Why is Cash flow so important?
Why is positive cash flow mandatory in a real estate investment? I understand looking for positive cash flow is a good proxy to avoid making bad deals when you’re a beginner, but if you’re careful in your estimates and run the numbers properly, I would believe you can still enjoy a decent return on your property even if your initial cash flow is inexistent.
Let's take the example of a zero-CF property (i.e. it's zero after opex, capex, vacancy, PITI, property management etc..) in the following situation:
- I put down 20% as down payment for a 30 years loan, at 4.5%
- The property doesn’t appreciate over the years and I sell the property after 30 years for the same price
- I incur 5% closing costs at purchase, and 5% selling cost when exiting
- I assume no inflation (hence selling price = acquisition price)
In this context, my IRR would be 4.55%. I agree it's not that great but it's not a pure financial loss either (it would become only if you lack sufficient liquidity to operate the asset as planned over the period). The definition of "bad deal" here would relate more to the opportunity cost of such investment compared to other investments (financial markets), than a real financial loss for the investor (i.e. ending up with less cash than originally invested).
Let's now modify a bit our assumptions by including some inflation in our model (say 2%, in line with historical average). The direct consequence is that our initial cash-neutral property just became CF positive in Year 2 and it will keep improving year after year (as long as you can increase rent in line with inflation, and that expenses also follow the same pattern). In this scenario, our IRR rises to 9% (assuming an exit cap rate of 4.9%, in line with the acquisition cap rate). Again, this number may not seem like much but I don't think it looks that bad: this investment basically gives me the opportunity to put to work an amount at an annualized rate of 9% for 30 years. And if I decide not to sell the property after 30 years, I would still enjoy significant positive cash flow (due to the full debt repayment), and owe a property with 100% equity in it.
So, I know that a vast majority of you guys preach the importance of cash flow, and I’m not trying to convince anyone of the opposite (I’m just a beginner trying to truly understand things). I’m just trying to figure out why we don’t want to look at the overall picture when making such investment? I understand the importance of cash flow if you plan on living from it, but for someone with other sources of income (main job), I don’t see why CF would mean more than other sources of return?
Thanks!