Why is Cash flow so important?

9 Replies

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!

Hi @Account Closed . In a perfect world, sure, it's not a total loss or a terrible deal to get the properties in your scenario. Now in the world we live in, think about how one single tenant won't be living in your property for the entire 30 years. That means you'll be dealing with vacancies, evictions, and fees to get your property rented to new tenants. Then add in the maintenance issues. Our first month as new landlords we had an AC blowing hot air and a broken pipe in the backyard. Three months later our tenant didn't pay rent and we had to start an eviction which ended up in her abandoning the property and us spending $8,000 in a cleanup/rehab of the property. Now we finally got it rented back out and the property has bugs so we have to spray for bugs and the AC is old so we needed to do an acid wash on it. That's another few hundred bucks. The roof is at the end of its life so in the next year or two we will have to spend another $8,000+ on a new one. And the AC once that's gone another $6,000+. Of course we knew these things going in. We knew the floors needed redone, the AC and roof were old, that the property needed updating. But still. There are those things that pop up and break that you'll need to fix. Whether or not you want to live off the cash flow, why risk your money for a property that doesn't cash flow? Real estate is risky. What if in 30 years when you want to retire the market is down and you can't sell and you held on to this property for so long and have to wait another 5 or 10 years for it to pick back up? Anything is possible. If you're going to take this risk, make sure it at least cash flows so that you cover any expenses that come up along the way. It's not a slam dunk to invest in any deal and wait for appreciation to happen. I recently read that appreciation should be seen as the icing on the cake, not as the reason to invest. I hope this helps!

Thank you for your answer Elenis.

Regarding your first point. I understand life happens, but everything that you’ve listed initially are costs that have been included and accounted for in the example (vacancies, evictions, capex, maintenance). Obviously, I don’t have a magic crystal ball so I cant perfectly estimate the cost of such expenses when they pop up but I can at least budget for them (which is the case in the example above).

Regarding your second point, if the market is down, I could still hold the property. Let’s remember that I’m talking about a property that has zero cash flow at inception. It doesn't mean that 30 years from now, that would still be the case (I assume it would not). Of course, we can also assume that over 30 years, we will face 0 inflation or even deflation, but then REI as a whole would become very challenging.

Final point, I do not include "appreciation over inflation" in my calculation: the only reason why the sale of the property in the second example is higher than the purchase price is due to compounding inflation. The exit cap rate multiple used is the same. So I'm not really betting on any positive market trend that would lead to better-than-inflation appreciation (so no icing on the cake I believe)

Thanks again

If I were to modify the initial question, it would be: Why is cash flow at closing so important? Obviously you wouldn't have any cash on cash return at closing, but if you expect the property to cash flow in the next few years (which is the case if you're neutral at Year 1 and inflation kicks in), I really don't see the issue

What do you guys think?

I would agree. Although the 4.5% IRR is the base case scenario with no inflation at all, a bet I wouldn't want to take on the general economy. In the second example, the return is 9%, which is not a bad number in absolute terms. And in these circumstances, locking a 9% returning asset for 30 years doesn't seem a bad deal at all when I compare it with other potential investment opportunities

Also, tying up money is relative here. First, the asset starts generating CF after year 1 (but let's assume a few years) due to the depreciation of the loan, so it's not like I'm living with a complete burden. Second, even without selling the property, I could still refinance and tap in the equity to do other things, so I'm not completely blocked here either.

What do you think? In any case, thanks for the feedback, I appreciate the discussion !

First, and last mistake you are making here. You're trying to analyze a REI in the same way as you would another (stock market) investment...and you can't. There are so many things that are different, and that are irrelevant from the stock market that don't translate in the same way into REI...like IRR. You can use the same formula, but a REI is more "mobile".

Second mistake, is you are not comparing apples to apples in the overall comparison here. An example, and a huge one, is how much cash does it take to "enter" each use of funds...the two uses being a stock investment and a REI investment? IF you had $100k to invest, you would need to spend all $100k to get a $100k investment. If you put that $100k into REI, you could get a $500k investment. IF your return was based on the value of each investment, and they were the same rate of return, the REI would be 5 times that of the stock market.

Also, keep in mind that if the property value was 5% return, and the CF was too, you would be getting a compounded return by way of investing the cf as well.

You can't analyze a REI the same way as you would a stock market investment. If you do, you are missing out on many of the advantages REI offers, that the SM doesn't.

Thanks for your feedback.

I'm not sure to follow the first point: Why can't we compare two investment vehicles (such as stocks and RE)? or at least compare potential returns? Also, I'm surprised that you consider IRR irrelevant in RE. It would appear to me that, on the contrary, IRR is a great tool (but not the only one) to assess an opportunity as a whole as it benefits from many advantages: it values time and takes into account leverage, cash flow, debt repayment, inflation, appreciation, etc..

Regarding the second mistake, indeed for a certain initial equity, the size of the investment is significantly different. REI is the only asset where you can borrow 80% of the funds, unlike stock investing. And that's why you can manage to get great return on you investment even if conditions are not ideal (i.e. cash neutral property where bank debt is still being paid down).

Regarding the compounded return, the IRR does assume cash flows (if any) are reinvested at the same rate of return as the project itself, so this aspect is also included in the calculation (and that's why people use MIRR if they want to adjust this reinvestment rate)

Again, thanks for your answer!

Originally posted by @Account Closed :

Thanks for your feedback.

I don't know where to begin, but I'll give it a shot:

I'm not sure to follow the first point: Why can't we compare two investment vehicles (such as stocks and RE)? or at least compare potential returns? Also, I'm surprised that you consider IRR irrelevant in RE. It would appear to me that, on the contrary, IRR is a great tool (but not the only one) to assess an opportunity as a whole as it benefits from many advantages: it values time

...Me:  No, it counts time...not the same thing.

and takes into account leverage, 

Me:  No, it doesn't consider the reuse of the same funds, thus reducing the cost associated from the leveraging.

...cash flow, debt repayment, 

Me:  Not the correct way.  It has a place in the formula for it, but it shouldn't even be part of the formula if you have positive cash flow since the tenant is paying the mortgage...not you.

...inflation, appreciation, 

Me:  So what.  Counting on assumed future events that you have no control over isn't investing...it's speculating, which is another way of saying guessing.  Cash flow isn't guessing...it's now, and it's real.

...etc..

Me:  The list of "etc" for REI is long and plentiful.

Regarding the second mistake, indeed for a certain initial equity, the size of the investment is significantly different. REI is the only asset where you can borrow 80% of the funds, unlike stock investing. And that's why you can manage to get great return on you investment even if conditions are not ideal (i.e. cash neutral property where bank debt is still being paid down).

Me:  Again, No.  Cash neutral is losing.  It's losing because along with the power of leverage, comes the exponential power of using the same money over and over...never spending it.  We're not talking about the profits here, we're talking about the "seed" money.  When you pull the seed money out of a stock, you no longer own the stock.  You can pull your seed money out of the REI, and with positive cash flow, you can reinvest it in another property (over and over).  The same money, and each time it moves, you retain all the previous investments and the cash flow and appreciation each property has.  That's the compounding I was referring to. 

Regarding the compounded return, the IRR does assume cash flows (if any) are reinvested at the same rate of return as the project itself, so this aspect is also included in the calculation (and that's why people use MIRR if they want to adjust this reinvestment rate)

Me:  see previous answer.

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