Looking to get into real estate investing and have a super basic question but I couldn't really find an answer so please bear with me!
I see lots of information around cash flow and the importance of cash flow in owning rental properties and analysis for investment/purchasing. My question is, why isn't it smart to buy cash flow negative properties that are still paying down your principe and building equity for you- assuming you have the cash to support? For example, if the cash flow is -$200/month but the tenant is paying down your mortgage, isn't there a value to that from an investment perspective? If so, what is a reasonable loss per month to tolerate to build this equity? $100/mo, $200/mo? In this example I would be paying $2,400 per year to own this property to get all of the deductions and build equity in the property? Not particularly concerned with appreciation.
For perspective, I live in southern California and find it hard to find cash flow positive properties based on todays price. I'm investing for long term wealth, not to replace my current full time job income.
@Mark Kohn, this is a great question and a very polarizing one. A lot of people on BP will tell you that cash flow is must and any deal that doesn't cash flow is a bad one. My opinion is that is has everything to do with you and your goals. Additionally the answer lies in what you need right now. Can you afford to be cash flow negative? Do you need the supplemental income in the form of cash flow to survive. If not, then you are in a different situation. Cash flow is one way that folks make money on investment properties. The other three ways are 1. tax breaks (a. depreciation and b. repairs, improvements, real estate tax are all income tax deductions) 2. equity build-up through principal pay down, and 3. appreciation. When folks only focus on cash flow, I believe they are missing out on opportunities.
So, to now answer your question, yes there is value from an investment perspective if someone else pays down your mortgage and you are cash flow negative. What you should look at is the cash on cash return. If you are paying $200 out of pocket each month, and your tenant is covering the rest, how much principal is being paid down. What is it costing you ($200) to pay down how much ($XXX principal) per month. If you are comfortable with that return, then go for it.
Second, what are your long term goals? Do you want a large portfolio to build financial freedom, do you want a couple of properties to supplement the income from your W9? Do you want to use individuals properties over time to scale to large multi-family or commercial properties? All of these answers will help inform the level of risk you take right now.
Hope this helps a little bit. I am happy to answer any other questions with only my opinion. Feel free to reach out. Good luck!
@Mark Kohn, this is a great question and a very polarizing one. A lot of people on BP will tell you that cash flow is must and any deal that doesn't cash flow is a bad one. My opinion is that is has everything to do with you and your goals. Additionally the answer lies in what you need right now. Can you afford to be cash flow negative? Do you need the supplemental income in the form of cash flow to survive. If not, then you are in a different situation. Cash flow is one way that folks make money on investment properties. The other three ways are 1. tax breaks (a. depreciation and b. repairs, improvements, real estate tax are all income tax deductions) 2. equity build-up through principal pay down, and 3. appreciation. When folks only focus on cash flow, I believe they are missing out on opportunities.
So, to now answer your question, yes there is value from an investment perspective if someone else pays down your mortgage and you are cash flow negative. What you should look at is the cash on cash return. If you are paying $200 out of pocket each month, and your tenant is covering the rest, how much principal is being paid down. What is it costing you ($200) to pay down how much ($XXX principal) per month. If you are comfortable with that return, then go for it.
Second, what are your long term goals? Do you want a large portfolio to build financial freedom, do you want a couple of properties to supplement the income from your W9? Do you want to use individuals properties over time to scale to large multi-family or commercial properties? All of these answers will help inform the level of risk you take right now.
Hope this helps a little bit. I am happy to answer any other questions with only my opinion. Feel free to reach out. Good luck!
- If you're negative regularly, when big capex items come up you're going to come out of pocket for those, when you've already been out of pocket to cover the debt & expenses every month
- If you're just making money on paydown, the return you make is painfully low for the early years of the mortgage is just painfully low. Why bother when you could invest in an Index fund instead?
- Why bother with negative cash flow and very low return when there are cash flowing options out there? Albeit not in your market, but there are options out there.
Investment properties should be wind in your sails! They should be extra motors on your boat! Negative cash flow is an anchor.
