The Myth of Positive Cash Flow

This is a column by real estate writer Rachelle.

Does it ever make sense to buy a real estate investment that is cash flow negative? Of course it does! Sure we’d all rather buy a nice well maintained cash flowing building stuffed to the gills with working professionals who all pay their rent by postdated check before the first of the month. Does this property even exist? If it did why would the owner sell it?

Cash Flow Positive Doesn’t Mean Anything!

There are number of ways to make almost any property cash flow. For instance you could buy a $500,000 condo and pay cash for it and rent it for $1000 per month. It will cash flow and you’re a hero… right? Not really, sorry.

You can also remove a chunk of very real expenses (like real estate agents do) to make your new acquisition sound better than it is. Vacancy and maintenance are two of these expenses. Some months may go by without anyone moving or things breaking. If you do the property management yourself, there is no expense, right? Again, not really. These are real costs that must be budgeted for and that will eventually catch up to you.

You could also buy a building with 10 suites, include all expenses and then your cash flow is $100 per month. Positive cash flow indeed. A million or more price tag, and $300,000 down plus closing costs and you’re making a whole $100 per month for your trouble. Don’t spend it all in one spot!

As you can see this oft repeated mantra means absolutely nothing. Investors go and try to find the holy grail of positive cash flow and they are looking for the wrong thing.

Cap Rates and Interest Rates

First, to measure the viability of your investment, use my Cap Rate Spreadsheet which is a measurement of a real estate investment.  When you play with the spreadsheet it immediately becomes apparent that your ROI (Return on Investment) is the difference between your mortgage rate and the cap rate. So if your mortgage is 5% and your Cap Rate is 5% you make about $0. If your mortgage rate is 5% and your Cap Rate is 6% that means you will make 1% but on the whole value of the building.

Why Buy Cash Flow Negative?

There are all kinds of reasons to buy cash flow negative properties. Land for instance is always cash flow negative. The usual strategy for buying land is to pay for it and wait. Buy on the outskirts of a growing city and pay the loan and property taxes year after year and wait until your land is desirable. Some investors take this a step further and brave the intricate morass of regulation and subdivide their land into lots for homes. This is just one example of a profitable way to make money in real estate that means continual outlay of cash into the asset for long periods of time. The sale of the land nets the profit or loss depending on how smart your selection process was.

The real estate market is currently very competitive. Investors are looking for ways to increase their returns. The stock market burned a lot of hard working savers. Lots of them are looking to do better than the 2% interest offered by high interest savings accounts. Naturally many of them have turned to real estate as a sure bet. Most of them don’t read Million Dollar Journey and they are trying to find positive cash flow in all the wrong places. I have explained at length that properties should pay you and how to calculate Cap Rates and ROI (return on investment) in my post Landlord Math.

Value Add Properties

A Value Add property is the most common way to buy cash flow negative and make a return. Basically you are finding a property that no one else wants. It’s ugly and needs TLC. Maintenance has been deferred and sometimes it’s no longer livable. Vacancy and evictions are the norms. A property like this can be bought and made to cash flow like crazy. You buy at today’s market prices which are not sustainable but you develop the property from horrible to very good. Tenants move and you fix and renovate and increase the rents. It can take several years before the building stabilizes and starts to pay you.

Highest and Best Use

Sometimes properties are not properly designated. For instance I saw a property for sale on Gerrard Street here in Toronto being used as a principle residence for the last 50 years. Surrounding this property are commercial spaces. The property is worth a lot more as a commercial space as it would generate a lot more revenue. There are so many strategies that change the use of properties, I can’t even enumerate them all.

Appreciation and Falling Markets

Most of us have only known a real estate market that consistently goes up. Does this mean that you should not buy? It’s much better to buy into real estate at the bottom of a downturn. However; if you want to invest in real estate you have to buy in the market that exists today, not the one that may exist tomorrow. The trick is to buy the right property at the right price.

No one’s building goes up in a falling market no matter how great it is. What matters is your ability to withstand a downturn. If the building is paying you to own it, this gives you the freedom of not caring how much it is worth. Like a well chosen dividend fund, it goes up, it goes down… who cares when you’re getting 9% ROI. I’d go long on the mortgage to make sure that when rates rise, I’d be protected until enough equity is built up to be able to refinance at almost any rate.

The Real Secret to Real Estate Success

The true mantra you need when looking at real estate is “How Can I Make Money from This?” There are as many ways to make money in real estate as there are buildings. Every building and location is different. You need to be flexible and innovative and learn as much as possible about the business. You’ll need to be prepared for a prolonged search and to say no to investments with no potential. In times when the real estate market is tight, money is cheap and competition is fierce, you’ll want to separate yourself from the pack and look for something different in neglected asset classes.

Happy Hunting!

About the Author: Rachelle specializes in renting property on behalf of landlords and is the blogger behind Landlord Rescue. She also works with investors to find good investments in Toronto and surrounding areas. Her passion is bringing multi res properties back from the brink and maximizing profitability. Check out some of her other real estate posts on MDJ.

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Canadian Freedom
9 years ago

I can see that positive cashflow may be considered a myth for those of you who are not willing to look beyond high cost of living cities. Personally I would rather stick with my basic strategy of making real cash after expenses month over month. It starts out as a trickle but evolves into a stream. No argument that it takes some work though.

Rachelle
10 years ago

Samson,

The cap rate is not affected by the size of the down payment or the mortgage %.

NOI/purchase price=Cap rate

Your cash on cash of course is affected by both these factors.

Rachelle
10 years ago

You don’t get a “miscellaneous” clause.

You get the actual vacancy numbers according to CMHC

You get property management expense where you could add a few percentage points.

You get maintenance which you can decide what % that is…condos have to keep 15% of all maintenance fees for instance. If you budgeted 10% of the gross this should cover a good amount.

