Cash Flow is Not King
You have likely heard the phrase “Cash Flow is King.” Is it the most important consideration for return on investment (ROI)? Do you need cash flow when you invest in a property??
What is cash flow? It is the cash left after all the expenses have been paid by the income the property has provided.? Income is related to the rents of the units and/or something on the property like laundry facilities or storage. The expenses include but are not limited to, financing, taxes, insurance, an allotment for maintenance and management, vacancy contingency, and sometimes utilities depending on the property type. Suppose there is a deficit, meaning the income is less than the expenses. In that case, there is a negative cash flow, which means that each month’s expenses need to be covered by a source outside of the individual property’s income.
When the cash flow is negative, the property is considered to be bleeding money and labeled a negative cash flowing property.
Should someone buy a negative cash flowing property?
As usual, it depends. While positive cash flow is like insurance for unexpected expenses and adds to the return on investment, it is not the only consideration when purchasing a property for ROI over time.?
Factors that play into a decision for an individual who may be considering a negative cash flowing investment are:?
As always, a thorough analysis of the numbers is essential to determine the return on investment over a desired time. It may be cash flow negative for a year or three, which may make a difference in the outcome. Here are a few scenarios where starting with a negative cash flowing property may make sense. I will use a single-family property (house, half duplex, townhouse) as an example.
No downpayment:?
Sometimes a property can be purchased without putting money down, or in the case of inheriting a property, where the equity is already in the property. In situations where you have not put cash in the property, you will still be ahead of the game even if you are negative cash flowing for a couple of years.?
For instance, consider the typical route:?
You acquire a property worth $500K. If you were to get a mortgage on the property’s full value, you would access $400K (as a mortgage) and leave $100k in as a 20% down payment (or equity).?
Alternatively, consider:?
You get this property through inheritance, so you didn’t have to put $100K capital (down payment) into acquiring the property. It is negative cash flowing $500 per month (the expenses are higher than the rental income), so you would be cash flow negative $6,000 at the end of the year.?
It would be 16.7 years before you reached the $100K you would have had to put down if you purchased a property of that value conventionally. If you have that $100K at your disposal, you can use most of it to create more money while absorbing the negative cash flow for a few years.
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Value Add:
Adding value to the property can increase the ROI even if it is negative cash flowing, to begin with. For a single family property, you may polish it up to increase the rents. You may be able to add a suite to the property as well. On a single family, unless you are adding an additional dwelling, the rent increase may not justify a negative cash flow unless other factors come into play as well.?
In a multifamily building, fixing up units to increase rents will have a bigger impact on the ROI. More about that in the next consideration.?
Rising Rental Rates:
Rental rates and raising rents are dependent. Some markets have rent controls preventing owners from raising rents too much. In other locations, rents are determined by the market rates. If the market is increasing in rental rates due to migration, increase in property values, increased expenses, revitalization in an area, and if the property you purchase will see improvements, the cash flow may be negative for a year or two until the rents are increased to market values.?
For a single family home, you may be able to weather the time before the rents are increased and have the mortgage paid down during that time and appreciation. Depending on the amount of increases over a few years, this could be a good reason to get into a property now rather than later.
Rising rental rates are particularly useful when looking at multifamily properties; the increase in rents brings up the Net Operating Income (NOI), which will substantially increase the property’s value. This return on investment can quickly overtake any extra paid-in cash flow shortfalls if you can source capital for the shortfall.?
Rising Market:?
Are you investing in an appreciating market where the value of properties increases each year by 3-5% or more? If you purchase a property for $500K in a market that appreciates 5% each year, in 5 years, your property will be worth $638,140.78. In that same 5 years, if you are cash flow negative by $500/month, you will have paid $30,000 extra for the property and gained just over $108K in equity.?
Where does this lead?
This leads to a comprehensive cost-benefit analysis. While the simple examples above give some insight into potential upsides, these may not work out for similar opportunities. Due diligence is necessary to make the best decisions based on the goals, financial situation, and ability to absorb potential downsides of the investor. Talk to other investors and check your numbers twice.
Is cash flow king?
Cash flow is great and something to aspire to. It is not the only indicator of ROI; it is only one way of creating ROI in real estate investing.
For additional information, check out this video Negative Cash Flow Can Work (Q&A with Huong Luu & Michel LaFleur)