Investing or buying cashflow?

33 Replies

Want to get the more experienced folks' opinion on something I'm thinking about....

It's easy to increase cashflow with a greater downpayment / less leverage. However, is that really investing or something akin to buying an annuity?

I don't think there's anything necessarily wrong with buying a cashflow stream; it's dependent on your goals. However I don't think it's necessarily investing in the Warren Buffett sense of the word.

I'm interested in if everyone thinks this is a distinction worth  making? If so what's a good way to quickly determine the difference? Cash-on-cash return or Return-on-equity? Cap Rate? Whatever the opposite of cap rate is: figuring out what the returns would look like if you were to 100% leverage the property? 

thanks

@Chris Gordon
Cash on cash is only one metric which is not the correct metric for long term buy and hold. For long term you should measure your IRR (internal rate of return). This is the interest rate you are receiving for your investment.

For Investments you want to balance equity and leverage. There are different ways to get equity (cash, sweat equity etc) and your Levered IRR will change based on the cash invested you have in the deal. Typically the less cash you have in the deal the higher IRR but that also is not always the smartest business model as if you over leverage and their is a market correction or if your cash flow is reduced you are very limited with your options

@Chris Seveney , how do you actually do IRR? My basic understanding is you need to know all income and expenses for a period of time, so effectively you can't apply it to analysis of potential investments (pre-purchase), unless you use assumptions and plugs? Is that what you're implying?

@Chris Gordon
When analyzing an asset whichever method you use is a forecast as you cannot predict future cash flows or values.

You can create an IRR calculator in excel which definitely read about as the IRR function is best if only basing it on yearly inflows and outflows. You probably can download one or get a financial calculator.

@Chris Seveney   that's interesting.. lets say you buy a rental for 100k with minimum down  20k.

you make 150 a month cash flow ( realistic numbers unless you value add or get some smokin deal)

something happens and you need to sell in 5 years

you bought for sake of argument in a non appreciating market as many on this site admit they are fine with..

now you go to sell.. 60 X 150 a month = 9k   you have 10k in sales costs.. figure 6% plus closing cost plus seller credits and honey dews on the house plus it makes the math easy.

so you net 90k add in your 9k positive cash flow your at 99k... so just about break even but now your had to recapture 15k of deprecation and pay tax on that lets say 5k for easy math.. so now over a 5 year hold your 150 a month Coc really has a negative IRR since you lost right at 6K of actual cash and your only gain is whatever little principal pay down you got on your longer term note.

Do you think I have that right.. only reason I bring this up is I sold a bunch of my rentals and that recapture hit me hard personally.. but I just wanted to reposition to notes as I am not a very good landlord..

I think this is why if you think my numbers are correct.. that folks need to accelerate pay down so that you can pay these off quick so if U do need to sell and most people sell every 7 years stuff happens they have some true equity. or at least some cash coming out of the deals.

@Chris Gordon So some of this boils down to “pick your metric” as you can optimize cash-on-cash and return-on-equity. Some people just care about cash-flow because it lets them reload to buy their next property. Others will sacrifice cash-flow today by putting their property on a 15 year mortgage. They don’t want to pay as much mortgage interest and they can look at IRR and favor in the mortgage principal pay down. And they’re “sacrificing” some cash-flow today for a lot of cash-flow in 15 years. They’re really just two sides of the same coin.

What you should probably do is decide what variables are optimal for you and then analyze all of the properties the same way. So for all of my deals it’s 25% down, 9 months PITI, my commercial mortgage terms, etc. So I keep the playing field “level”. But I’m also a little screwy in that if there’s immediate rehab I just roll those dollars (mentally) into the down payment. It’s “real cash” that needs to go into the deal during months 0-6.

So you have to decide what makes sense for you. But once you do, analyze all of your deals the same way.

@Jay Hinrichs - you are correct especially in non appreciating markets. In appreciating markets the numbers change slightly as if the market appreciates 2% annually if you have $20k in a $50k deal or $20k in a $100k deal having safe leverage can help. I agree with you 100% though that the less leverage the better. While having leverage is not bad it can assist in growth exponentially, reading posts like I just did of an investor having $100k in loans at 25% and wondering what to do with a new $50k LOC and thinking he should continue to invest it vs. paying down a 25% loan scares the hell out of me.

I also find that many investors in non appreciating markets to do not calculate the cost of sale and other implications in there calculations. 

Buying money is not investing unless it is done on the money market.

Equity reduces cash flow from the property turning the brick and mortar into a liability not a asset.

