When I first decided to become a real estate investor I worked with a mentor who had many years of experience in purchasing real estate investment, both industrial and multi-unit residential. Over our years of analyzing and purchasing real estate I heard one particular term thousands of times. He would say if you don’t remember anything else, Steve, remember this: “Cash Flow is King”.
It’s a simplistic philosophy, at least by his standards, and basically meant if the property didn’t have a positive cash flow after all debts, including financing, are paid, we weren’t interested.
Whoa! I don’t need to see your ire; I can feel it already.
You want to jump through the screen and say “Steve… wait just one minute, it’s not that simple”!
You’re going to say “There are many factors to consider which directly impact cash flow, what about down payment? The more money you put down the less debt to carry and the higher the cash flow!”
You’re going to tell me there are many cases where you could show a double-digit return through tax deductions, principal pay down’s and equity appreciation, all with zero if not negative monthly cash flow.
You’re absolutely right, I would agree; if your cash flow is negative, and small enough, your loss could easily be covered on an annual basis, by tax considerations on their own, let alone an even modest appreciation. BUT, and I say this in big capital letters, this is a slippery slope and can become an avalanche in a hurry.
Negative cash flow properties are called alligators and alligators need to be fed every day. On the other hand, equity may be real and tangible, but it’s not easily accessible or edible. You may have heard the term “you can’t eat equity” in other words it can’t be used in your daily operations, or perhaps more aptly put, you can’t use it to feed the alligator.
“Aahh… but Steve,” I hear my fellow investors saying, “you can’t look at your real estate investment on a monthly basis. You have to keep an eye on the big picture and look at your returns long-term.”
Believe me I get it, however I would pose this question:
How does the monthly deficit actually get paid?
You can’t refinance every month to get money, and isn’t that really just paying debt with more debt? There is no tax advantage that can be counted on each month or a principal pay down scheme to help feed the alligator. Sure, you may have cash contingencies built into your model, most good investors do, but aren’t those really for unforeseen problems like unexpected vacancy, bad roofs, burst pipes? Can you really use contingency monies to cover ongoing shortfalls for any length of time?
I can tell you where this money comes from: it comes out of your pocket, and more importantly it comes out every month, not just at the end of the year. You may be getting 15% or more return on your initial investment annually but if you’re going to purchase properties in a negative cash flow position, particularly if it’s more than one, you had better have a plan as to how ongoing monthly shortfalls will be dealt with.
It doesn’t take much imagination to envision the potential for disaster, should the market take an unsuspected turn or any costly problems arise, if a significant portion of any portfolio is structured around negative cash flow deals, regardless of the overall returns. (See U.S. market crash)
I’m trying not to be overly dramatic or harp on doom and gloom, but I do hear a particular term more and more that makes me uncomfortable. The term is “neutral cash flow”. More and more commercial investors are telling me that they purchased a property with a neutral cash flow.
If you haven’t heard the term it basically means that you’re buying the property with no positive cash flow but in theory no loss either. In other words, the existing income will cover all the expenses; basically breakeven. However in my experience, unless you are an absolute guru at predicting expenses, any property that is termed neutral cash flow, more often than not means really negative cash flow.
I understand real estate is a hot commodity right now and everybody wants to get involved but when I hear investors tell me all they want to do is break even or be neutral I can’t help but wonder how carefully they’ve actually reviewed their revenue and expenses and how often these really become significant alligators.
Please, be leery of negative cash flow deals when you are investing in real estate. If you’re going to pursue a negative cash flow deal, be ultra conservative in your due diligence. Think carefully before you build a portfolio around this strategy and remember alligators can become big and hungry in a hurry.
Better yet how about being a little more patient, a little more selective, and more thorough in our due diligence and buy something with a solid positive cash flow. How about starting in the black and if we have a problem, maybe we go in the red, but usually only for a bit, rather than starting in the red where a problem only takes us deeper. Believe me it can be done!
I would offer up one final piece of advice, when you are evaluating investment real estate, train that little voice in the back of your head to keep whispering: “Cash Flow is King… Cash flow is King.”