Cash Flow: Do We Really Need It?

Question

I am still trying to figure out the cash flow issue.  For an investor that doesn't care about cash income from a property, and if total return is good, why does it make such a difference.

For Example:  A $100,000 property, rents for $1200.  $600 expenses.  90% mortgage at 7%.

Cash flow is essentially zero.   Assuming 0% appreciation, rent increase, expense increase, and vacancy.

Total rate of return is still 14%.  That is not so bad?  Help me to see the light!

Account Closed · Answer

Mike,

Scott has it correct. I am not saying I do not like your way of investing if we are talking about properties that cash flow, equity when you buy, etc.

I am objecting to how you explain your position. It comes across like others must be wrong if they are not doing the same.

All of us are speculating when we assume that an average or a trend will continue. Even expecting the tenant to pay the rent next month can be speculations. Granted some things are much more common and are very likely to happen without being able to know for a fact they will happen.

I advocate that people focus on the cash flow when they buy to hold. If you have an alligator it will remind you each month and people tend to sell too early when they face feeding an alligator. You and I are on the same page there.

Your model does not work in high value, low rental income areas. Most of the state of CA would be an example. As I have said in the past a valid solution is to pump more cash into the deal if you want to buy and hold. Flip some deals to build cash and use it to buy down the debt on the one you want to keep.

I happen to also do deals in OH so in OH I can follow a model closer to what you use. Different strategies for different markets.

Inflation is a given. Wages tend to go up over long periods of time. The GNP of a country tends to do the same even when you factor in recessions. Housing also follows the same trend lines. Like the apartment owner surveys that show expenses are 50% of gross revenue you will find that appreciation is sustainable but not easy to predict with precision.

Bottom line Mike.

We agree completely on the value of positive cash flow (after real expenses like you factor in).

We disagree when it sounds like you think there is only one model. In your market I would agree that you should plan on no appreciation. In other markets assuming X% is almost a given when you look at the demographics and employment trends.

We also agree that over analyzing a situation is a waste of time. So many variables most of which you just can not predict with accuracy.

Fuzzy logic does show that you can still spot trends even when there is noise. Volatility in appreciation does not mean that a trend or average can not be determined.

Things where we agree and things where the difference is more based on market realities given local market conditions?

John Corey

Scott Weaner · Answer

Mike, I don't think that John "doesn't like" your method of investing.  Your method seems to be as safe as you can get.  If/when I find properties that meet your requirements I will jump on them.  John probably would too.  (Much easier said than done around here)

I still feel that speculation does not rule out a deal as an investment.  I believe that most investments are speculation.... investing in stocks, businesses, etc.  These are all speculative.

Michael Rossi · Answer

John,

We are not in a fight, we are simply discussing different ways to analyze property.

I wholeheartedly agree!  In addition, I completely, 100% agree that there are many different ways to invest and that any method that results in a profit is good.  I am only presenting my opinion and you are presenting yours.

This is really a discussion about risk.  I am very risk adverse.  I use the money from my rental property business to eat, buy toys, go on vacation, continue investing, etc.  Therefore, I can not have a bunch of properties that lose money today in hopes they will appreciate tomorrow.  One of the main reasons I started my business was because I wanted to build wealth.  I want the wealth NOW, not in 10 or 20 years, so I do not count on the principal paydown over decades to meet my goals.

I have absolutely NOTHING against any manner of investing that you or anyone else practices.  Many people have made a lot more money than I have by betting on appreciation.  I would call that speculation, but that's just me.  Higher risk can result in higher rewards.  That's not what I do, but I think it's great if someone is smart enough to do it.

I have no "model" and I am not making any assumptions.  I am not predicting anything other than the cash flow (and equity) of a property NOW.  What happens today does not depend on assumptions about what will happen tomorrow.  Wheatie said it better than I did when he said:  "If you make it complex, you have to put in way too many assumptions and then the result is meaningless."  I agree with that.