It makes no sense to buy a property with negative cash flow. There can be exceptions... like if you had inside knowledge that the value of the property might be influenced in the near future... like if Wal Mart or Disney was buying the property next door, etc. But for the run of the mill residential property it just isn’t a good move. What if the market takes a turn for the worse . You would be upside down AND have to pay for your renter to live in the house.... how bad would that be?
There are just too many deals that “work” (positive cash flow) to take a negative cash flow deal. While I’m not a fan of out of area investing for myself, if there were no positive cash flow deals in my area I would look elsewhere.
I'm in Central Florida and regularly find deals that provide a 20-30%/year ROI. Most are C+ class properties in the $75-80k range that we will drop maybe $5,000 into them to make them rent ready. Maybe new flooring, some new paint, etc. I've found that nicer homes that cost double what we usually pay don't return any more profit due to how rent scales up. It typically takes $25-30k to close on a house that will gross $12,000 a year, and net 5,000-6,000 after PITI, with a maintenance reserve included.
California is definitely outside my knowledge base other than scratching my head how a 1,200sf property can cost $500,000 on the flip shows on TV! Likewise other markets might be outside your knowledge base. Just know there are plenty of cash flowing deals to be had away from your high priced market.
Looking to get into real estate investing and have a super basic question but I couldn't really find an answer so please bear with me!
I see lots of information around cash flow and the importance of cash flow in owning rental properties and analysis for investment/purchasing. My question is, why isn't it smart to buy cash flow negative properties that are still paying down your principe and building equity for you- assuming you have the cash to support? For example, if the cash flow is -$200/month but the tenant is paying down your mortgage, isn't there a value to that from an investment perspective? If so, what is a reasonable loss per month to tolerate to build this equity? $100/mo, $200/mo? In this example I would be paying $2,400 per year to own this property to get all of the deductions and build equity in the property? Not particularly concerned with appreciation.
For perspective, I live in southern California and find it hard to find cash flow positive properties based on todays price. I'm investing for long term wealth, not to replace my current full time job income.
Thanks in advance for any insight!
Mark,
You need some opinions from fellow Socal'ers! With all due respect, our is a very different market than you'll find in PA or VA or FL.
I think you're right. Cashflow is one benefit of real estate, but far from the only one. Cashflow is extremely important if you don't have income from other sources or are operating with a slim reserve fund. This scenario describes a lot of investors here on BP, almost all of whom live in a markets with strong cashflow options.
I invest in Los Angeles for myself and my clients. I'm constantly preaching the benefits of principal paydown and longterm appreciation. I wouldn't bank on appreciation in Cleveland, OH, but in a well-chosen submarket in Socal, one can should underwrite appreciation into their projections.
Over the longterm, equity growth builds more wealth than cashflow. If you have income outside of real estate, you should investing for longterm equity growth, not cashflow.
I scour the LA market for properties that are cashflow neutral because I don't like the idea of negative cashflow. I don't think it's absolutely wrong to invest in a negative-cashflow property; I just prefer not to given my current financial position. My ideal property has a 1-2% cash-on-cash return, but a 30%+ upside from in-place rents, and is in a rapidly gentrifying LA neighborhood.
An investor from PA might says, "Are you kidding me? A 1% cash-on-cash return? I can easily find you a 10% cash-on-cash in my market!" Well, sure... but how much is that building going to be worth in a decade?
Likewise, if you suffer a small negative cashflow for a decade, but the building is worth significantly more when you sell, that makes for a smart investment, right?
Even David Greene, on a BP podcast, made a point about losing $5000/month on a Beverly Hills mansion only to realize $5M profit when you sell it in ten years. It was a hypothetical, but his point was that wealth is built through equity.
So don't listen to the naysayers from other states! Robert Kiyosaki made some good points, but his books aren't gospel! If you're in a financial position that allows for negative cashflow, and you're confident in your longterm projection of the asset's value, then make that investment. I'll tell you something: some of the richest investors in the county pursue this strategy every day.
