculating Free Cash Flow
Here are the main benefits of calculating your free cash flow:
- Accurate measurement – There’s nothing as bad as “guesstimate” in the investing world. “Guesstimate” means that not only are you guessing an estimate, but you are also estimating a guess. You may as well stake all your money at a roulette table in a casino. Calculating your free cash flow helps eliminate this guesswork. It’s a trustworthy measurement since you can evaluate your valuations with certainty.
- Reduces uncertainty – Nothing can completely eliminate the uncertainty in investing. It’s part and parcel of the process. However, free cash flow calculations help manage the uncertainty and risks involved. This is because the calculations will help an investor see opportunities that make financial sense and separate them from those that will make losses. This way, the investor can decide whether they should become more aggressive or conservative depending on their investment goals.
- Offers a close property value – It’s natural for real estate investors to look at property values every single day. However, many of the valuation metrics found online today aren’t accurate. Most of the metrics are only used because they’re easy to calculate. The problem with this is that they can make an investment property look good when, in reality, it’s not. Free cash flow calculations give investors a closer and more inherent property value, helping them make better business decisions.
- Provides an insight into an investment’s future – Using the free cash flow model, investors can determine how fast their investment is going to grow. All they need to do is use the property’s current market price and work backward. This has other benefits as well since investors can tell the real current value of a property, if it happens to be under or overvalued.
Cons of Calculating Free Cash Flow
Here are the downsides and potential limitations of calculating free cash flow:
- Can’t solve all investor problems – As much as the free cash flow calculation formula is accurate in providing predictions that are used to simulate future growth, the metrics can only go so far. Many uncertain things happen to an investment within a year. Free cash flow calculations can’t provide a one-size-fits-all solution unless a certain level of risk is integrated into the equation.
- Only works when there’s transparency – If you’re in an investment club, free cash flow calculations will only work if a club has 100% transparency. If there are some inconsistencies in the operations, then the uncertainty is stronger than the ability of the free cash flow formula to work for the investors.
- Only works depending on the projections provided by the investor – When calculating the free cash flow, an investor has to make estimations for the future. It’s these estimations that determine whether the projections are accurate or fall short. A slight miss of just 1% can change the financial outlook by up to tens of millions of dollars.
- It may not be ideal for long-term investors – Free cash flow calculations can work for short-term investors, such as flippers. However, you may want to reconsider it if you want to make a 20-year investment. It may not work for long-term investors since there are many variables and unforeseen circumstances that may occur within that 20-year period.
How to Calculate Your Free Cash Flow
By looking at the free cash flow formula, you can tell that it has many financial figures involved and may be quite complicated. Since the calculations are sensitive, you want to avoid making any errors that could lead to grave business decisions. This is where Mashvisor tools come in.
Aside from showing you the best place to buy rental property, our rental property calculator is designed to help you carry out an investment’s cash flow analysis fast and accurately. You can carry out the entire process in just a matter of minutes since you simply need to enter a few variables and the cash flow will be calculated immediately. This is a must-have tool for investors who either want to make an active investment or earn passive income.
Our calculator uses rental comps, property characteristics, and predictive analytics to estimate the rental property expenses and projected rental income. This means that you’ll be assured of an accurate cash flow forecast.
That said, the Mashvisor investment property calculator does the following:
Estimates Monthly Property Expenses
Mashvisor helps investors forecast their monthly rental expenses, including one-time expenses such as inspection fees and recurring monthly costs, such as property taxes, insurance, management, and maintenance.
The best thing about our rental calculator is that you get metrics for both traditional and Airbnb rental strategies. This approach helps you select the rental strategy that matches your investment goals.
Also, our calculator is interactive. If your research indicates that some variables may be different, change or add some expenses to see how that would affect your cash flow.
Estimates Monthly Rental Income
Mashvisor property calculator also gives you estimates for rental income. Like monthly expenses, the income estimates are for both traditional and short-term rental strategies. You can also change the rate to see how it would affect your cash flow.
Calculates Cash Flow
Our calculator will calculate the cash flow based on the estimated monthly expenses and income. If you’ve made any adjustments to these metrics, the calculator will reflect this.
Calculates the Return on Investment
Cash flow alone isn’t enough to evaluate an investment’s profitability. You also need to calculate the return on investment so that you can take into account the total cash invested. Naturally, you want to buy a property that offers a high return on investment.
Mashvisor’s property calculator helps you calculate return on investment metrics, such as cap rate and cash on cash return. Again, you get metrics for both rental strategies.
The free cash flow formula helps companies determine how much cash they have at their disposal, after settling all costs associated with the business. The simplest way to calculate your company’s free cash flow is by subtracting your capital expenditure from your operating cash flow.
Mashvisor tools are here to help you calculate your cash flow. Sign up today and start your 7-day free trial.