Is Buying a Rental Property with Negative Cash Flow Ever OK?

by | BiggerPockets.com

Cash flow—it’s a term real estate investors eat, sleep, and live for. Maybe it’s used in reference to bigger sums of cash flow, as in flipping, or more often it’s used in terms of the monthly cash flow that a rental property does (or doesn’t) bring in. Either way, cash needs to be flowing in for a real estate investment to be a win.

The first question every investor should ask when they are shopping for an investment rental property is whether or not it will cash flow.

The second question every investor should ask, should they find out a property isn’t expected to cash flow, is if there’s no cash flow, where will my returns come from?

I’m going to offer a couple scenarios where negative cash flow each month on a rental property may still lead to an investing win down the road.

But first…

How to Determine Monthly Cash Flow

I suppose it would help to make sure you know how to calculate cash flow in the first place. You need to know the cash flow numbers that you can expect.

The monthly cash flow is determined by the expenses and the income on a rental property. If the income you receive from a property is greater than what you have to pay in expenses for the property, you will pocket cash every month. This is referred to as “positive cash flow.” If the expenses equate to an amount larger than the income you are collecting, however, then you’re going to be in a “negative cash flow” situation.

If you want a simple way of running some basic cash flow equations to help you determine if the outlook of the cash flow is projected to be positive or negative, check out Rental Property Numbers So Easy You Can Calculate Them on a Napkin.

You’ll see in there a discussion of cap rate and cash-on-cash return. You don’t need to focus too heavily on the details of those numbers quite yet, but as you progress, you’ll want to get more savvy on both of them. They should be critical numbers in your analyses. But for now, you’re mainly looking at whether they are positive or negative.

If you are running the numbers on a property and they are showing that you can expect positive monthly cash flow, great! That is desirable. There are other factors at that point that will determine the feasibility of those numbers holding true, but I’ll save those for a later discussion. (If you’re just dying to learn more now and can’t resist, check out 4 Buying Criteria for Rental Property (& How I Determine a Good Deal. Look at the first two criteria I list in there, as they most relate to what is being talked about in this article.)

cash-on-cash-return-real-estate

Related: 4 Essential Strategies for Taking on a Negative Cash Flow Property

But what if the number that shows up is telling you that you can expect a negative monthly cash flow on the property, which specifically means you will be paying out of pocket every month on your investment? Is there ever a time that this could still lead to a profitable rental property?

What to Do in Times of Negative Cash Flow

The first thing to know is that most properties will yield negative monthly cash flow. True story! Why is this? Well, that’s just how the world works. Believe it or not, most properties actually make horrible investments. I’ve heard that upwards of 80 percent of properties are bad investments. To be honest, I believe it.

The first consideration you need to look at if you have just calculated negative monthly cash flow is what are my goals and what am I trying to accomplish with an investment? Then how does this negative cash flow situation fit into those?

Obviously, the goal with real estate investing is to make a profit. I really can’t see any other reason why you’d get into investing if your goal isn’t to receive financial gain somehow. So then what do we look at once we’ve discovered we shouldn’t be expecting a profit with monthly cash flow?

There are two scenarios where a negative monthly cash flow may be able to be made up:

  1. Appreciation
  2. Long-term gain

At first glance, these two may seem like they are the same thing. In some cases, they are. But in the way that I am referring to them, they mean two different things.

Appreciation

Most everyone is familiar with this term and what it means. It’s often the first thing people are taught when it comes to profit with real estate.

Appreciation is when the value of a property increases over time due to various things like increased, demand, weakened supply, or inflation or interest rate changes. Historically, real estate values tend to increase over time. This is one of the largest benefits to real estate as an asset class and also one of the greatest hedges against inflation.

But how strong is appreciation, and how reliable is it?

Different cities across the U.S. have had notoriously different appreciation trends over the years. Some markets (e.g. Los Angeles, San Francisco, and New York City) have had incredibly steep gains in appreciation throughout the decades. Some markets have gone the other direction and lost tremendous value over time (e.g. Detroit). Still other markets that have remained fairly stable over time, meaning not a major bout of appreciation but not a major loss either (e.g. Indianapolis or Kansas City).

Related: 4 Non-Negotiable Rules For Buying a Negative Cash-Flow Property

So where you buy a property will have a direct bearing on whether or not you can expect appreciation, and if you can expect it, how much you can expect.