It makes no sense to buy a property with negative cash flow. There can be exceptions... like if you had inside knowledge that the value of the property might be influenced in the near future... like if Wal Mart or Disney was buying the property next door, etc. But for the run of the mill residential property it just isn’t a good move. What if the market takes a turn for the worse . You would be upside down AND have to pay for your renter to live in the house.... how bad would that be?
There are just too many deals that “work” (positive cash flow) to take a negative cash flow deal. While I’m not a fan of out of area investing for myself, if there were no positive cash flow deals in my area I would look elsewhere.
I'm in Central Florida and regularly find deals that provide a 20-30%/year ROI. Most are C+ class properties in the $75-80k range that we will drop maybe $5,000 into them to make them rent ready. Maybe new flooring, some new paint, etc. I've found that nicer homes that cost double what we usually pay don't return any more profit due to how rent scales up. It typically takes $25-30k to close on a house that will gross $12,000 a year, and net 5,000-6,000 after PITI, with a maintenance reserve included.
California is definitely outside my knowledge base other than scratching my head how a 1,200sf property can cost $500,000 on the flip shows on TV! Likewise other markets might be outside your knowledge base. Just know there are plenty of cash flowing deals to be had away from your high priced market.
I live in Hawaii and similar to California with negative or very little cash flow. It’s been a couple of years and I have built quite a bit of equity in my Hawaii properties. I am okay with me paying as little as $100 per month and tenants paying the rest. If your end goal is to build equity, putting in a little to reap a lot works for me.
Most folks on here on BP will tell you (and I think the comments on this thread reflect) that you shouldn't ever buy with negative cashflow. I say do it if you want, but make sure it makes sense.
I currently own a property in San Diego which is cash flow negative about $200/month, but which also has appreciated 50k per year, year over year, since I have bought it. In the past 6 years I have paid out of pocket approx 15k to PITI in exchange for 300k in equity. I'll take that any day.
Each deal is different. Evaluate it, and if it fits your profile and desires, go for it.
@Mark Kohn This is such a great question that I myself have actually been going back and forth on, so thank you for posting it on BP.
After reading the comments, I have to say that I agree with @David Campbell in the respect that buying a negative cash flowing property might be well worth it in the long run (which sounds like that's your focus), as long as your financial situation allows you to do so.
For someone who's looking to build as much passive income as possible to replace their job income, obviously this wouldn't make sense so you would want to invest in cash flow markets, which San Diego is not of them for the most part.
For me, I'm also taking the long term approach since I'm in no rush to replace my income, so Investing for equity and possibly appreciation would make sense. But once again, It's going to depend on the deal and whether or not it fits your criteria.
When I saw your post I knew you were here in California before I started reading your post :-)
Never buy for negative cash flow.
If you insist on buying in California where you live so you can "be able to swing by and look at your investment" then buy in an area that will give you some cash flow. Whether you are in Beverly Hills, San Francisco or LaJolla, you will be able to find an area within 50 miles of that same area that is what we Realtors describe in a politically correct way a "working class, blue collar, up and coming neighborhood". I own rentals like that and am cashflow positive, without worrying about being able to collect the rent because I (carefully screened and) put Section 8 tenants in those properties. The money is guaranteed, no one is running around with pit bulls and smoking god knows what and I get a free inspection each year by the Oakland Housing Authority or the Contra Costa Housing Authority.
If your on your 10th property, no problem go ahead. The issue with negative cash flow properties early on is that they put you in jeopardy of being forced to sell the property. During a downturn (no tenant) or if you have a major Capital Expenditure (new roof etc) where will you get the money to pay for that?
One of the key things that investors here focus on is also building up funds for your next investment. You don't have to ask when the funds are in your bank account. (low appreciation-good cash flow) When the funds are in equity.. you have to go to the bank and ask for a refinance to get access to those funds.
If you need a property to cashflow to buy it, and the cashflow is less than $200/mo you probably shouldn’t buy it. One water heater or refrigerator or air conditioner or water leak and suddenly you have a zero or negative cashflow situation.
