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.
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.