There are a few problems with banking on appreciation, too. And don’t get me wrong—when appreciation works, it can really work. But some of the factors you have to consider are:

  • Time in the real estate market. Are prices closer to peak prices or are prices low? If you buy properties during a recession, chances for appreciation are much higher. But if you are buying properties when prices are high, closer to peak prices, how much room is there for appreciation on the property? The answer will always vary, but the chances are going to be significantly lower than if you’re in the middle of a crash and real estate is basically on sale.
  • Predictability. Appreciation is hard because it’s incredibly hard to predict. You can look at trends over time, certainly, but the science behind it is not obvious and doesn’t follow a specific formula. So, while the idea that “real estate will increase in value over time” is probably accurate, when exactly will it increase and by how much? And to throw an extra wrench into it, not only is it unpredictable, but it’s certainly not guaranteed either.
  • Paying with a mortgage. Ultimately, if you are going to profit from appreciation, the amount of appreciation a property sees needs to be greater than the sum total expenses over the course of time you hold the property. This includes things like property taxes, insurance, repairs, improvements, etc. But even if people remember to consider all of those expenses, one major expense people tend to forget about is mortgage interest. If you take a mortgage out on the property, you will be paying interest on that mortgage. That is an expense to you. Let me give you an example. You decide to buy a $500,000 property, and you take out a 30-year mortgage with a 5% interest rate on it. You put a 20% down payment on it ($100,000). Over the course of those 30 years, you will pay ~$373,000 in mortgage interest. Your property would need to appreciate to a value of basically $900,000 just to make up for the mortgage interest alone. That’s not including a single other expense.

Appreciation can apply in a sense to rents as well. In theory, rents should increase over time, so you may be able to get appreciation not only just on the overall value of the property but also in the rental income you are receiving.

Appreciation can absolutely can work—and has worked for millions of investors over the years, but it can also be very dangerous. In addition to calculating how much you would need to get in appreciation so you can have an idea of whether or not it’s even feasible, then you need to also add in how much you are spending each month in negative cash flow to see what those numbers look like and then compare everything. How much loss can you continue to shell out in hopes of reaching later gain? How long can you keep going with that before you’d need to see that appreciation? Again, it’s doable, but it should be done with caution.

Long-Term Gain

I can best tackle this one with an example. Despite my notorious history with investing in out-of-state properties, some partners and I just went in together and bought a duplex local to me in Venice Beach. We are currently negative $800/month in cash flow, just with the income versus the mortgage payment. That’s not including additional expenses with repairs and such. And many could argue that we are much closer to peak prices across the board than we are in a crash, so we paid quite a bit of money for this property.

So why’d we do it? Well, to be frank, the intention for that duplex is that it’s going to be my long-term home. I’m not moving in right now, but eventually, I will move into one of the units, and that will be my final home. So we plan to hold onto it for longer than the 30-year mortgage term. That is one part of why we are comfortable with it. The other part is that it’s in Venice Beach. Properties in Venice tend to run with very minimal vacancy rates, they can easily be filled with short- or long-term tenants, and the city is exceptionally desirable and continuing to grow. Lastly, Venice is sandwiched between two areas (Santa Monica and Marina del Rey/Playa Vista) that have already grown tremendously. Venice hasn’t done it just yet in the same way they have, so it’s a fair assumption it’s going to be building up soon itself. And then more generally, Los Angeles is a city that doesn’t seem to be losing steam anytime soon (to say the least). While not a single one of these factors is guaranteed, that’s a lot of positivity in terms of the outlook for this property. What it boils down to is the confidence in the long-term gain combined with the uniqueness of the situation. It being my “forever home” will be a massive holding under my belt as the mortgage gets paid down. Is it worth a $800/month loss right now? We seem to think so.

Should You Buy a Rental Property with Negative Cash Flow?

I’m going to venture and say, no, usually not. However, if you can succinctly determine that there’s a really solid chance for appreciation or there’s a unique situation that warrants long-term gain on the property, then yes, you can profit off of a negative cash flow property. But is that strategy a good one for newer investors? Probably not. Is it a solid one when the real estate market is closer to peak prices than not? Probably not, unless you have one of those really unique situations like I do with my recent duplex purchase.

Always be sure you know what you are getting into with an investment property. Why are you buying it, what source of profit do you expect on it and how confident are you in the feasibility of getting that profit, and what risk factors are you taking on? If you can intelligently answer those questions, you are probably on your way to becoming a successful real estate investor!

For kicks, if you want to read more on the differences of investing for cash flow or appreciation, check out Investing for Cash Flow or Appreciation—What’s the Difference?

This should be a fun one. Experienced investors—do you buy negative cash flow properties? If so, where do your returns come from specifically?

Weigh in below!

