What to Calculate in an Expensive Area with low Cash Flow

Question

Hi everyone - my husband and I came across a great deal on a Hoboken Duplex yet the cash flow and COC ROI isn't the highest. However, it's in an area that is super popular and with a little work, we could raise the rent to be alongside that of the other rentals in the area. What are some things I should be calculating if the cash flow isn't super high but has potential to grow given the area.

Twana Rasoul · Answer

@Serena Tillman I don’t like applying same rules to all real estate in all markets. What I buy in areas of the Midwst for instance I would definitely need cashflow right out of the gate especially since growth is very little to none.

In my local market in San Diego, initial cashflow is difficult without value add and even then sometimes it gets you to neutral cashflow to start off, depending on the amount of value added. Does that mean I don’t invest locally? Absolutely not, it’s a strong market for appreciation and that also means I am able to raise rents every year, a healthy amount, to get to neutral and eventually positive position while at the same time enjoying debt pay down and overall appreciation.

Kai Van Leuven · Answer

@Serena Tillman

This is a great question. There are many on this site who would buy a poor investment, in a bad area, that will never appreciate and think they are great investors! Lol. They will use small numbers to justify COC and other useless metrics.

I buy in an expensive area where the calculations are a little different. This is what I look for.

1. How much equity can I have in the property at the end of it?

2. Will it positive cashflow at the end?

3. Is it in a good area where rents will increase?

4. What will this area look like in 30-40 years?

It is the road less traveled on BP but the way to actually do well in real estate!

Joe Villeneuve · Answer

The exact same things if the cash flow was high and the area had no growth

Joe Villeneuve · Answer

When you bank on properties that have no or poor cash flow, and are counting on appreciation, you're losing money.  Appreciation builds equity on a 1 to 1 basis meaning every dollar the property value goes up (or down) is the exact dollar amount of change in equity.  Equity is your cash held prisoner in that property.  It has no value to you in that state, until you access it (liquidate it).  It's a trophy.  It's one of the best trophies, but it has a 1 to 1 value and you can't do anything with it as equity.

Cash flow is liquid and as it builds up it can have a 5 to 1 value.  How?  If you actually use it  as a down payment on another property, and that DP is 20% of that property value.  One dollar of cash flow can be said to equal 5 dollars of equity.  Equity has a lineal return, whereas CF, due to it's liquid state, can have an exponential return.

I'm not saying equity isn't a good thing...not at all.  I just don't consider it a substitute for cash flow because you can't count on it, and because of it's limited growth potential.  If a property cost$100k and you put a DP of $20k down, you just bought $20k in equity.  If that same property increased its value from $100k to $150k in a 10 year period you would have $70k in equity,...and that's a great thing...however, it's not as great as having $5k in CF from that same property, and every time that CF accumulates to $20k, you buy another $100k property with $20k down...which increases your CF by $5k for each of those properties.

At the end of that same 10 year period, the 2nd person would have 7 properties, $35k in CF per year, and $140k in equity (+ appreciation on each one).  The fact that CF is liquid and usable NOW, as opposed to equity, it has the ability to grow much faster than the equity.

My conclusion is this.  I will never buy a property that has only the chance of future equity at the price of little, no or worse...negative CF, but if I can get both...:-)

Lee Ripma · Answer

@Serena Tillman

You want to look for upside on the property value. It’s not so much about what you’re buying it for but what it’ll look like in a year. Can you force a lot of appreciation? Can you get rents up significantly?

Dan H. · Answer

Comments:

• There are low cost ways to extract equity achieved
• The appreciation is tax deferred.  When I extract the appreciation, I do not pay taxes at that time on the extracted value.  Cash flow gets taxed.
• The appreciation when extracted can be used to purchase subsequent properties just like the cash flow, but without having paid any taxes on it.

New investors often need the cash flow to sustain the property.  Many do not have an option of purchasing property on overall expected return if the cash flow does not meet their needs.  It is unfortunate because they are excluded from purchasing the highest return properties.

I have purchased a projected cash neutral RE (duplex).  In a year, I had extracted $90K (and it was still projected cash neutral).  It projects modest positive cash flow now (50% rule would show $260/month, but my projection shows $580/month), but it is with a very low trapped investment (~$20K could not be extracted in part due to low refi appraisal which is common in my market).  It has achieved a great return because I have little invested.  That $90K extracted was invested in another RE (that projected modest positive cash flow and had a value add worth ~$25K).

I would not be adverse to purchasing a cash negative property if it would provide an outstanding return (such as the example above).  I look at return on investment.  The only reason I care where the return comes from is because some sources of return are more work than others (cash flow is easy, Value adds take more work).  If the work load was the same, I would not care about the source of the return.

As for counting on cash flow, it is not a sure thing.  During the Great Recession there were many areas that had significant rent declines (Detroit, Vegas, much of Arizona, etc.).  The cash flow in these areas went from positive to negative for many investors.  Similarly, there are areas in this pandemic that have higher rates of rent default than other areas.  Much of the rent delinquency will never be paid.  Some investors who thought they had positive cash flow are currently not obtaining their projected cash flow.  This is a localized issue as many,probably most, landlords are collecting their full rents (we have so far collected full LTR rents, but are down ~$60K on STR rents).

Serena Tillman · Answer

@Allan C. awesome, thank you Allan! I’ll be sure to check it out.

Allan C. · Answer

@Serena Tillman you’ll need to understand how to perform an IRR calculation. Simple CoC does not give you a clear understanding of investment fundamentals if appreciation potential is high. You also do not properly account for time value of money without calculating IRR.  Excel has an IRR function that is straight forward to use.

Serena Tillman · Answer

@Joe Villeneuve And what would that be? I’m a newbie to this.

Serena Tillman · Answer

@Lee Ripma I can definitely force appreciation! How would I be able to calculate or estimate what it would look like in a year?

What to Calculate in an Expensive Area with low Cash Flow

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