If you’re frustrated by trying to find a deal that offers great cash flow, you’re not alone. Unfortunately, it’s challenging to find a deal with an excellent cash-on-cash return in today’s market.
Basic market dynamics have been making cash flow harder to find for nearly a decade, and the current red-hot market is making things worse. I recently simulated cash flow for the largest 588 cities in the U.S., and the average (unweighted) cash-on-cash return was -6.5%.
But fear not. Cash flow is only one of four ways that real estate investors generate income from rental properties. There are other ways to generate great returns.
Cash flow is super important for investors looking to quit their jobs or reaching retirement age soon. But if you’re in the game for the long run, there are good returns out there even without cash flow.
Why is cash flow hard to find?
Cash flow is getting harder to find for a straightforward reason: Home prices are growing faster than rent.
Because the home price is the foundation of many of the largest expenses an investor faces (principle, interest, taxes, insurance), when home prices go up, so do expenses. Therefore, if rent does not keep pace with the rate of home price appreciation in a given market, the cash flow potential of that market (or the market as a whole) will decrease.
Let’s look at a very simple example from Columbus, Ohio (which I chose randomly).
Back in 2014, the median price of a home in Columbus was $148,600, with a monthly rent of $954. By April of 2021—exactly seven years later—the median home price in Columbus was $244,200 with a rent of $1,302.
Both went up a lot! But housing prices went up more. When you calculate the compound annual growth rate (CAGR) for home prices, you get a growth rate of 7.4% for home prices, compared to a growth rate of just 4.54% for rents. This discrepancy will have a large impact on cash flow.
Let’s see how these changes would impact cash flow if our only expenses were taxes and P&I. I am using just these expenses because they are easy to calculate and don’t vary from home to home. All we need is the price of the house to calculate them.
Using the BiggerPockets mortgage calculator, I determined monthly principal and interest payments for the median home in 2014 and the median home in 2021. I also saw that the effective tax rate in Columbus is 1.48% and calculated estimated taxes (I know that the median sales prices don’t equal the assessed value for most houses, but I am just trying to make a simple example here).
|Annual income from rent||$11,448|
|Monthly payments and interest||$567.55|
|Total yearly payments and interest||$6,810.60|
|Effective tax rate||1.48%|
|Total yearly payments, interest, and taxes||$9,099.88|
|Annual income from rent||$15,624|
|Monthly payments and interest||$932.67|
|Total yearly payments and interest||$11,192.04|
|Effective tax rate||1.48%|
|Total yearly payments, interest, and taxes||$14,806.2|
The cash remaining after just two expenses – P&I and taxes—was about three times greater in 2014 than it was in 2021.
This is just a very simple example, but this dynamic exists across almost all markets in the U.S. Looking back to 2014, the average CAGR for rent is 4.1%, which is great! But, compared to home prices with a CAGR of 6%, income is not keeping pace with expenses in most markets in the U.S.
Unfortunately, this dynamic is accelerating of late as well. Since the beginning of 2020 and the COVID-19-induced craziness in the housing market, home prices have gone up on average 12.8% in the U.S., while rent growth rates are less than half at 6.1%.
If you’re wondering why rents have not kept pace with housing prices, that’s a great question with a very complicated answer.
Storm conditions are perfect for growing housing prices: low interest rates, surging demand, and very low inventory. On the rent side of things, my personal opinion is that stagnating wages in the U.S. limit rent growth.
As you can see from the chart above, wage growth has not recovered from the financial crisis. Experts recommend that renters spend no more than 30% of their income on rent. If their income does not rise, the total dollars renters can/should spend on rent does not rise.
As the chart shows, wage growth has averaged around 3.5% since 2014. I do not think it’s a coincidence that rent growth has averaged a similar amount (4.1%) in the same time period.
What to do about it
Let me start with what I know will be a controversial statement: you don’t need cash flow to succeed in real estate investing.
Cash flow is just one of four ways to generate returns from rental properties. The other three are amortization (using your rental income to pay down your mortgage), appreciation (gains in property value), and tax advantages.
And while many, particularly here on BiggerPockets, preach that “cash flow is king,” that’s only true for people who are eager to quit their jobs and invest full-time or those who are approaching retirement age. For anyone looking to generate returns for the long run and not live off their investments right now, you should be investing for total return. You need to look at all four ways of generating returns and determine what investments help you increase your net worth the most.
First, let’s look at that average deal from Columbus from earlier. Then, I ran the 2021 numbers through the BiggerPockets calculators, and here is what I got.
Doesn’t look great. With -$209 per month in cash flow and a CoCR of -4.8%, this deal stinks, right?
Well, in terms of cash flow, yes, it does. But look at that five-year annualized return number.
The average annual ROI is almost 16%. That’s amazing. And if you’re wondering, I assumed 4% appreciation (it’s averaged 7% since 2014) and 2% rent growth (it’s been over 4% since 2014). So even when forecasting declining growth rates, you can expect an awesome return even with negative cash flow.
How is this happening? With property prices appreciating each month and your rental income paying down your loan, your equity continues to grow. I recently did an analysis that shows that paying down your loan alone can deliver a 4-5% CAGR for a median-priced property. That’s pretty good for just paying your mortgage on time!
Building equity can, as shown in this example, generate a great return. If you build up enough equity, you can turn that into cash flow when you want to live off your investments.
How? Deleverage your portfolio.
If, for example, you amass $1 million in equity over the next 10 years, you can sell your portfolio and proceed to buy a rental for all cash at a 7% cap rate.
With an all-cash purchase, cap rate = CoCR, so you would be netting $70,000 a year (7% * $1 million) from your $1 million in amassed equity. Pretty good!
That’s an extreme example, but my point is to show that you will have options in the future if you build equity now. You will be able to decide how to adjust and redeploy your equity to fit your changing lifestyle and goals.
To be clear, I am not necessarily recommending operating a rental property at a loss (although you could). However, I would want to, at a minimum, break even on any investment I make.
To demonstrate this point, I cooked the number on the last calculator report I showed to modestly break even.
$11 per month certainly isn’t something to brag about, but a nearly 19% annualized return is. Also, just because you start merely breaking even, that doesn’t mean you will never cash flow. If rent goes up, your cash flow will too.
If you can find a deal that breaks even and has the potential for market appreciation, you can generate a great total return without cash flow. Look for cities with strong population growth, income growth, and low unemployment rates.
So what should investors do?
It’s time to face reality. Cash flow is tough to find. If you can find it, great! Go for it! But if your market isn’t producing strong CoCRs, that’s okay too.
When I simulated cash flow for 588 markets in the U.S., only about 18% of them produced a positive CoCR. This isn’t 2010–things have changed!
On the other hand, over 50% of markets produced home appreciation rates of over 2% annually over the last decade. That is enough to outpace inflation and generate a solid return. Moreover, 40% of markets even delivered better than 4% appreciation per year.
You need to look critically at your market, the strategy you want to pursue, and your personal goals. Don’t avoid deals just because cash flow isn’t great. Instead, you need to take what the market is giving you—and right now, in many markets, it’s giving appreciation.