Cash Flow Sucks!!

10 Replies

Hey everyone!

I've been doing my due diligence before I start investing.

It seems as though most people want to find properties which main criteria being that the property has positive cash flow.

One book I've been reading makes the claim that "Cash Flow Sucks!" mainly the point being that positive cash flow is a very slow way to building wealth through REI.

Basically the concept is that if you have a property that is generating... lets say 500 dollars a month, after all expenses.

That’s 6,000 dollars a year of extra income for you. Now the problem is that, this money is considered taxable by the IRS. Also, in areas that have a high probability of positive cash flow, you often sacrifice being in a highly appreciating market.

So, if you are only focused on positive cash flow, you will be paying the IRS a good chunk of your money, and you will be short changing yourself on appreciation.

According to this book, appreciation is the best vehicle for wealth building in REI. This is mainly due to the use of leverage.

Let's say that you have a 500,000 dollar property and you put down 100,000 for a 5:1 LTV.

If that property appreciates 5% then you have 25,000 dollars of new equity, which is a 25% return on your investment of 100,000. And this money is not taxable, and you can also later do a 1031 tax deferred exchange and eliminate your capital gains on that specific property.

Also, this effect is compounded if you want to take you new equity and cash out refinance and use that as a down payment on a new property, and simply keep that cycle going.

So instead of getting a few hundred dollars a month, you can get a 25% or greater return by using leverage and then utilize your new equity to make down payments on new properties.

As long as you can make these properties break even, or even maybe a little negative in cash flow, as long as you can float it, you have a higher likelihood of making much more money over time than simply focusing on positive cash flow.

What's everyone's take on this perspective?

Thanks!
-Sean

LOL, and now let's look at when the bubble busts and there is no longer appreciation or values are decreasing (which they are RIGHT NOW in many of those formerly hot areas). How do you pay your mortgage payment when you have no equity to refinance and you aren't cash flowing. That is a very dangerous strategy. Now when the market is hot, I think it will work well, but when the market slows down (and it will and is in many areas) then you are stuck in a very precarious position.

Also, you don't pay tax on that $6,000 in cash flow when you factor in depreciation. You get to write off your depreciation against your income from the property, which with a 200K property is something like $7,000 in depreciation a year.

Now, yes, cash flow is a slow moving beast, but it is the difference between the tortoise and the hare. I personally think a combination of a quick income producing strategy and a steady income strategy are the best bet to develop wealth in real estate

http://www.marketwatch.com/news/story/home-prices-go-negative-first/story.aspx?guid=%7B30B54985%2D2189%2D4AE9%2DB8E5%2DECF89F6095F3%7D

I do agree that a mix of both cash flow and a good market is the key to maximizing profit in the long run, and there are probably many good points in that guys book. But it sounds like it over emphasizes appreciation over cash flow when both are important.

Another thing that positive cash flow lets you do is immediately go out and look for another property to buy because your not using your salary from your day job to cover the negative cash flow on the other property. Sooooooo.... then you could theoretically buy 100 properties over 10 years or so. I think I would rather have 5%-7% inflation on 100 properties than 35% on 1. Obviously you would use his strategy to buy more than just 1 house in 10 years, but it surely couldn't let you buy more than maybe 5 of them in that time period if they are breaking even or negatively cash flowing right? And how can you guarantee they will all appreciate by at least 35% either? Not to mention by the time you own just 1 tenth of these properties they will have a positive cash flow of $5,000 a month (10 * $500/mo), thats more than many people make in a year!

Someone please correct me if my logic is seriously flawed here.

Thanks for your responses guys!

Ryan Webber, SoBeREI, and charles whitaker, all three of you folks seem to think that a mix of both appreciation and cash flow is the best solution.

SoBeREI, you said that you'd rather have 100 properties in 10 years appreciating at 5-7%. Actually if you put 20% down on a property, then 5-7% is going to be 25-35% return on your personal investment.

For example if you put down $100,000 on a $500,000 property and your property goes up by 7% then your $500,0000 property would be worth $535,000. Since you only put down $100,000 and your property appreciated by $35,000, you effectively made 35%. Even though the property only went up 7%.

So 100 properties appreciating at 5-7% with a 20% down payment would be incredible!

My question would be then, without counting on appreciation and then using cash out refinancing, how would you get those 100 properties in 10 years?

Thanks!
-Sean

If you are gambling on the property appreciating then you are just gambling. If you know your market and you are able to buy below market and re-sell the property, then that is something else.

Cash flow is your insurance and allows you to have someone else pay for your investment.

Vacman

Yeah I guess it would be kinda hard to get 100 properties in 10 years without some kinda appreciation working for you. I was sorta thinking that there would be some appreciation anyway since most properties seem to appreciate over time even in the worst markets. However there would probably also probably be times in there where lending standards would losen a bit to where you can more easily find 0-5% down financing (not in the next few years though). Then all you gotta find are those deals that are so good that they positive cash flow with 0% down. But I guess thats the holy grail of deals right there too.

Maybe I was just a bit over ambitious with the number of properties you could buy in 10 years there. :wink:

Its funny my dad (maybe most in the baby boomer generation feel this way) always taught me that appreciation was a given in real estate. Even if just a little. However these days with the run ups being caused by people treating REI as the next (get rich quick/stock market/retirement fund/pick your investment) scheme, its starting to look like appreciation is truly no longer something we can rely on. Then again maybe its just where I'm located. What do you guys think?