You don't seem to like my way of investing.  That's fine.  I again challenge you to tell us YOUR method of investing.  Why not just spell it out?  If you're looking for areas that will appreciate and you are willing to lose money in the short term in hopes of future gains, why not say so?  That's a valid method and it is your money.  I have laid out my strategy, please lay out YOURS.

Mike

Michael Rossi · Answer

John,

Quite the contrary, in regards to our cash flow discussion, I am not guessing about anything.  I am taking a well established expense figure and plugging it into a simple mathematical equation.  The data from hundreds of thousands of rentals in the United States backs that up and so does my personal experience.  No guessing here.

Does that mean that each individual rental unit will have that exact cash flow in a given year?  Absolutely not.  Does it mean that my entire portfolio should perform as expected?  Yes.

The differences in these two approaches is striking.  One is evaluating a deal for the purpose of determining what will happen immediately after buying the property.  If I buy this property today, will I make money starting day one?  The advantage of this approach is that buying a property at a big enough discount to make it cash flow today means you have significant (normally at least 30%) equity today AND a positive cash flow today.  If the market worsens, so what?  The market can still drop significantly and I still make money.

The other approach attempts to justify a deal today by plugging in a bunch of guesses about what will happen several years into the future.  That is what happened to hundreds of thousands of "investors" who are now being foreclosed upon.  They bought at an insufficient discount believing that housing prices were going to continue going up.  They guessed wrong and are paying the price for that guesswork.  I heard a report this morning that about 30% of the foreclosures are investors who are losing their properties.

I will only do deals that are a sure thing.  However, I'm not against anyone else doing things differently.  Even if you want to put it all on RED in Vegas, I'm fine with that!  If you win, your strategy will look great.  If it comes up Black, well.....

Mike

Account Closed · Answer

Mike,

You continue to prove my point. You expect averages to hold true, that things "should perform" (your words). Predicting the future based on a blend of the past (an average).

You can not predict any more than anyone else. Averages that are well established are reasonable as a guess but they are not certainties in the future. Just probable.

Have you ever read the book 'Fooled By Randomness' or 'The Black Swan'? Same author, Nassim Nicholas Taleb

Having a cushion or multiple ways to win helps reduce the damage when the error happens. 30% equity when you buy implies that a correction is not as likely to hurt your overall position. Well done in using what the British call a belt and braces solution. If the belt brakes your pants will stay up given the braces (suspenders is the US term).

Your model and your assumptions are not facts. The average is a blended value that is likely but not locked in as fact. At a practical level averages can be fine but they are not a guarantee about the future. Averages can change over time.

No business can predict the future. Period.

What you seem to be saying but can not quite spit it out is you do not feel that factoring in future appreciation is wise. It is not what you do. Your 2%/50%/30% set of rules do not consider appreciation. It is but one person's view rather than a fact that all successful investors do the same.

The historical average for US house appreciation is pretty well established. The US has had a rising market for over 60 years. Maybe more volatile than you would like so you just ignore the variable. There is an average for appreciation that comes from a very large sample size. Larger than the sample used to produce the 50% rule. If size matters then the appreciation figure must mean something.

Keep it simple when explaining why you do not factor in appreciation. We all use assumptions (guesses based on averages) about the future when looking for deals. You have clearly demonstrated you do so in this thread and others. You just do not factor in appreciation.

Though you say that people are free to do what they like you somehow feel the need to disparage people who do not do as you do. Can you really be so certain that your way is the only way to invest successfully? Could it not be true that more than one investment strategy can work? Could market conditions have a lot to do with what works?

Your model works well for you and it does so in your market. Well done. Keep it up and please keep sharing what you do. At the same time...

Others prefer other models. Maybe because of their income from a job they like, the market conditions where they live or their skills (property management, contractor skills, etc). Some like to pound nails, clean toilets and other things. Others like to focus on finance or short term deals. There is no need to think one model is superior in the absolute. Maybe individuals want to feel superior but the models are much more agnostic.