The biggest mistake, so call investors make, is in not recognising that every property has two distinct income streams that must be accounted for separately.  Cash has a minimum opportunity value in my books of 10%. With mortgage rates below that value cash in a property is losing money not increasing cash flow.

The property itself that you are investing in generates a separate income from that generated by your cash.  Two separate and distinct investments. Cash buyers prefer to ignore this fact to appear to enhance or take advantage of artificial returns. All they are really doing is saving the prevailing mortgage interest rate (at best) at the cost of devaluing the income on the property. You can not increase the return on your cash without devaluing the income on the property.

A investor that does not deduct a return off the top of their rental income, equal to the opportunity value of cash,  prior to any other expenses places a value on their cash investment as a income stream at zero. They believe that their property is the only entity generating a income or combine the two as a single entity. They do not view their cash as imposing a negative drain on the property itself.

I view cash investors as creative accountants....smoke and mirror profits.

But, buy, but ,but but....each to their own.

You can not increase cash flow with cash. You can however trick yourself into believing that is the case.

I'm still trying to figure out how "buying cashflow" is OK?  In the end, isn't that kind of like buying something just because it's on a 2 for one sale, that you wouldn't have bought in the first place.  The more money you spend in the beginning, the larger the number you have set as your break even point, and the longer it takes to reach.

At the end of the day it is about putting the money to work-whether yours or someone else's. Being retired I am buying cash flow and using my own money; I can buy an annuities, index funds, invest in stocks, and/or buy property etc. Whatever makes me feel comfortable and meets my goals. When you are young you typically need leverage to grow that empire/thing you want, and that's good. For me, as an old guy my interests have become far more conservative, and return focused; but I still want it to be fun! REI fulfills that desire, and you are right there is not a lot of Warren Buffet about it-but I don't have his budget. ;

Cash verses leverage is the faith verses atheist of the real estate investment world. We each have our position and no debate will sway the other side.

Agnostics hold the middle ground.

@Chris Gordon @Joe Villeneuve   I think the answer is simply what are your goals.  We buy cash flow thats how we do it but what does that mean.  To me cash flow is the net income you recieve after all expenses including your mortgage payments.  If you have a fixed amount of cash you can use it in multiple ways to increase cash flow consider the following ways to invest 150K

1) 150K in savings account yields about $1200 per year in interest assuming you find good accounts, in this scenario cash flow is $100 per month

2) $150K used to buy a single property for cash. Lets assume for simplicity it exceeds the 1% rule and rents for 1600 a month and your costs are right at 50% so it cash flows $800 per month

3) $150k used to put 20% down on 5 houses identical to the one in 2) above.  In this scenario, you put down 30K on 5 properties and each property cash flows before mortgage payments $800 and each property will have a payment around $700 per month (I am assuming you will end up with 5% loans and 25 year amortizations which pretty typical on investment property in my experience at the moment) leaving cash flow of a total of $500 per month, significantly less than the $800 or so you got for buying 1 for cash however you will also be paying down the mortgages at a rate of about $200 per house per month which is another $1000 per month in potential gains.  Bringing your potential return to $1500 per month.  

If there is appreciation in prices the leveraged portfolio will gain even more quickly 5X as fast and the non leveraged option 2.  However the opposite is also true that it will decline in value 5x as fast in a down market.  So in the end it seems to me that the issue do you want maximum cash flow or maximum potential net increase.  We buy cash flows but we also include a component of leverage.  We do this because it fits what our goals are however because each deal is different and each persons risk tolerance is different you may or may not want to leverage.  You might want to put 50% down and get two properties for the price of 1 instead of 5.  

Personally we have some free and clear properties and some 30% down and recently we bought 3 duplexes with 70% down because we had a 1031 to do.  In the end it important to think through the numbers and remain flexible to make the choices that work for your situation.  

Originally posted by @Jeffrey Holst :

@Chris Gordon @Joe Villeneuve  I think the answer is simply what are your goals.  We buy cash flow thats how we do it but what does that mean.  To me cash flow is the net income you recieve after all expenses including your mortgage payments.  If you have a fixed amount of cash you can use it in multiple ways to increase cash flow consider the following ways to invest 150K

1) 150K in savings account yields about $1200 per year in interest assuming you find good accounts, in this scenario cash flow is $100 per month

2) $150K used to buy a single property for cash. Lets assume for simplicity it exceeds the 1% rule and rents for 1600 a month and your costs are right at 50% so it cash flows $800 per month

3) $150k used to put 20% down on 5 houses identical to the one in 2) above.  In this scenario, you put down 30K on 5 properties and each property cash flows before mortgage payments $800 and each property will have a payment around $700 per month (I am assuming you will end up with 5% loans and 25 year amortizations which pretty typical on investment property in my experience at the moment) leaving cash flow of a total of $500 per month, significantly less than the $800 or so you got for buying 1 for cash however you will also be paying down the mortgages at a rate of about $200 per house per month which is another $1000 per month in potential gains.  Bringing your potential return to $1500 per month.  

