Cash flow is not God

Before people criticize, I will state that cash flow is important to an investor.  However, the purpose of this article is to present the other investments that are on the table.

Let's break down the types of investments a bit. There are equity investments and there are debt investments.  Generally, when one is investing for cash flow it would be a debt investment that will have (hopefully) some appreciation.  Here is a list:

- Apartments (5 year hold and flip)

-Single Family Residence (Buy and hold)

-Retail Center

There are, of course, more, but you get the point.  Let's go beyond the clear fact that one should never bank on appreciation and talk about the cash flow.  Let's say you have an apartment complex that you purchase at $1,000,000.  Of this $1,000,000 you have put in a whopping total of 20% which is $200,000.  The building is cash flowing 10% which means you are receiving a 50% cash on cash (annually).  Now, let's say that this scenario was true, it is fantastic and everyone should drop what they are doing and go into apartment buying.

Here is the catch, you financed the building for 80% and now you are at risk.  No biggie, the economy won't crash until long after you are out of this building.  We are in a down economy right?  Not so much anymore.

Let's look at the alternative.  If that is a debt investment, then what is a comparable equity investment that can match the returns.  In the equity world we don't always look for cash flow as the only source of returns.  I know this sounds crazy, but we also look for value add projects.  What is a value add project?  Here is a short list:

- Single Family Residence (fix and flip)

- Entitlement/Zoning change

- Apartment building (with renovation)

Again, there is more, but this is a decent list.  Ok, so in this list we see that apartments and single family homes are a repeat item.  This is because you can take the same assets and form a different strategy.  The value add strategy will allow for people to not care (so much) about appreciation or cash flow and see that a significantly higher return can be achieved by adding quick value.

Let's talk about the least known on the list, entitlements.  All developers work with the local governing bodies to rezone or entitle a parcel of land before building.  However, did you know that this portion of the development process allows for the highest return throughout the development process.  Now let's break it down.  Say you purchased a piece of land at $1,000,000 (infill parcel) in the center of Los Angeles (applies to anywhere) and you picked it up in all cash.  You purchased this asset as an REO (because you are a smart investor) and its pre-2008 value was $2,000,000.  This is great, but do you just wait for appreciation to renew your assets value?  No. Now you look at your asset and it is zoned as R-2 (single family 6 units per acre), you see that there is an opportunity for value add to rezone the piece to R-3 (multifamily 24 units per acre).  This requires a bit of know how, but if you are dedicated then you can very easily double or triple the value of the land.  Then you take this parcel a year later and sell it to a developer for $2,500,000.  Did you just make a 250% ROI?  Yes.  Sounds too good to be true? No, but if you are listening to the banks which want you to make a 3% ROI and be happy then maybe it is.  Let's recap:

1. Buy REO asset

2. Value add process (4 times allotted units per acre)

3. Sell to developer ready to build (your welcome Mr. Developer)

Now, this process can be done on any type of asset and the more experience you have the more you will be able to judge the value of an asset.  Whenever you are working in either debt or equity you always want to make sure that due diligence is completed.  When in doubt throw it out, a better asset will come along.

The point of all of this is clear: cash flow is fantastic and you should definitely focus part of your efforts to attain it.  However, value add to your investments, whether it be apartments or land, should be a focus as well.  If you look at 10% cash flow ROI vs 30% value add ROI (without monthly cash flow) which do you want?   Remember, short term gains cannot beat out long term benefit.  Diversify and keep learning about new ways to invest.

Dmitriy