This is the first installment of a four part series on what I describe as the three types of cashflow (as it relates to Real-Estate) … feel free to weigh in!
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I think, by now, most of our readers no longer subscribe to the “buy property for the tax deductions and future appreciation” scams of the 90’s and 2,000’s that resulted in one of the biggest property busts that the USA has ever seen.
But, I fear a new mantra – not quite as dangerous, but one that can squash your future returns (hence, financial dreams) like a kink in a fireman’s hose [AJC: that’s probably the worst simile that I have ever written] …
… it’s the ‘positive cashflow’ mantra.
You see, there are three types of positive cashflow, when it comes to Real Estate … and, I’m not sure that you will read about this anywhere else, but here it comes:
1. Tax Cashflow
2. Fake Cashflow
3. Real Cashflow
… only one of which we are really looking for, although, any great property purchase will probably exhibit characteristics of all three.
First, though, let’s review the typical property; the one that doesn’t produce any cashflow at all and loses you money … it’s negatively geared!
Negative Cashflow
A property produces rents – hey, even your home produces a ‘rent’ … it’s just that you don’t bother to pay it to yourself, but you should 😉 – and those rents are offset by costs: e.g.
– Mortgage Interest
– Repairs and Maintenance
– Vacancies
– Provisions
And, there are many others …
… interestingly, the last two aren’t strictly a ‘cost’ but a lost opportunity to earn rent – it amounts to the same thing: more cash going out than going in.
If the property has more expenses going out than money coming in from rents it is said to be Negatively Geared; this simply means that you are losing money!
So, why do you do this? Well, the promoters of such property – and, there are many such ‘promoters’ (e.g. builders, developers, real-estate agents, etc.) – will say that you do it for the FUTURE APPRECIATION …
… definitely lose a little bit of money today for the chance to make a LOT of money in the future.
There’s a word for that: gambling. I prefer poker; you may prefer lotteries; let others gamble on this kind of real-estate.
In the next installment in this special 4-part series on real-estate, I will cover the first kind of ‘positive cashflow’ real-estate: Tax Cashflow.
Great topic Adrian. My wife and I have been pondering this very same topic with our rental(which was our previous home). We are negatively geared by $250.00/month on that property, have great renters that have completed their 6 month lease and are continuing to rent month to month while they continue to try and get their home in Connecticut sold, then move on to purchase their own home here in Louisville.
Money seems to be tight for them from all that I can see, however they are able to make this rent each month, so I’m a bit afraid of raising rent on them, but it really troubles me to be negatively geared for the moment. This property (according to this years filing) has given us a pretty large tax deduction, which has certainly saved us money, perhaps enough to pay us back the monthly amount we have lost to make us break even. Not to mention, it is in one of the most premiere areas of the city and has enjoyed one of the highest appreciation rates this city can offer, but as your post suggests, we don’t want to get caught up in the hope of appreciation.
The plan of course has been to refinance this home asap, but after talking to a couple of lenders, they all say the same thing. We’ll need to put down between 30-40k to get a refinance(they all want 25% down with this market on any investment property, even with our great credit). The home is worth between 320-325k and we owe 279k on the mortgage, so hence, the difference is about 30-40k cash to put down.
We can certainly put that cash down on it this year to make that happen, but i’m just not sure that’s the best move for that cash on a rental that is valued in the 320k price range. In that price range, if repairs are needed, they will of course far exceed the price of for example, a 100k rental.
Now i’m just wondering if it would be smarter to sell that home, take whatever gain we can get from the sell, even if it’s only 10k, stop losing 250.00 per month and pool this money along with the money from the sell of the home into our regular monthly savings pot and shoot for other property investments that might make more sense.
Any thoughts or suggestions?
@ Scott – You are hinting at the first type of positive cashflow: Tax cashflow. I will cover this in the next installment …
As to whether to raise rents, sell, etc. it all boils down to the numbers (and, the Number): take a look at you expected long-term return from this place v what you can get elsewhere … probably, elsewhere will win if you DON’T factor in appreciation. The house MAY win if you hold long enough.