What’s the cashflow on a 401k or an ira? I’m betting it’s negative for 40 years.
Here’s my negative cashflow property.
$3,000/mo rent
$3050/mo payment of which $700 is interest, $30 is insurance, and $450 is property tax.
plus I have $400 Hoa it’s a lakefront townhome with docks
So it’s negative $450/mo cashflow, but the profit is $1420/mo ($3000-$700 - $30 - $450- $400hoa) almost all of which is tax free because the depreciation is $1393/mo. It’s a townhome so In the five years I’ve owned it I bought a garage door opener ($300 installed) and a microwave (also $300) (I’m only responsible from the studs in.) so they’ve paid $180k in rent, I’ve kicked in about $30k to get $300k in equity (it’s appreciated a little over $200,000). I’ve had the same tenants there for 5 years and they have 3 years left after several extensions if they ever move out I’ll make it my summer home for 2-5 years. (If they are still renting in 5 years the loan will be paid off and it will change to over $2k/mo cashflow and profit.)
I just prefer newer properties and shorter loans. you could make just about any property cashflow with a 50 or 60 year loan
OP: only you know if a property being cashflow positive or negative would make any impact on your life. $2-500/mo is more important if you’re making $40k/year than $200k
@Mark Kohn You never want to buy a property that is CF negative. If everything is going perfect and you lose $200/mo it may not seem like a big deal but what happens when the tenant moves out or you have a maintenance issue? You will have to come up with the money out of your own pocket. The reason you want positive CF is that it allows you to keep the property through ups and downs of the market and wait for appreciation. You are no longer investing you are gambling that the rents appreciate or you can refinance the property into a positive CF position before you run out of money. The only reason I would buy a "negative" CF property is if I was in an area that was appreciating, like in so. cal, and I would live in one of the units. The only reason I would do this is because I can live for a similar or cheaper price than renting or buying a SFR.
Thanks for the responses and warm welcome to the forum- really appreciate you all providing your insight into my question.
A couple have mentioned that you shouldn't buy a cash flow negative property because it will be a challenge when you need a new roof, have a vacancy or have a maintenance issue. Isn't that all typically accounted for in the property analysis and built into your rental price (I have been using 5% vacancy, 5% maintenance/repairs, etc in my analyses)- is there something else that I am missing here?
If I can't cash flow, why isn't there value in buying an asset with someone else building your equity for you? Quick math on a 400k SFH with 20% down, the principal would be paid down about 5600 in year 1 and 5800 in year 2, etc. I get that this is overly simplistic, but if I'm out of pocket $200/month to get $466/mo in equity thats not horrible, understand this is not liquid and if the cash is important then this is not ideal.
Again, I'm coming at this as a way to build long term wealth in addition to day job and not necessarily looking at BRRR to multiple properties etc. Between deductions and appreciation it seems at least in certain markets, you don't need to cash flow to have a nice real estate ROI and build wealth. Thanks again for your thoughts!
Well, if you're looking at principal reduction as a way to increase equity, then you can do that with anything you purchase with debt.
On CF, if you can turn it around and make more money fine. If you'll always be in the hole, why would the prop value increase (the better way to increase equity)?
I care less where my return comes from. I would have no issue buying a property with huge negative cash flow if my conservative pro forma showed a high rate of return or infinite return (most of our local RE has produced infinite return).
I looked at a property a week ago and seriously considered an offer and likely would have, but I felt I was too busy. $1.1m, if made rent ready it would lose about $3.5k/month (using 0.7 ratio as 0 CF which is roughly accurate in my market). That was not going to be my plan for this property, but even if it were my pro forma likely would have this property producing a decent return. My plan showed a very good return, possibly infinite with a favorable appraisal.
Those who need cash flow are limited to properties that have cash flow. Those that are not constrained by needing cash flow have RE opportunities that are not available to those that must have the cash flow.
