How to calculate cash flow in downturn

Question

So I see people on here doing case studies calculating scope of work and calculating cash on cash return and monthly cash flow but I see these numbers are based on the loan terms and fixed and projected cost of maintenance and vacancy. It also uses it uses the current rent comps of comparable homes. My question is with the market peeking out is anybody looking at the possibility of 5,10,15 years from now the rental comps being much less, And having a negative impact on the cash flow and cash on cash return. Should there be another line item under potential costs factoring in a potentially reduced rate of cash flow based on a reduced amount of rentable price in a downturn. Does anybody use this type of thought process when purchasing a rental or is it just a thought that if the market does start to pull ￼back that the property would just be liquidated. Also is there any type of historical data or chart that would show how the rentable cost per square foot would be negatively impacted per percentage of downturn of market value of the property?

Joe Villeneuve · Answer

CAPEX...Capital Expenses, and yes...the items you mentioned are a few examples.

Joe Villeneuve · Answer

First, Cash on Cash Return is only measured in the first year of ownership.

Second, you can't forecast anything financial that isn't fixed 5, 10, 15 years from now...and no matter what the financial market is doing.

Third, just because there might be a downturn, doesn't mean rents will go down.  On the contrary, if you pick the market correctly, they should actually go up.

Forth, and this is a personal philosophy, I don't like to hold any rentals (SFH) past 5-7 years anyway.  For a couple of reasons:

1 - I want my free dead money out of it in cash

2 - I want out of it before the property nails me with all of the 5-7 year CAPEX costs.

Dan Moore · Answer

Thanks Justin. I'm certainly no ones mentor. While we've had rental properties for years, they have always been ancillary to our normal business. Switching over to making REI our primary business is a new focus for us so in reality, I consider myself a newbie at this. I'd certainly be happy to be a peer.

Justin Miles · Answer

@Dan Moore this is exactly the type of forecasting I’m referring to (like a stop loss in stock trading) thank you for the thought out response. If you can follow people on here you’d have a follower. Too many people don’t spend enough time on risk mitigation I’ve seen it crumble my friends 13 home portfolio in 08. Leverage is a great way to compound but I like leverage off a bottom rather than a top. I’m new to real estate investing but tenured in the stock market and hope to transition that knowledge to rei. I’ve grew up in a home life of constant remodel and Reno so I have a skill set in that as well. Just finished my first book by J Scott and will be continuing my learning curve for the next year when I will be selling my current home and walking with some good equity. All together with partner will have about 340,000 in free cash. Looking for a mentor if anyone has the time or want to do that. Would be willing to share my knowledge of stock market trading and investing.

Dan Moore · Answer

I’m not sure it’s safe to say rents don’t go down in a down turn. When new homes stop selling, builders will sometimes turn to rental for cash flow. A brand new house down the street renting for even your current rental rate (assuming it does) means your older home will have to decrease to compete. The worst thing you can have in business is a desperate or stupid competitor. Track home builders in a cash crunch can be both.

Saying that interest rates go down in a down turn is also not entirely correct. This is the lowest interest rate environment in my lifetime. Rates were higher in every previous downturn that I recall, back to the S&L crisis in the 80s. If inflation cranks up, recession or not the rates will rise to offset, most likely. If you have a fixed rate then who cares. If your model is built on refi or an ARM. You could be screwed.

I’m not saying hide under the covers, but the last 15 years are not a reliable indicator of what the next 5 will be. No offense to the many smart people on this site, but many of them have been through maybe one down cycle. They are not the same, and they are rarely what you expect.

We always model a lever plan. If the market does this, what lever will we pull (lay-off, sell of x properties, rent for cash flow at x percent off normal rates). If the market does this, minus another 10% we pull the first lever and then the second (move in with parents, rent primary home, etc, you get the idea). This minus 20%, lever plan 3. Predict the best, worst, and expected market.  Then figure out how you’d react in each scenario and run a simple Pro Forma.

It’s not being paranoid. It’s having a plan and executing if the need should arise. We did this each year in my old business which did about 100 mil annually and was VERY cyclical. If the market tanks, we update it much more frequently (in 2009 where we lost 80% of our market potential, we updated it weekly) but we looked at it each year as part of our business planning. It is a lovely thing to see an inch of dust on it, that means that the market is doing well this year.

Nowadays (in this business) the process is much more compact and less detailed but we still look at it.

Justin Miles · Answer

@Joe Villeneuve I’m green to this. When you say capes your referring to things like roof replacement. Ac goes out big items like that?

Justin Miles · Answer

@Anthony Dooley thanks. great points and why I think my property currently would not warrant a rent as it’s an A. Just another check in the sell it column. That’s good to know that rent prices stay steady.

Matt Leber · Answer

@Justin Miles downturn shouldn’t affect cash flow much, as rents are not guaranteed to go down. You may see more renters enter the tenant pool if we see a downturn, which would technically raise rents. Even if rents did go down, it would take a drastic decrease to cause my rentals to be negative cash flow. If someone were to buy properties that barely breakeven cash flow-wise, that is when they might get in trouble.

Anthony Dooley · Answer

@Justin Miles A downturn is only a problem if you are selling a property. The market value of the property has little to do with the rent in a downturn.

Loan terms that are fixed rate do not change with recessions. ARM rates tend to increase when the economy is hot and tend to get cut during recessions. The rents in D and C properties don't change because they are already low. Rent in a B property may flatten, but shouldn't go down unless there is too much inventory. If jobs leave the town, people leave too. Class A properties could be affected because people may move down in price to a B or become roommates to save money.  I don't buy A class property.

How to calculate cash flow in downturn

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