About Author

Ali Boone

Ali Boone(G+) left her corporate job as an Aeronautical Engineer to work full-time in Real Estate Investing. She began as an investor in 2011 and managed to buy 5 properties in her first 18 months using only creative financing methods. Her focus is on rental properties, specifically turnkey rental properties, and has also invested out of the country in Nicaragua.

13 Comments

  1. William Morrison

    If the Cash Flow does not include an estimate for future repairs, maintenance and vacancies, then my answer would be no.
    Unless you are planning on using disposable income/resources from other areas of your net-worth/income.

    I add to the known costs a factor for all three, repairs, maintenance and vacancies to calculate my cash flow. I find many do not. I use a percentage of the expected rent. I build a reserve with it.
    It’s a different percentage depending on the type of neighborhood.

    If my numbers are a little less including that contingency, then the answer might be yes.

    If its your first property those future costs will have to come from somewhere.
    If you have a vacancy, you are a 100% vacant. 🙂
    The more properties you have the less likely they will all be vacant or need a large repair at the same time.
    Then your reserve can be smaller per unit.

  2. Paul Ewing

    I haven’t bought a negative cash flow property, but I have bought a couple that are only positive by $50 or less. This is after reserves and I pay myself $100 per unit to manage them so I am not totally bare bones. Anyway I normally want at least $200 a unit cash flow , but these are on 36 and 48 month personal loans which have monster payments. After those are paid off the properties will be paid for and producing very good cash flows.

  3. Alex Hamilton

    Surprised that more investors are not using the benefits of providing “Special Need Housing” to avoid negative cash flow. Low income Baby Boomers in retirement, elderly and with disabilities are renting properties inadequate to meet their needs, and are looking for service enriched housing. When 53% of all medicaid long term spending by the government has been on Home & Community based services their may be an overlooked resource. A 3-4 Bedroom house used as a personal care home can bring the income of 3-4 homes, not withstanding operational expense…Just a suggestion for the negative cash flow property you may have purchased. But, I agree that unless its a deal to hard to refuse, avoid buying a negative cash flow property.

  4. Lewis Christman

    I’m not looking for negative cashflow at all however a good property that I end up paying 100 or 200 a month (to each their own) might be a good deal for the fact that the tenants are paying the mortgage for me and this would be after all expenses, mortgage, coningency (capex / repair) fund and property management fee.

    500,000 property I put 20% down plus closing costs so in at 115,000 and in 30 years I have an asset worth 500,000 with no appreciation or a much larger valued asset with appreciation that now does cashflow (with the mortgage paid off). 200 a month means I invested an additional 72,000 over those 30 years. Also rising rents over time may erase that 200 a month outflow as well.

    • Ron Read

      I disagree with the above example of putting $115k down to own a $500k property which will not appreciate in 30 years.
      The stock market has averaged 9.69% compounding over the last fifty years, if you had expectations that that wouldn’t change much, your $115k investment in an index fund might be expected to grow to about $1.8 million, and without all the headaches of managing an active investment.
      The only reason to make that play is if you realistically believe the value of that property would exceed what you can get investing the money passively, or you could eventually grow rents to get a better return.

  5. Michael P. Lindekugel

    There are a few material misstatements in this article and the other articles referenced.

    The cash flow description and calculation in this article and reference articles are incorrect. The articles incorrectly refer to cash flow and net income and mix them up. They are entirely two different financial statements and calculations. The financial ration calculations are not correct.

    “The monthly cash flow is determined by the expenses and the income on a rental property.” Cash flow is not income less expenses. Income less expenses is Net Operating Income (NOI) or Net Income (NI) from the statement of operations or what most people know as an income statement or a profit and loss statement. NOI and NI are part of cash flow, but they are not cash flow. NOI and NI are never used to calculate return on investment (ROI) or interest. Those terms are synonymous. Only cash flow is used to calculate ROI. The statement of cash flows is entirely different financial statement just as the balance sheet is a separate financial statement.

    Net income is calculated for accounting and tax purposes in real estate as:

    Statement of Operations
    Gross Rental Income
    -vacancy
    = Effective Rental Income
    + other income such as laundry and vending
    = Gross Operating Income
    – Operating Expenses
    = Net Operating Income (NOI)
    – Mortgage interest (not the mortgage payment)
    – Cost Recovery or depreciation
    – Loan amortization costs
    = Net Income Before Tax (NIBT)

    That is your statement of operations or income statement or P&L. additional steps are necessary to calculate cash flow.

    Cash Flow
    NOI
    – Annual Debt Service. This is the full principal and interest payment.
    = Cash Flow Before Tax.