Once you have no need for cash flow, there is little point distinguishing the source of the return. It also opens up opportunities not available to those that require cash flow.
By the way, I am in escrow on my first local property that is being purchased largely for its cash flow (my first rental was purchased in 1993). After it closes, I may post the financials just because of how different it is than our usual purchases.
1Q. A couple have mentioned that you shouldn't buy a cash flow negative property because it will be a challenge when you need a new roof, have a vacancy or have a maintenance issue. Isn't that all typically accounted for in the property analysis and built into your rental price (I have been using 5% vacancy, 5% maintenance/repairs, etc in my analyses)- is there something else that I am missing here?
1A. A good estimate is that all buildings expenses should be between 35-45% of the income. All expenses includes insurance, taxes, maintenance, etc. Depending on whether you self-manage or outsource it to a PM will affect your expenses as will the age of the building. Usually when underwriting to get a ball park I estimate 50% for expenses and if the numbers work I go for it. Since the expenses are usually 35-45% but I like to be more conservative up front. If you buy a duplex, triplex, or fourplex that will minimize your expenses since you will live on property and you can do a lot of work yourself. Those % are estimates that vary based on each persons risk tolerance but I suggest you also have some type of maintenance fund as well. How much you keep in that fund is up to you most people seem to settle on about 6 months of expenses.
2Q. If I can't cash flow, why isn't there value in buying an asset with someone else building your equity for you?
2A. There is some value in having your tenants paying down your loan. Remember properties do not always appreciate just like the stock market does not always go up. The key is to not put yourself in a position where you have to sell the property when the market is down. In the long run a property will be worth more down the road even if it is just because of inflation. If you are in So. Cal you will see the appreciation happen much quicker. So if you have the +CF then the chances of something negative happening is minimized. Living on the property helps with this because you are on property as the manager and you do not have your own rent or mortgage along with any unforeseen expenses that come up. At the beginning of your "investing" career you do not want things that cost or place a significant strain on your capital. Once again especially in So. Cal I recommend getting into a residential MF (2-4units) to minimize expenses and increase your net worth if you want to stay local/self-manage.
+CF is the way to maintain the property without having to include any more capital after the initial purchase or at least minimize you contributing anymore money. Using your $400k house example lets say the avg. appreciation in your market is 5% including any corrections or recessions.
$400,000 Purchase Price $ 80,000 Down Payment (we will not include closing costs to keep it simple) 30yr @ 3% $1,349.18/mo = PI payment
Lets say you rent it for $2,000/mo and you have 40% expenses (which includes taxes and insurance) $2,000 -40% expenses $1,200 NOI -$1,350 PI payment -$150/mo Cash Flow = -$1,800/yr
SO year 1 you went up $20,000 in appreciation and lost -$1,800/yr of cash. If you can cover it, the building appreciates and no one moves out great. The problem you run into is if for some reason you can not cover the cash and you have to sell and it happens to be in a correction or recession. Even though the numbers still do not seem that bad tenants do move out so if you have a house you will probably have one month vacant but since you were at a negative cash flow this is going to be a big hit. You will still have most of the expenses on the building plus you will have to pay ~$2,000 to get it rent ready so you can lose ~$4,000- $4,500 that month. So expenses can add up fast.
Negative cash flow for those who can afford is ok. The matter does not lie if the cash flow is positive or negative, but in the total return of the property.
Assuming a negative cash flow to a low return is a mistake. The fact you have negative cash flow does not tells me the tenor , DP, and other factors important to do the analysis.
So you need to take in consideration the investment and the return. Cash flow negative is a game for an investor with W2, for example. It will give the extra mile of paying low taxes ( enhancing total return of the investment).
Finally, after analyzing the investment, if you can really afford the negative cash flow, go for it. You might have an edge in the negotiation. Just remember you need to have enough not just per month but also for unexpected expenses.
That is a great question, and I think it depends on your goals and your market. I've learnt that some markets are "cash flowing" markets, and others are "equity" markets. Some deals will still work if you can afford a negative for a period of time (while still having reserves), and then refinance and get all of that back through equity and better rates for example. In the right market, this can work.
