This is the third installment of our series on the three types of Positive Cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Last week we discussed the first of these (Tax Cashflow), cleverly designed to make Negatively Geared real-estate look like a good deal. As I said:

By allowing you to pay less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

Today, I will introduce you to a simple, but powerful concept that will allow you to take any piece of real-estate and create positive cashflow … it’s so simple, you’ll wonder why you didn’t think of it sooner 🙂 But, you’ll quickly see why I call it …

Fake Cashflow

If you want a property to produce positive cashflow without doing a lot of work and research, use the 7million7years Patented Positive Cashflow Formula:

Pay Cash!

Now, this isn’t a stupid idea, it’s actually a valuable – and, under-appreciated [AJC: pun intended] – Making Money 301 wealth-preservation strategy … and, it works because it eliminates a (actually, usually THE) major expense on your investment property: mortgage interest.

Without interest, the chances are that your property will produce enough rental income to cover vacancies, repairs & maintenance and other typical costs, yet still produce a very healthy profit … perhaps even a livable income for a MM301 ‘retiree’.

The problem, of course, is that the rest of us – those still trying to accumulate wealth – (a) don’t have enough cash to buy much (any?) real-estate outright, and (b) real-estate’s growth is typically just around inflation-to-6.5% (depending upon who you believe) … hardly earth-shattering.

But, we don’t HAVE to pay cash for a property to produce this kind of positive cashflow return, we just have to decide how much cash to put in … as best explained by Shafer Fincancial in a comment to a recent post:

Here is how it works. Most folks, including myself, advise re investors to make their properties cash flow for safety (comparing your costs with the rents received). So if one person can get a loan for 7% and the other can only get a loan for 9% in order to make it cash flow, the later will have to put down more capital (down payment). If you are leveraged at 80% LTV and a property cash flows you only have to tie up that 20% capital. However, if you are having to put down 25% to make the property cash flow because of a high interest rate on the loan then you have 5% more capital tied up in the property for the same capital appreciation.

$100,000 property
Person A cash flows with $20,000 down payment
Person B cash flows with a $25,000 down payment

Think about it:

You put 0% down and you have a negatively-geared ‘dog’ … and, if enough people do it, a future real-estate crash (a.k.a. ‘credit crunch’)  on your hands.

You put 100% down and you have a positively-geared ‘retirement investment’ that ‘only’ grows with inflation (unlike CD’s – which ONLY provide some income).

… surely, there is a ‘break-even’ point somewhere between the two, where the property will cashflow positive, but you only have to put in a deposit and you can borrow the rest from a bank like a ‘normal person’?

Yes there is, and we ‘twist’ the Shafer Financial example (he was talking about the ‘cost’ of different interest rates) to illustrate the point very nicely: Property B may be a ‘dog’ with a 20% down payment @ 9% interest, but if you just up it to a 25% down payment also at 9% interest, you lower your monthly mortgage payment just enough to make it break-even on a monthly (or yearly) basis, or even cashflow positive.

So, fiddle the numbers on a spreadsheet (with the help of your accountant, if necessary – they LOVE this kind of stuff!) and you will find the break-even point (i.e. the point where the property JUST starts to cashflow positive) and if you can afford the deposit, perhaps you have a ‘winner’?! 😉

But, it comes at a ‘cost’ or two:

1. You need to come up with a bigger deposit … which, means that you may not be able to buy as big/many properties as you like, and

2. The more money you put in, the lower your overall return (annual compound growth rate); again, Shafer Financial explains nicely:

The interest rate on mortgage debt on investment property does curtail capital appreciation …

$100,000 property
Person A cash flows with $20,000 down payment
Person B cash flows with a $25,000 down payment

Property appreciates 3% for five years. Aproximiate value of $116K.
For simplicity stake; No excess cash flow for five years (unlikely)
No tax advantages.

Person A ROI= 12.47%
Person B ROI= 10.4%

Having to put that extra $5K down to make the property cash flow cost you 2% in the return department. Note that the property only appreciated 3% per year, yet the rates of return were 10% and 12%!