    “The first thing to know is that most properties will yield negative monthly cash flow. True story!” Negative cash flow never fits into a good investment. I would never allow a client to buy property with negative cash flow. It is fool’s game. Remember the Great Recession which was the worst recession in US history and the only recession that was started by housing and lending?

    “Obviously, the goal with real estate investing is to make a profit.” No, the goal of any investment is cash flow and ROI or interest on your investment. Cash flow and profit are not the same.

    “There are two scenarios where a negative monthly cash flow may be able to be made up:
    Appreciation
    Long-term gain”

    Appreciation and long term gain are the same thing. Its the difference between the future selling price less selling costs and the adjusted basis of the asset.

    The only thing this article got right was “Should You Buy a Rental Property with Negative Cash Flow? I’m going to venture and say, no, usually not.”

    Real property is not special compared to other asset classes except for the fact that you can add value. The financial statements and interest calculations or ROI calculations are exactly the same across all asset classes.

    In the end what matters is cash flow and correctly calculating the interest on the investment. That is done with discounted cash flow techniques such as Internal Rate of Return (IRR) and Net Present Value (NPV).

    • Michael P. Lindekugel

      depreciation and depreciation recapture tax upon disposition of the asset needs to be accounted for in the cash flow and IRR. passing to heirs is a different question. that is usually done at FMV or discounted FMV when the entity holding the asset is properly set up for gifting discounted ownership.

  6. johnny wolff

    In invested in 2 negative cashflow properties in Austin while I was there and plan to hold both long term and according to my model (Austin appreciation beating inflation by 1% for the next 15 years) the total return on these properties will beat out my total returns on my cash flowing KC properties…by a lot.

    Looking at total return from all segments (cashflow, appreciation, mortgage paydown, tax advantage) is the only way to look at property AND your entire portfolio. Your whole portfolio should be a balanced mix of all tranches so that you maximize your total return while hedging against the risk of each tranch (cashflow – rent amounts decreasing; appreciation – home prices decreasing; mortgage paydown – N/A; tax advantage – tax law changes)

    I’d totally buy a duplex in Venice…BUT I’d also buy enough cashflowing properties elsewhere in tandem or as soon as possible to offset the negative cashflow.

  7. John Teachout

    Because we’re old geezers, our real estate investment is focused solely on cash flow as we’re living off of rental income. (our only source of income at this point). That said, we recently purchased a property that has negative cash flow due to the fact we financed the entire cost of the property with a HELOC on our primary residence. As we own this property for a while, the loan repayment amount will get smaller every month and it won’t be long before it has positive cash flow and that will continue to increase as the principal gets reduced. So the negative cash flow situation is temporary. That would be another scenario where someone might consider a negative cash flowing property.

  8. Christopher Smith

    It is, of course as with any decision that has very many fact specific elements to consider and evaluate its not always an easy or an obvious call.

    I bought several properties at the depth of the housing crises in the far East Bay Area NorCal, and my income goal at that time was 80% to 90% appreciation driven, not cash flow centered. I actually was cash flow positive from the very beginning and have enhanced that quite a bit since then, but even if I had not been net cash flow positive the properties would have been total killer investments. They are up about 150% over a 6 year average holding period based upon underlying appreciation alone.

    Would I recommend others to do it, only in relatively infrequent and special situations after very careful assessment and analysis. But in my case, for every dollar of rental income cash flow (now about 110K per year), I’m still earning at least another 3 in appreciation even this far out from the 2010/11 trough (that really surprises me, in a good way).

    From inception, its been about 5 to 1 total, so without question appreciation has been king for me. Its nice too from the tax side since none of that appreciation is currently taxable, where about 1/2 of my rental net cash is currently taxable. But that’s OK, since as they say in the business “pigs get fat and hogs get slaughtered,” by reporting net taxable income on all my properties I presumably will be keeping on the right side of the revenue authorities. 🙂

    The really tough call now is whether to bail out and reinvest for higher cash flow in other markets (I have a couple of properties in the Midwest with higher current cash flow percentages). But I just read my CA market will likely appreciate by 11% over the next year, so I will be staying put. With that much underlying tax deferred (possibly tax free) appreciation, I just don’t see the desirability of reestablishing myself with all that that entails anywhere else – at least for now.

  9. Erin Spradlin

    I’ve heard about people buying properties and after rents paid, being out of pocket $100. Obviously, everyone wants cash flow- but being out $100 bucks/month while having other people pay down the mortgage on a very nice property over time (that hopefully appreciates) and/or you can use for some other reason (vacation rental twice a year). Either of those scenarios also change the calculus when thinking about buying a negative cash flow property.

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