If there is appreciation in prices the leveraged portfolio will gain even more quickly 5X as fast and the non leveraged option 2.  However the opposite is also true that it will decline in value 5x as fast in a down market.  So in the end it seems to me that the issue do you want maximum cash flow or maximum potential net increase.  We buy cash flows but we also include a component of leverage.  We do this because it fits what our goals are however because each deal is different and each persons risk tolerance is different you may or may not want to leverage.  You might want to put 50% down and get two properties for the price of 1 instead of 5.  

Personally we have some free and clear properties and some 30% down and recently we bought 3 duplexes with 70% down because we had a 1031 to do.  In the end it important to think through the numbers and remain flexible to make the choices that work for your situation.  

 #1: When you deposit into a savings account, you are not spending money.  You still have access to it.  Doesn't apply here.

#3:  First, how much you put down has nothing to do with appreciation.  It's the same for all if all have the same property value.  It has nothing to do with Down Payments.  A $100k house value appreciates just as fast putting down $100k or $0.  The appreciation is based on the value, not the DP...and this works for both gaining and losing in appreciation.  The equity gain/loss is equal to the appreciation gain/loss.

When you say you are "buying cash flow" what you are actually doing is paying cash in a larger lump sum, for a cash return in smaller increments.  So, if you pay $120k to get $1000/month, you are buying $1000/month for $120k.  This means it will take you 10 years to break even on your cash, before you start making a profit.  If you spend $24k (20%) to get $600/mo +/- (assuming 5% loans), it will take you a little over 3 years to get even...and start making a profit...and in both these cases, the equity gained from appreciation is the same, since both properties start out at the same value.

I like free and clear properties too, but I'm never the one that pays it off.  I let my tenants do that for me.  That's their job, not my money's job.

@Thomas S.   "You can not increase cash flow with cash. You can however trick yourself into believing that is the case."  

...and that says it all.  

The problem is when "%'s" are used to rationalize "$$$'s" that don't work, any investment can look good.  Try spending %100,000.  I think most will only accept $100,000.

@Joe Villeneuve I think you missed my point.  

#1 sure you still have access but if you plan is to put it in an account and live off the interest your cashflow is 100 per month

#3 i didnt say it effected the appreciation I said you got the benefit of 5x the appreciation.  Ie if you own 5 150K homes and there is 5% price growth then you get 5% on 5 homes instead of on 1 home.  if you had one your portfolio value would go up $7500 if you used leverage your portfolio value would go up $7500 for each of the 5 homes for a total increase of $37,500 which is 5x as much.  

When I say I am buying cash flow what I mean is I trade dollars in my bank account for streams of income.  Certainly there is no difference on appreciation on the individual property whether or not it is free or clear on that we agree completely.  I love leverage and I also like to have tenants pay it off but it doesnt always make sense.  It is a math problem, in your example sure take the loan makes great sense, other times like when you are forced in to 5% loans with 20 year ams it and high fees on a property you plan to keep for a few years it doesn't make sense to take a loan.

I have loans on 2 condos, 4 duplexes, a 12 unit, and a 19 unit but dont have loans many low priced single family properties 

@Chris Gordon , circa 225BC, Archimedes worked out that all he needed to move the world, was a place to stand, and a lever.

Over 2000 years later, if we want to get exponentially wealthier than our own cash will allow, do we still question - that it's leverage (ie. OPM) that we need? Cheers...

@Brent Coombs I'm not questioning the use of leverage, however the more of your own cash you put into a deal the  better the cashflow looks. That's not investing to me, that's buying cashflow. If you accept that as fact then you really need to consider, hypothetically, what a 100% leveraged property looks like...does it cashflow after all expenses then? If it doesn't then it's probably not a good investment. Pretty much the opposite of cap rate.

...the wide variety of answers and points bring brought up has shown there's not agreement around this idea of buying cash flow vs investing in assets.  

@Jay Hinrichs I think you left out the benefit of the depreciation each year of the 5 years.  Assuming your earnings are low enough to take passive losses against income, you would have had tax savings from the depreciation to add to your cash flow during the 5 years.  If you earned too much to take the passive losses, you would have carried those passive losses forward and they would have reduced the impact of depreciation recapture.  I don't think this changes your point, but worth pointing out to make the analysis more accurate. 