SoBeRei,

100 rentals in 10 years is VERY doable and without even 1 penny in appreciation. I have acquired several dozen rentals in the past 3 1/2 years without any problem and my goal is to have 100 at the 5 year point.

While we're speaking of appreciation, would you rather gamble on appreciation of 35% in a few years or buy at a 35% discount and pickup 35% in equity at closing? For me, that's an easy choice. You make your money when you buy, not with risky speculation.

Also, if you want to build a large rental portfolio, you MUST buy without using your own money. Even if you have to put down $5,000 per deal, you'd need a half a million dollars just to buy 100 rentals. OUCH! There is plenty of 100% money still out there if you've got excellent credit and a connection with your local banks. In addition, it is also possible to get 100% financing with subject to, lease options, and owner financing.

With rentals, CASH FLOW IS KING! Even $100 per unit per month in cash flow is real money if you have 100 rentals ($10,000 per month). In addition, if you do the management and maintenance yourself, you will earn at least another $10,000 per month. That's $20,000 per month. To get a positive cash flow, you almost always MUST buy at a discount. If you buy each rental at only a $20,000 discount, then with 100 rentals, you have $2,000,000 in equity even without a single penny of appreciation or considering any principal paydown of the mortgage by the tenants.

Buy a rental for appreciation? GET REAL!

Mike

MikeOH,

I agree, I would love positive cash flow!

And combined with appreciation, that would be awesome!

Also, getting a property for 35% less than its worth would be a steal!

How do you realistically get a property for 35% less than what it is actually worth? How does a seller really lower their price that much without being absolutely desperate to sell, or without the property having some serious problems?

And what does that do for your reputation if you are consistently making offers at 65% of their true value and getting rejected 99% of the time? Wouldn't real estate agents and others develop a bad taste in their mouth for working with you and begin to not take you seriously?

Also, would it make sense to take your positive cash flow and then use that to control another mortgage to help you gain more properties and increase your portfolio?

Thanks again!
-Sean

Mike, I don't think anyone was suggesting buying a rental for appreciation. But Vacman might have been asking if it was wise to buy properties in areas of good cash flow as a priority over areas with historically good appreciation (even if they have no cash flow). And like you I think the answer to that is yes properties with positive cash flow is better. Which is exactly why I haven't bought anything here in South Florida so far and am looking long distance, even if I have to pay a prop manager and stay on top of them constantly.

Also it would be great to buy a property with 100% financing and the more under ARV one buy's it for the more likely one is to get 100% financing. However its still really hard for us newbie investors with no proven track record to get a bank large or small to give us a loan on an investment with none of our own "skin in the game" so to speak. I have no doubt you have no problems getting 100% financing from your bank. But then again you know and deal with that banks president, and have more than proven to them that you stick with your properties and pay off your loans. However for us starting out in the game we can't just tell a bank that, we have to earn their trust for a few years. Thats what I'm seeing so far anyway. But maybe I'm just looking in the wrong places for money then.

Oh well I will keep looking anyway. I just think its a bit tougher for the newbies to get good financing deals than experienced investors. If you know of some good places I could find lower down financing pleas tell, I'm definitely looking and am all ears.

Vacman,

I don't consider buying a property at a 35% discount to be a steal. Quite the contrary, I won't even consider purchasing a property unless it is at least 30% below market value. I consider buying a property for 20% of its market value (80% below market) to be a steal!

I don't make a bunch of lowball offers on properties being offered at retail. That's ridiculous, although I know that some of the gurus promote this silly idea.

In fact, the deals usually come to me. Just this afternoon, I got a call from someone wanting to sell their house. I didn't ask any details about the house (I don't care) - I simply asked how much he wanted for the house and where it was located. He wanted $59,000! I told him that I didn't pay more than $30,000 for rentals in that area. I'm certainly not wasting my time looking at or talking about a property that is priced at twice what I would pay.

My realtor knows my purchase criteria. She knows that when she brings me a deal that meets my criteria, I WILL buy it immediately. Therefore, when she finds out about someone that is desperate to sell, she calls me. I will immediately go look at it and put a contract on it (if it is a deal). Then, I WILL close on it quickly.

Just yesterday, I was at the hardware store. My phone rang and it was a potential tenant. I told the potential tenant my screening criteria during the call. When I hung up, the clerk said "I wish I had done that." I asked if he had rentals and he had two. One of the tenants was causing him great problems. I invited this person to our local REIA meeting. Situations exactly like this one often lead to deals. I have never gotten a deal looking at internet sites. You've got to get out there and meet people if you want the great deals.

Many of the great deals do have problems. I bought a duplex that was a REO. I paid $11,000 for the property (after making this offer every other month for a year to the bank). The property was a crack house that had been condemned by the city as a health hazard. There were several 5-gallon buckets of human feces in the house.

I cleaned up the considerable mess (3 LARGE dumpsters) and spent about $25,000 repairing the property. That gave me a beautiful duplex worth $81,000 for about $36,000. This is a typical deal.

Also, would it make sense to take your positive cash flow and then use that to control another mortgage to help you gain more properties and increase your portfolio?

Not for me. I use most of the positive cash flow to eat, pay my bills, pay my mortgage, go camping, etc. I do use some of it for rehab costs on new units, but I buy all of my properties without using my own cash.

I make my money when I buy. Needless to say, I like any appreciation that I get, but I just consider it icing on the cake!

Good Luck,

Mike