Investing for positive cash flow is the best way to invest in real estate. This post will explain why and more.
An investment property is said to be cash flow positive when the rental income generated by the property covers all expenses incurred by the property and puts some money in your pocket. It is this simple principle when not followed leads to bad investments.
Between 2005 and 2008, many investors failed to adhere to this simple principle and what resulted was probably the worst recession caused by hundreds of thousands of foreclosures. Investors assumed that property prices would rise in perpetuity and they can make a tidy profit by selling to the next highest bidder. Investors focused on “equity growth” rather than “cash flow”. Fueled by greed, they were not afraid to buy properties that were in a negative cash flow situation from day one. This means expenses where greater than income. They wrote monthly checks just to be able to hold on to their investments. All they had to do was wait for a year and sell at a higher price. It did happen for a while and this short term profit in turn drove more people to get into real estate investing. Then some thing happened. Interest rates started to rise. This made the already worse negative cash flow worse - monthly payments got higher. As the recession hit, home prices started to slide. This bad situation was compounded by the fact that many investors purchased multiple negative cash flow homes. (There is a famous scene in the movie, “The Big Short” where a stripper in Las Vegas claims to one of the lead characters that she owns five rental properties). Suddenly investors found themselves holding onto properties that not only produced negative cash flow but also were worth far less than what they had paid for. They stopped making their payments. The end result was people lost everything they owned and their credit scores plummeted and now they were forced to rent. As the foreclosures spiked, the demand for rental homes spiked. Everyone that was able to successfully hold on to their homes were able to enjoy one of the greatest rental markets for years to come. The only folks that were able to hold on to their properties were the ones with positive cash flow properties. The only exception to this were investors that were super wealthy and were able to handle the negative cash flow for a few years.
Now that we have seen the perils of owning negative cash flow properties, let us look at the advantages of owning a positive cash flow property. The beauty of a positive cash flow property is that it does not matter if the price of the property goes up or down. You can hold on to the property as long as you want, because rent takes care of all expenses and then puts some money in your pocket. So, it is a safe and smart way to invest for the long term. Over the long term, property values rise due to inflation. Eventually, when you decided to sell, you would have enjoyed all the cash flow and because you were able to hold on to the property for a longer duration, you would also be rewarded with equity growth. In addition to equity growth, rents also rise over time. So, your positive cash flow situation would have gotten even better with time. Additionally, in good times and bad times, there is always demand for good rental properties. When the economy is good, home prices go up, so more folks will be looking to rent and as a result rents rise. When the economy goes bad, people are cautious with home purchase and look to rent and as a result rents rise. You get the picture. By now, I hope you are convinced that buying positive cash flow properties is the way to go.
So, the next question is, how to tell if a property has potential for positive cash flow? It is actually quite simple : You estimate the rent and add up all the expenses to see if the rent covers everything and some. Expenses include items like property taxes, insurance, maintenance, property management fees, HOA fees, debt service etc. PropsHub has built a wonderful free ROI calculator that make the process of figuring out cash flow really simple. Check out their calculator here : https://www.propshub.com/roi-calculator. Once you land on the calculator, type in the property address and you are on your way to figuring out the cash flow. The beauty of this calculator is that is automatically pulls income expense estimates for most properties in the USA and as a result you will have a good ball park. Once you have a ball park, you can tweak the numbers, simulate different what-if scenarios and save your version of the ROI. You should verify these numbers with a qualified property manager before taking the buying decision.