It is always surprising to me how many different opinions there are on BP about this topic.  By definition, everything discussed above is an investment.  There are lots of ways to put your money to work both in real estate and outside of real estate.  All of them come with varying levels or risk and reward.  There is no one right way to invest in real estate (or anything else).  If there was, there would be a lot fewer successful people on this site as I see a lot of people who have had success using conflicting strategies.

@Chris Gordon You're going to get a wide variety of preferences because in the world of REI, most investors will invest via the Equity Placement route meaning they're buying cash flow with a break-even analysis reflecting when they will really start "Cash-flowing" on an investment.

I'm sure if you were to ask most investors at which point in the investment property lifecycle they break-even and truly start cash-flowing they either haven't figured that out or don't know how to calculate that number or what the true IRR on a property is going to be because they think once they close escrow with 20% down they are cash-flowing on day 1.

When @Chris Seveney talks about the IRR for a long term buy-and-hold, I factor in a rehab at year 15 of a 30 year hold, whether it's due to wear and tear, or possible change in interior styles to remain competitive in the market. Most investors don't do this, they only factor in a percentage for CapEx but this doesn't cover the rehab over a 30+ year hold, the CapEx is only covering things like HVAC, roofing, etc... at the end of the 30+ long-term buy-and -hold most of these properties will have a negative or very low IRR.

@Andrew Johnson covers a portion of this as he mentioned factoring in his rehab cost during his initial stages, not sure if he's referring to long-term property holds of 20-30+ years.

Also keep in mind these strategies will change based on property type, SFR, Duplex, Quads, etc... will be treated differently than a 20 unit building, which will be treated differently than a 120 unit asset, and so on.... this will also get you different replies to your question as the different debt structures will fulfill different requirements of the investors.

At its most basic level an investment(for our sake) is something with will make you money when all said and done. My theory and what will work for me(I don’t really NEED my investments to cash flow for 20+ years) is this..... 

EX.... I invest 50k to acquire a property. I rent it out for 1000/month. Mortgage is paid by tenants rent over X amount of years. Mortgage is paid off and that is when I’ll begin to pay myself back for initial investment. After X amount of years of rental income after mortgage is paid off..... once monthly expenses are taken care of the rest is profit. Along the way you can use the equity/property to leverage more deals, increase rent to create more cash flow, sell for profit, etc..... I know not everyone is looking to ride it out for 20+ years but that’s what my goal is. As with most things..... a million ways to skin a cat. 

Great question @Chris Gordon . I can see your argument on the subject, We have a tripod of investing criteria that we use. Our primary focus is cash flow, but the other 2 help balance and ensure a solid investment all the way around. I blog about them here: https://www.biggerpockets.com/blogs/8160/52878-how...

In short, here's is why each is important to us:

  • Cash-Flow: helps push us toward exiting the rat race
  • Cash on Cash Return: I want to do better than the market or other asset types; this also helps ensures we don't use more than necessary funds (leverage) to acquire a property...which I believe is the point you're trying to make. 
  • Asset Acquired below market value: this typically puts us into a value add situation. We are a long-term buy & holders, but never want to be in a position where we can't exit a property without needing to bring money to the table. This is 3rd on our list and the most flexible criteria. Real like example of this scenario: https://www.biggerpockets.com/blogs/8160/71180-we-...

Great question!

Originally posted by @Ray Johnson :

@Chris Gordon You're going to get a wide variety of preferences because in the world of REI, most investors will invest via the Equity Placement route meaning they're buying cash flow with a break-even analysis reflecting when they will really start "Cash-flowing" on an investment.

I'm sure if you were to ask most investors at which point in the investment property lifecycle they break-even and truly start cash-flowing they either haven't figured that out or don't know how to calculate that number or what the true IRR on a property is going to be because they think once they close escrow with 20% down they are cash-flowing on day 1.

When @Chris Seveney talks about the IRR for a long term buy-and-hold, I factor in a rehab at year 15 of a 30 year hold, whether it's due to wear and tear, or possible change in interior styles to remain competitive in the market. Most investors don't do this, they only factor in a percentage for CapEx but this doesn't cover the rehab over a 30+ year hold, the CapEx is only covering things like HVAC, roofing, etc... at the end of the 30+ long-term buy-and -hold most of these properties will have a negative or very low IRR.

@Andrew Johnson covers a portion of this as he mentioned factoring in his rehab cost during his initial stages, not sure if he's referring to long-term property holds of 20-30+ years.

