Cash Flow Matters More Than You Think

[Paul Zimmermann]

With DSCR loans, a property that cash flows well can open more options.

That’s why I always tell investors to spend as much time understanding rents and expenses as they do finding the deal.

[Dan H.]

As is often the case, I am the contrarian.

I am all about total return and do not give a $hit about initial cash flow.

1) There is poor correlation between initial cash flow and actual long term cash flow. The reason for this is that RE market prices are based on numerous criteria. Some of the big ones are expected appreciation, expected rent growth, and risks. In most markets, the market with the highest rent to price ratio is the lowest class areas. This is because of the risks and effort to have rentals in that market. Similarly, the markets with the best initial cash flow typically have poor historical appreciation and rent growth. The properties with poor initial cash flow often have good/great historical appreciation. Rent growth has a strong relationship to appreciation. To use real numbers, Core Logic shows that the average SFH year over year rent increase in my market was $700/month. Imagine how this rent growth improves the cash flow. The better appreciating property is likely to have the better cash flow over a long hold.

2) cash flow is taxed annually. Appreciation gets taxed at property sale and there are legal means to avoid paying the taxes upon selling. RE investors often are in high tax brackets and those that are not strive to get into high tax brackets. My goal is to obtain return while minimizing taxes. If I have to pay taxes of 40% on cash flow but nothing on the appreciation (even extracted appreciation), then the cash flow only provides 60% value compared to the value achieved from appreciation. Appreciation accomplishes paying less taxes much better than cash flow.

3) Some people act as though cash flow is guaranteed. At the Great Recession (GR), there were many markets that suffered increased vacancy and reduction in rents. Detroit, Las Vegas, much of Arizona, etc had actual cash flow reduced due to the GR. In contrast there are many cities that have not had a single 10 year period since the numbers were tracked without appreciation (my market is one such market). Appreciation may not be guaranteed, but it has yet to not happen for a 10 year span in my market.

4) the reality is cash flow cannot match the return from leveraged appreciation. My lowest appreciating property has appreciated $2.6k/month (on a total purchase price of $167k with no closing costs that I purchased leveraged). I have multiple that have appreciated over $10k/month one of which was purchased at $640k at 80% LTV (so $128k invested plus closing costs). Cash flow simply cannot match the return from a high appreciation property.

5) I do not need the cash flow.  If you require the cash flow to live and hold the properties, then cash flow has to be a priority.   If you are fortunate enough to be able to handle negative cash flow, you can concentrate on total returns   If you concentrate on total returns, the best total returns happen with high appreciation.

Now to show that my actions match my post…

One of my more recent purchases was the most negative cash flow non-commercial property I have heard of. $2.35m with fully occupied rent of $6k. My initial plan was to brrrr, but when rates rose I decided that I would do the value add without the refi. This removed some of the urgency and I had another large rehab going at the same time. So it took us 3 years to stabilize. Outcome: property is worth over $1m more than purchase and rehab costs and I expect rents to average over $20k/month this year (PITI is just under $9.5k). I purchased leveraged. My return far exceeds my total investment and it now has modest cash flow (modest for its equity (my underwriting shows $1230/month cash flow). Principle paydown is currently $2675. Current value exceeds $3.5m. My return so far has exceeded 50%/year.

Good luck