Now in the real world you must account for the cash flow over time and the tax advantages to compute ROI. But this is a perfect example of how interest rates effect return. Also, note that the higher the leverage (above 75% LTV for most folks) the higher the interest rate is likely to go. So, there is usually a break even point for leverage/cash flow that takes into consideration the interest rate.

This is that ‘leverage’ thing that makes real-estate such a wonderful investment, producing returns (for well-selected / purchased real-estate) well above the naysayers moans that real-estate only grows “according to inflation” or “6.5% a year” (depending upon who you believe).

So, the problem with Fake Cashflow is that – while we can ‘force’ a Positive Cashflow out of almost any piece of real-estate by simply putting more of our own cash in it up front – it tends to reduce leverage, hence reduce our overall returns. This is why I call it ‘Fake Cashflow’ …

There has to be a solution … and there is: see you in the final installment in this series, where I show you how to find ‘Real Cashflow’ 🙂

Last week I told you that there are three types of positive cashflow Real Estate:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

Today, I want to discuss the first of these … cleverly designed to make Negatively Geared real-estate look like a good deal!

Tax Cashflow

In the first installment, I explained that most real-estate (especially residential real-estate, and single family homes and condos in particular) has more costs (e.g. mortgage interest, vacancies, repairs & maintenance, provisions, etc.) than income (i.e. rents), forcing us dumb investors to gamble on the future appreciation of the property … and, we can see where that has lead us!?

So, those developers and promoters with lots of real-estate that costs way too much to buy found some money to help you cover your losses and turn them into a ‘profit’ … from this, comes our first opportunity for the Holy Grail of Real Estate: Positive Cashflow property i.e. one that puts money INTO your pocket each year.

Now, I said each year for a reason: tax.

Uncle Sam will help you to help these property promoters to become rich by encouraging you to buy their overpriced, under performing real-estate! Take Scott, for example:

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.

As Scott has discovered the ‘secret’ is in tax-deductions …

… naturally, almost all the expenses that you have on an INVESTMENT property are tax-deductible, not just including mortgage interest (as in your own home) but, also ‘business’ expenses like repairs and maintenance … even vacancies allow you to earn a little less income, so you pay a little less tax … but these will probably not make a property cash-flow positive on their own.

Actually, the real secret is in the ‘provisions’ … a provision is a fund that you build up over time to allow you to cover major costs later (e.g. an Emergency Fund is a kind of provision).

You see, Uncle Sam allows you to ‘build up’ a fund over time to replace the building that you have on the property, and all the things that you have inside the property (e.g. stoves, lights, carpets, curtains, etc., etc.). You probably borrowed the money to buy all these things – and, are tax deducting the mortgage interest – but, the nice people at the IRS allow you to take a ‘double deduction’ in the form of a Depreciation Allowance on these items, as well.

It becomes another expense that you can get a tax deduction on, and because the property may not have enough income (hey, it’s already Negatively Geared!) you can lower your personal tax bill instead.

By paying less personal income tax, the promoters of these schemes will show you that the property can pay it’s own way (Neutrally Cashflow or Neutrally Gear) or even Positive Cashflow!

Unfortunately, it’s all on paper … and, it relies on you earning a high income … and, will probably only work for one or two properties because you won’t have enough personal tax to ‘save’ for more properties than that.

When you ‘run out’ of personal tax deductions you can’t make any more properties Tax Cashflow Positive … it’s all smoke-and-mirrors.

So, when it comes to real-estate, you want tax deductions and you want tax cashflow, but you don’t want to buy a property that only has this kind of cashflow, if you can find something better.

In the next installment, we’ll look at something even more fun: Fake Cashflow.

My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I don’t have to invest the full 100k. I can finance most of it, secured by the real estate. So, let’s say I can finance 80% of it, which means I “only” need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

– very well-established commercial strip-mall in a great area

– fully rented, with long leases

– currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

– It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t 🙂

– There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee is  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee …

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

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.