The goal of real estate investment is to BUILD WEALTH. Deploy your capital in the best way to achieve the net worth you are aiming at based on the best opportunities reasonably available to you. Everything else is just noise.
If this means feeding the alligator for a couple of years on a property or continuing to catch a falling knife for a while and you have the capital, then so be it.
@Mark Kohn From a strict financial perspective, the only two things that matter at the end of the day are (a) total return on your investment and (b) tax responsibilities on that return.
(a) is measured by the IRR of an investment. If you're considering a type of asset to buy (SoCal SFR rental, in your case?) and don't create a proforma that projects the IRR (including the impact of cash flow, capex, amortization, rental rate changes, earned appreciation, and unearned appreciation), you're playing darts in the dark. There's people who play in the dark, and those that play with the lights on. Play with the lights on and you'll usually win.
Why is that so important? To calculate that IRR, you'll have to make assumptions about what will happen: When will the roof need to be replaced? When will rental rates increase? When will you get your first non-paying tenant? How much will it cost you to fix up the property? What direction will interest rates go? What will inflation do? Will demand for that type of home go up or down?
Lots of questions; do you know all the answers? Of course not. But it forces you to understand what you're doing. By thinking about all these up and downsides, and playing with spreadsheets to see how they each impact your total return, you'll be able to compare two investments (an SFR in SoCal, and a triplex in FL, for example). You'll see which variables drive your returns, which ones drive your costs, and where your risk is at. And, you can decide how confident you are in projecting each.
From there, you can move from asking the question you asked in this thread to asking more nuanced ones that impact those variables and from which you can actually act, "Do you think residential interest rates will continue to track the 10y treasury if it's forced higher?" or "Can I really expect tankless water heaters to last 20 years in practice?" or "What are some other ways ya'll generate more income from urban properties that have backyard space?"
Sorry this got long, but I hope it gives you a sense of where you should aim as you go from noob to sophisticated (if you choose to do so). Or, forget all this high brow stuff and just go with what has worked for others - even the Farmer's Almanac often gets it right because it recognizes that even if you don't understand why, you should often pick what worked in the past ... it's more likely than the alternative to work again in the future.
And is it ok to buy free cash flow-negative properties? Yes. But, I don't. ... Unless I'm going to tear down and develop the property. :-)
I guess what I'm missing is why are you fighting to justify negative cashflow when (according to some of the California crowd that is commenting) you can find something close enough to home that is at least cashflow neutral while building equity? Unless you are prospecting in a gentrifying neighborhood then your upside is WAY down the road but what happens if you chose wrong and the area goes south, or California passes an ordinance that inhibits your value. This doesn't seem like a good way to limit down side risk.
If you aren't banking on appreciation then why not buy somewhere where you can get cashflow on top of paying off the mortgage?
Thanks for the responses and warm welcome to the forum- really appreciate you all providing your insight into my question.
A couple have mentioned that you shouldn't buy a cash flow negative property because it will be a challenge when you need a new roof, have a vacancy or have a maintenance issue. Isn't that all typically accounted for in the property analysis and built into your rental price (I have been using 5% vacancy, 5% maintenance/repairs, etc in my analyses)- is there something else that I am missing here?
If I can't cash flow, why isn't there value in buying an asset with someone else building your equity for you? Quick math on a 400k SFH with 20% down, the principal would be paid down about 5600 in year 1 and 5800 in year 2, etc. I get that this is overly simplistic, but if I'm out of pocket $200/month to get $466/mo in equity thats not horrible, understand this is not liquid and if the cash is important then this is not ideal.
Again, I'm coming at this as a way to build long term wealth in addition to day job and not necessarily looking at BRRR to multiple properties etc. Between deductions and appreciation it seems at least in certain markets, you don't need to cash flow to have a nice real estate ROI and build wealth. Thanks again for your thoughts!