The profits and cash we each make spends the same.

It makes no sense to fight a battle you can not win.

John Corey

Account Closed · Answer

Mike,

You are guessing just like everyone else as you can not predict the future. You have your formula, your guesses and then reality happens.

If you want to claim that some things are more likely they you are agreeing that modeling has a purpose.

What more can you add other than we all make assumptions, we all make predictions about what is likely and then we make a decision plus live with the results.

Your blog is full of times when you estimated something and got it wrong. Very few are material but the principle is still there.

A budget is by definition a guess about the future. The actuals show what really happened. Until the past is the past all we have is the present and predictions about the future.

John Corey

Michael Rossi · Answer

REI,

I agree with you that there are many ways to do things and I'm fine with anyone doing anything they like (it's their money).  As I said in my post, I also have absolutely no problem with analyzing a property 10 different ways, with all kinds of assumptions.  In fact, I am not against a person analyzing their property with a crystal ball or an astrological chart if that makes them happy.  All I'm saying is that a person should realize the difference between reality and a bunch of hocus-pocus guesses.  Analyzing a property 10 different ways with multiple assumptions won't add one penny to your spendable cash at the end of the month.  It's fine to put in assumptions and dream about what COULD be.  I'm more interested in looking at the reality and determining what WILL be.

Wheatie,

That's funny.  I guess all of us did similar things when we started.  When I started, I bought a "property management software" and would enter all the info about each property and each tenant into the computer.  I no longer do that.  Looking back, that was so silly.  It took a lot of time and simply duplicated information that I already have in multiple other documents.  Putting it into a computer didn't do one thing to improve my business.  All it did was waste my time.

Mike

Michael Rossi · Answer

Reflex,

My question is WHY BOTHER?  Business is really not this complicated.  I am a simple person and I run my rental property business based on one simple principle  -  MAKE MONEY.  I'm not saying that there is anything wrong with analyzing a property 10 different ways, but from a profitibility standpoint, it is all but worthless.  When you put in that inflation factor - you're guessing.  When you put in an appreciation factor  -  more guesswork.  Some people use cap rates  -  more guesswork (because there is no good source for market cap in most areas).  My point is that  being successful in business really boils down to having a positive cash flow each month.  If you buy a property at enough of a discount that it will have a positive cash flow NOW, then you'll probably do fine.  If you need a bunch of optimistic assumptions to come true, you probably won't last long.  Principal pay-down is good, but it is difficult to eat.  It's just about that simple.

Mike

Jon Holdman · Answer

I'm actually in agreement with you, Mike, it doesn't need to be complicated.  If you make it complex, you have to put in way too many assumptions and then the result is meaningless.  I said I made a complex spreadsheet that tried to account for everything when I was starting.  I no longer use that, and instead, just do some simple number crunching, most calculating payments, on possible deals.

It is helpful, I think, to understand the formulas that get used.  Reflex was asking about a "total return" number, which looked good even though the deal itself was bad.  Knowing whats in "total return" and more importantly, what's not, helps understand why the number looks good even when the deal is bad.

Jon

Account Closed · Answer

Mike,

You are such a simple guy.

Planning for what you can not predict is common. You have no idea when a child will die, when a roof will wear out or when your car will need replacing. People put aside money , educate their children and otherwise plan for things that you can not predict.

As you say below making guesses is common.

I agree that some folks spend too much time modeling and not enough time modeling. I also think that some landlords think too small. I used to rent from some that fit the profile. They did just fine but I would not say they did as well as they might have done. You could tell by the way they spoke about their business.

People are different and then do have different styles. It is really hard to say that one model is better than another. Some who do not follow the model you use have done much better than you have done if you measure things in terms of net worth and liquid assets. Others might be just the opposite. Or it is too early to tell as things change daily.

Conclusion: each person will choose their own path. It is very hard to argue that one path is better for all people all the time.

John Corey