The one factor that I can’t help you on is rentability: if these tenants DO sell and move on (in the next 6 mths to 2 years, I would guess) how rentable is your house and for what rate? THOSE are the numbers that you should be basing you calc’s on.
When doing these numbers, remember that there’s an “if all else fails, I still have the houses” Backup Plan aspect to all of this … that’s why I’ve held on to properties that don’t return a whole lot (any!) cash month-to-month.
In other words, I would hang on to it, until I had exhausted my other cash sources (if any) for investment.
Locking in the rate is a trickier one: I’m guessing that locking in current rates INTEREST ONLY (or a 15 – 30 year balloon) will probably make up the lost opportunity on the extra deposit – and more – if you DO opt to keep the property. You’ll have to run the numbers …
Finally, 6 months is probably too soon to raise rents … gotta be fair to the tenants 🙂
Your post suggests that anyone who is negatively geared on a rental should “abort mission” Adrian, but your follow-up to Scott doesn’t. In fact, your post suggests only one kind of cash flow is going to be what we want and we need to learn and stay away from the others.
@ Diane – Not really, Scott is suggesting that his property is ‘tax cashflow’ positive (or at least break-even) … not the same as negative cashflow, but he COULD do better.
And, when I went into my residential purchases I didn’t know any better, but they are also breaking even now or doing a little better.
Since I am cashed up at the moment, I see no need to sell out until I have run my cash out, then I will definitely exchange into a better performing commercial property or three.
You have to remember, I didn’t always have the roadmap in front of me that I am laying out for you, so I share my mistakes, along with my fewer successes, right here 😛
… the lesson is: don’t get INTO a negative cashflow situation, in the first place, but once you are there, we will need another post to tell you how to get out!
I have seem this time and again in commercial real estate. People are willing to leave a strip mall mostly empty, they are unwilling to do short term leases, or even to discount the leases. So what happens, there are tons of strip malls, and office buildings here in Arizona that are empty. They have this mindset that if they get a nice long lease that it will be better than the money now. This may have been the case in the past but to me it just seems so stupid.
An example is a building I was thinking of renting back in 2002. It was perfect for a business idea I had, I had the backers and was ready to go, I just wanted 6 months rent free and then to rent it for $12k per month, going up 5% per year. They would not budge on their price of $18k. It was too much so I passed. Well now it is 2009 and it is STILL empty, no one has EVER rented it.
Another example is a strip mall that I know of. It is very poorly designed but has over 400k square foot in total. Less than 50k square foot is rented out. A guy I know rented a 8k square foot space, and put a Filipino restaurant and grocery there. Soon the space next door was rented by another Filipino to build a karaoke club for Filipinos. It was all located in a part of the strip mall that was totally empty. The grocery store invested everything they had, over 300k into building out their store and stocking it. Then the economy hit them, and they could not pay the rent. On the 15th day of the month the landlord locked them out, charged a penalty and the guy could not come up with the 20k needed, over 50k in food spoiled and they guy was promptly out of business, and the guy next door also moved out The place is now empty. So what did the owner of the property have to loose to give the guy some time to catch up, maybe some discounted rent. He would surely not be making less than he is making right now, he has over 300,000 sq foot of other places to rent out, most of which are better. It was dumb and short sighted, but that seems to be the majority of commercial landlords, especially the distant ones who never even see the property.
I think of tenants as clients. They pay you and you should keep them happy. You have only limited supply so when you are full you can be more selective and follow the rules to the letter, but when no one is buying your product you need to sell at any price to make money, they still like to keep rent high, and if it not rented then they take the tax break at the higher level. That is illogical to me, but maybe that is why I am not as wealthy as they are. Or maybe they are just huge REITs playing the game with other peoples money and they don’t really care that much.
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@ Jason – Nothing wrong with doing a little discounting on a ‘product’ that you can’t seem to shift, right? 🙂
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