I care less where my return comes from. I would have no issue buying a property with huge negative cash flow if my conservative pro forma showed a high rate of return or infinite return (most of our local RE has produced infinite return).
I looked at a property a week ago and seriously considered an offer and likely would have, but I felt I was too busy. $1.1m, if made rent ready it would lose about $3.5k/month (using 0.7 ratio as 0 CF which is roughly accurate in my market). That was not going to be my plan for this property, but even if it were my pro forma likely would have this property producing a decent return. My plan showed a very good return, possibly infinite with a favorable appraisal.
Those who need cash flow are limited to properties that have cash flow. Those that are not constrained by needing cash flow have RE opportunities that are not available to those that must have the cash flow.
Once you have no need for cash flow, there is little point distinguishing the source of the return. It also opens up opportunities not available to those that require cash flow.
By the way, I am in escrow on my first local property that is being purchased largely for its cash flow (my first rental was purchased in 1993). After it closes, I may post the financials just because of how different it is than our usual purchases.
good luck
I never got around to post the financials on the purchase discussed above. In the San Diego market at that time, 0.7% ratio on C class and above that had no immediate high value cap ex items was about cash neutral at 80% LTV. Note with the rate increases, this ratio would no longer be cash neutral and you may need over a 1% ratio in this higher rate environment to be cash neutral at 80% LTV. Finding purchases with this ratio was challenging but possible in lower B class through C class small multiplexes. A 1% property was a unicorn find.
A birddog presented a property with a $15K finder fee. I looked at the county records and it looked to be a decent price but no significant value add. I do not purchase decent priced properties. I need a good purchase price or good value add to be worth my time and the risk. However, I followed that up by looking at Google Earth of the property. The pictures did not match the county recorded size. This was very obvious as it was not close to the size reflected in the county records. This was a high end compound. Maybe worth pursuing. We asked the birddog for information and he knew the rents which 3 small/medium size units were rented and one large unit was not. He was unsure of work performed on permit. One rent was way below market (almost 50% below market), the other 2 rents were significantly below market. They were all rent controlled and the units did not need rehab. I could move family into a unit but that did not work for us (child was about to start at UCSB out of town). Fortunately, it had been over a year since any units had a rent increase so I would be able to do max legal rent increase (~10%). We had no intention of not abiding by the rent control regulations.
How much could the large unit rent for? What exactly was market rents on all units? Why the discrepancy in size? How large was this compound? How much would Covid impact the rent on the units and the difficulty finding tenants? All part of the underwriting.
We did a rent survey and determined that the large unit would easily rent for $2850. The 3 small/medium size units we had market rent at $1300 (paying $990 after increase), $1850 ($1350 after increase), and $1500 (paying $900 after increase). Total market rent $7500. This was the elusive 1% property (using market rent) in San Diego.
What about the size? We went to the permit office to check the permits. For some reason our permitting office does not allow copies of the permits but we bent the rule and took pictures. We could tell virtually all the space was added with permits and could not tell for sure that any space was added without permits. The permits were stacked so in some cases the work from one was not closed when a new permit further adding to the compound was created. There was no way we or anyone would be able to go through those permits to show any of the addition was not part of the plethora of permits.
We typically fill our empty units in the initial open house. With Covid we could not have open house. I was scheduling everyone with their own time slots. The first day we had a tenant that paid $500 to hold the property. They were confident that they would pass our requirements, but one of their group changed their mind but this took over a week that they strung us along on getting the last application (we should have required a larger holding deposit or pushed back earlier and harder on not getting the application). Well they bailed and filed a dispute with Paypal. I countered that it was off market over a week and at that rent point we were out more than the holding fee. We won. As it happens we got real luck as the first people we showed it to loved it and were able to move in late the same week and had already provided notice etc. Under normal case the $500 would have not been sufficient, but the new tenants moved in around the same time we had expected the intial tenants to move in (we made mistake of not collecting enough holding fee but due to luck came out ahead).