Then if you use the cap rate spread sheet you can base your offer on the spread you want to make between the cap rate and the mortgage.

Govern yourself accordingly :)

P.S. The seller may forget lots of expenses. Get real copies of bills.

Multiple Egg Baskets
10 years ago

What would estimate as a good % buffer for miscellaneous when evaluating an investment property?

Rachelle
10 years ago

BobertinTo

I wrote it.

I also write that investment properties must pay you!

A great many properties that have been purchased in the last few years will not cash flow unless rents go up.

Distressed properties do not cash flow nor does land. 99% of what I see on the market is negative ROI once you factor in repairs and maintenance and property management.

There is a difference between trying to buy cash flow positive and removing real expenses or putting huge down payments on a building chasing the illusion of “positive cash flow”

There is also considerable profit in buying at distressed values and improving the asset, raising the rents and getting your money back via increased rent prices.

BTW for those who have asked me about including mortgage paydown in calculations.

Mortgage paydown is almost negligible for the first 5 years. You can’t spend that money to pay bills, renovate etc. Plus I want to try to keep things as simple as I can. That’s why I don’t include it.

GeniusBoy
10 years ago

Hi Rachelle:

Money Gal and I were discussing this in Canadian Money Forum, where she said what you did, that cash flow positive properties shouldn’t be a blind mantra, and that there are 3 conditions where it can be beneficial.

1) Cash flow positive
2) Tax deferrement benefits
3) Capital Gains

She’s absolutely right … you should have 1 of the 3 benefits. I think the tax defferement benefits are overrated. But the capital gains should not.

I agree with Sampson that the ROI and cap rates, should not be the guiding principles alone. Reducing the variability in the ROI and cap rates is of interest. i.e. if I don’t rent my place, what would the impact on the ROI and cap rates be.

I’ll give an example (the numbers are rounded for simplicity sake) The first income property I have makes $20,000 a year on a $400,000 property. But I put 5% down (or $20,000). The ROI is 100%/year! The cap rate is somewhere around 8%. But there’s still significant variability if I don’t rent it.

As an investor, I rather have a guarantee return on investment (a guarantee of 10%/year rather than having a 50:50 chance between -80 to +100%) … reducing the variability is worth something (i.e. think of it as the difference between stocks and bonds and the risk premium).

I think this variability consideration should be taken into account in the calculations. Some people don’t like to see variation in income and some places have more risk in variation than others (e.g. it may be that it’s probably more riskier to buy a place in the suburbs to rent than in downtown, although the percentage of profits may be less in downtown.) (The statement is an example, not a factual statement — I don’t know if that’s really true or not).

If you can find a cash flow property that also has a ROI greater than any other investment, it’s a no-brainer that you should do it.

BobertinTO
10 years ago

This is soo funny to me. Here’s why.

“With income property, it’s all about the cash flow. If you a buy a property without all the safety margin numbers in place, you will end up putting more of your hard earned cash into the property. Month after month, year after year you can look forward to owning a cash-sucking cow of a property.”

Who do you think wrote this.

Chris
10 years ago

I am closing on an income property at the end of the month that is certainly cash flow positive for the current owner (who bought it 25 years ago), but for me will take some time at todays purchase cost.

However, I entering this as a long term strategy. I think there are business improvements compared to how the current owners have operated the property, and the neighbourhood is quickly improving. The property has been well maintained but could use a bit of updating to obtain some, especially to attract gentrified rents.

I will also be occupying one of the units (it’s a fourplex) so I justify it being cash flow negative, as long as it is less than what my current housing costs are. I am hoping in short time though to live for “free”, which in an expensive city such as mine will be golden.

I studied the heck out of the CAP and ROI rates, and factored in cost increases and then doubled it to make sure that the numbers work even in a worst case scenario. However money was only part of the consideration; I could have bought a property that was cash flow positive right away, but I also wanted to live in a neighbourhood that appealed to me (and hopefully my tenants). The areas in my city where properties are cash flow positive right away are certainly not in the most desirable neighbourhoods (and are still based on collecting timely rent, being fully rented, and factor little for maintenance …highly doubtful)

Being a bit younger as well (28), it won’t be such a bad thing to have a small paper loss for the next couple of years as I have a growing income from my day job to offset.

In an average scenario, I expect to contribute for the next 2-3 years, live for “free” for the next 4 or 5, and then be cash flow positive increasing to retirement when the property is paid off. If I move into another property down the road, I intent to keep the rental, making it cash flow positive all the sooner.

Sampson
10 years ago

Very nice article Rachelle.

I’ve always been a believer that cash flow positive means very little. Your example of paying cash for an expensive property, then receiving $100/month is the best example to illustrate the ‘illusion’.

@ MoMoney,
A RE investment with good ROI and cap rate should be cash flow positive anyways if you take into account the mortgage capital payments which are savings for the investor and should be calculated as part of the cash generated.

I disagree. If you bought a few years back, 0-5% cash down, had a property that was revenue neutral, your ROI and Cap rate could be very high 5-15% since so little principle was used.

Also, cash flows on real estate properties can be easily ‘manipulated’ just like corporate balance sheets to produce cash flow neutral or negative scenarios.

Rachelle
10 years ago

@ Jungle

The Cap Rate is a measure of the investment potential of the building.

Higher is better.

MoMoney

If you’re looking in Toronto you’re not buying I guess.

If you’re not buying run down buildings which a lot of people don’t… you’re saying goodbye to what is possibly the most lucrative way of making money in real estate. Every $100 in monthly rent increase is worth $20,000 in the value of your building. I’ve seen buildings where improvements are made and suites rent for $300-$400 more each.

The point of this entire article is to stop reciting cash flow positive like a mantra and look a little further afield.