Also keep in mind these strategies will change based on property type, SFR, Duplex, Quads, etc... will be treated differently than a 20 unit building, which will be treated differently than a 120 unit asset, and so on.... this will also get you different replies to your question as the different debt structures will fulfill different requirements of the investors.

 great point I found myself in the same position when I sold 11 of my homes the last 18 months they were bought as new construction.. and I had to put 5 to 10k into each one to sell them.. bring them up to snuff to compete with other homeowners selling.. now for me personally I made the money on the tax play as I bought GO Zone and took the huge right offs day one .. and in my high earning years.. but I would need a cray super computer to figure out if it was worth it or not.  kind of why I like notes these days.. you buy a note you get income its definable and there are no extra costs to worry about you get paid off and do it again.. for me and my simple mind its better.. since I never spread sheet anything I just think about it in my mind.. LOL

Originally posted by @Jay Hinrichs :

@Chris Seveney   that's interesting.. lets say you buy a rental for 100k with minimum down  20k.

you make 150 a month cash flow ( realistic numbers unless you value add or get some smokin deal)

something happens and you need to sell in 5 years

you bought for sake of argument in a non appreciating market as many on this site admit they are fine with..

now you go to sell.. 60 X 150 a month = 9k   you have 10k in sales costs.. figure 6% plus closing cost plus seller credits and honey dews on the house plus it makes the math easy.

so you net 90k add in your 9k positive cash flow your at 99k... so just about break even but now your had to recapture 15k of deprecation and pay tax on that lets say 5k for easy math.. so now over a 5 year hold your 150 a month Coc really has a negative IRR since you lost right at 6K of actual cash and your only gain is whatever little principal pay down you got on your longer term note.

Do you think I have that right.. only reason I bring this up is I sold a bunch of my rentals and that recapture hit me hard personally.. but I just wanted to reposition to notes as I am not a very good landlord..

I think this is why if you think my numbers are correct.. that folks need to accelerate pay down so that you can pay these off quick so if U do need to sell and most people sell every 7 years stuff happens they have some true equity. or at least some cash coming out of the deals.

I do agree with your scenario if you do not 1031. I know you know all of this, but 1031 is only about $800-$1k/house, so by spending $11k in 1031 fees you could have rolled your basis into a larger property and saved $44k in tax liability. Not possible with notes, though. This is where I wouldn't see the point of selling the rentals. If you have an 80% LTV loan, or $80k on a $100k property, but you're only netting $100k-$10k selling costs - $5k tax liability = $85k. So selling 11 rentals @ $150/mo cash flow($1650/mo) to gain $55k cash does not seem worth it. You're getting a 36% return on that $5k/property. Even more if you consider mortgage paydown, further depreciation, etc. You'd be better off just refinancing and continuing to hold.

But, paying down the mortgage quicker doesn't seem like the right idea either. You're not increasing your IRR by paying it down faster. More than likely you're decreasing your IRR as you're putting more money into the deal. At best you're saving 4.X% in interest. You'd be better off finding some other route to spend your extra cash flow on, rather than accelerating the pay down.

There is no reason to increase your equity position in a non-appreciating market as it's likely resistant to the market downturns as well, so less risky.

@Chase Gochnauer   that's my exact point your STUCK.. small value assets are hard to sell.. in non appreciating markets.. and harder to 1031 since you have so little money coming out of them.

Also the major issue is many folks have no experience being landlords become landlords and don't care for it.. so it really does not matter they just want out... I know I fund a whole heck of a lot of burned out landlord transactions for my teams in 14 states.. I see the huds.. LOL..

and those folks don't post on BP.. on BP its all blue sky rentals are the way to financial freedom quit your day job.. live the life you deserve etc etc.. well for some for sure.. for many NOPE.. they are like why did I do that.. and they exit no matter the loss.

now this is more prevelant in the lower value asset markets.. not all markets are like this.

But I look at when I started hard money lending in 01 for turn key and I started in Detroit.. the homes there appraised at that time for 120 to 140 each rented for what they rent for today 800 to 900 in those days the .05% rule was fine.. we loan 80k as a HML .. well those homes tanked as you probably know many went down to less than 10k in value.. thankfully the 200 plus I did there I got refinanced out of them all. but you know long term lender lost their lunch and so did most of the investors in those days.

I am not prediciting another major meltdown.. but even  break even is not a good position to be in with rental properties in my humble opinion the risk/reward and hassle factor just weights on you.. but I know I am in the VAST minority in my thinking.

So my thought is you really need to get these things paid for and keep them forever.. but life happens and I would say 80% of people that have that thought process going in never make it past about 7 or 8 years.

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