Bird dog requested increased fee when appraisal came in significantly over the price. We told him we did our underwriting, pursuing, etc at the agreeed upon price. Then we ended up providing him $5K additional. Not because of the value but because he had to work this more than he likely had anticipated (and it did not hurt that it was a good value).
We made an error on closing and did not collect the deposits. It was in my opinion our mistake (we closed on 8 loans that day and this was the only one that was a new acquisition so we messed up in the 6 hours of signing) and the escrow company's (the paperwork that came over should have reflected the deposit as it was noted as a not owner-occupied, new acquisition). The escrow tried to get the deposit from the seller after the fact and he refused. Fortunately, the deposits were small especially on one unit.
Purchase: $620K
Birddog: $20k (agreed was $15K, but he earned the extra $5K)
Uncollected deposit: ~$2500.
Address the various inspection items most important being no front railing (see photo below for why it was critical): ~$3k using 2 of the employees I had back then).
Total: $645.5K
Loan 2.75%, 30 year, 80% LTC (near perfect timing on this loan as near lowest rate ever): Piti: $2549.
Market rent: $7500
Actual initial rent after initial increase $5990.
initial rent - PITI: $3441. My initial underwriting showed expected cash flow after allocating for all expenses was starting just below $2K.
We have had one tenant turnover (not the way below market rent unit, but one of the quite a bit below market rent units).
Current rent: $7515 with one unit way below market rent and one significantly below market rent and 2 units near market rent.
I also took unfinished existing space and converted it into >400' storage area (added insulation and climate control) that we have used to store items related to our STRs and other items we seldom need/use (like Christmas decorations and Halloween decorations).
With a single tenant turnover in 2.25 years and current cash flow after all expense allocations being over $3k/month, this purchase has worked out well for us. It is far from our highest return rate, but those had value adds and were much more effort. This was in pretty good condition (but not safe in a few places like no railings on a large potential fall) and has required relatively low effort to obtain $3K/month of cash flow.
@Mark Kohn This is a great question and one that has been asked quite a bit and most on this site will usually tell you if a property doesn't cash flow then they would never purchase that property. While cashflow is certainly important to consider in the short and long term, I don't use it as the only factor to determine if a property is a good deal or not. Initial cashflow is only one aspect...what about appreciation? what about principal pay down? what about historical rate of increase of rents in that market?
I like to consider everything and look at overall returns and any potential value add a property can offer whether it is being able to renovate and increase rents significantly, turn a 2/1 into a 3/2 or adding an ADU, etc.
Some say that say they would never invest in an initially negative cashflow asset and a lot of times unknowingly invest in a 401k which they don't know or realize is a negative cashflowing asset with none of the advantages that real estate can offer.
To sum it up: Cashflow should just be one aspect to consider, not the only aspect. For example for some place like San Diego, just for the sake of an extreme example to help make a point, what would you choose between these two options for lets say the same initial investment amount.....1. a property in La Jolla that initially negative cashflows $200/month or 2. a property in Lakeside that initially positive cashflows $100/month.
Another element to consider is how long the negative cashflow is.. I'm considering this same situation myself right now, but assuming the cashflow would only be negative for the first year or two or three.. with annual rental increases.. If that happens, it could quickly turn positive within a few years and then you would basically be at a cashflow positive investment, just a few years later.. This is in addition to the principal pay down and possible appreciation so you would also be building equity at the same time and eventually earn the negative cashflow back when it goes positive.
Also if you are conservative in your capex/maintenance/repairs estimate, and you don't actually have those repairs happen in those years. you might be positive/neutral in those years and can build up some reserve for the future years when you do have those expenses.
So if you project negative doesn't mean it will actually be negative, and just because you project postive doesn't mean it will actually be positive. Some years you could have large capex that wipes out all cashflow form a positive property.. and in this case some years you could have NO repairs or maintenance or turnover and end up being positive on in those years. All the estimates are just rough estimates, you never know what will happen in an actual property. Over the long term they will probably average out to the common estimates, but you will see equity buildup and hopefully turn positive at some point.
