What Cash Flow and Oxygen have in common in Real Estate
A few years ago we were on the hunt for a larger residential property to add to our portfolio. One of our colleagues put us in touch with a Realtor who was supposedly the go-to person in this sphere of real estate investing.
We had a long conversation about what we were looking for: the type of building, the location, the unit mix and the demographic that we were targeting. Everyone appeared to be on the same page.
Before long, potential properties started to come across our desk. They fit our requirements perfectly except for one point: They all had negative cash flow once financing, maintenance and repairs were taken into consideration. In some instances the rents could be raised over time while in other cases the utilities could be stripped out, but the end result was nonetheless negative cash flow.
We explained our problem to the Realtor: There’s no positive cash flow. We can’t buy these properties.
The Realtor’s response: “These are great buildings. They are in terrific locations and will appreciate beautifully over time. You will do very well with these properties.”
To which we said, “That’s great, but where is the cash flow in the meantime? The shortages will come straight out of our pocket.”
Realtor: “It will all work out in the end. Expecting positive cash flow from these areas in this market is unrealistic.”
We quietly parted ways.
Real estate investing is not like a fairy tale. Everything does not always work out in the end with happy investors riding off into the sunset.
People lose money, lots of it, because they don’t pay attention to the fundamentals of investing wisely. Positive cash flow isn’t just nice, it’s crucial. In fact, cash flow is very much like oxygen: Without it you have a big problem.
If you’re buying real estate banking solely on appreciation you’re playing a gambling game.
It’s great if it works out the way you hope it will with values continuing to rise at a steady pace. But what if they don’t? What if they flat line or worse, decline? What’s your plan then?
If you have a property that generates positive cash flow month in, month out, you will not panic if the value dips for a short while or even a long while. With every single rent payment the tenants are paying down your mortgage and you get some extra cash in your pocket after all the bills are paid. You now have passive income!
Real Life Example
In 2006 the Alberta market was on fire. Multiple offers were the norm and many buyers were placing unconditional offers (i.e. no inspection and no financing clause) just to be able to secure properties. Values were increasing rapidly and anyone who had property there was enjoying a wild ride up.
Then the financial crisis hit in October of 2008. Over the next year, values would plummet by as much as 25% in some cases. People who had just bought properties now owed more on their mortgage than the value of their unit. While this is certainly not a good situation, it’s not critical either if the units in question are cash flow positive. You guessed it though: People bought into the hype and bought cash flow negative properties in the hopes that they could cash in on the appreciation gain. When the crisis ruined the party, you know what hit the fan.
How do we know this? We own several units in Edmonton and our property manager has told us stories of owners who just walked away from their properties because they either couldn’t afford them or couldn’t refinance them due to the significant drop in values.
If you think that this is something that can’t or won’t hit closer to home, think again.
It’s true that Ottawa isn’t the “wild west” and our market has been much more stable. We are also not facing a bubble situation akin to the one in Vancouver or parts of Toronto. And yet we have seen a loss in values in some pretty surprising areas of Ottawa in the last year.
One of our clients recently found a home in Barrhaven that he wanted to purchase. The house is in a growing, popular part of Barrhaven so we thought that it would be fine. When we pulled up the stats for the area we found that there had been a small loss in value in 2012; 2013 pretty much flat-lined there. Our client turned his attention to Morgan’s Grant and found another potential home. Once again the local stats revealed a loss in value in 2013; this time the drop was significant. We have since discussed this with a Realtor we trust and there are certainly nuances to the statistics. But the fact remains that there has not been good growth in that area and some properties have shown a significant loss in value over the last twelve months.
Does this mean that the two areas we’ve just mentioned are not good areas in which to buy a home? Absolutely not. It does however point to the fact that markets are affected by many factors, some of which are unpredictable. Enjoy the ride up when it happens, but don’t count on it.
What about Rent to Own?
If counting on equity appreciation for your profits is problematic, does that mean that Rent to Own deals are inherently risky since they rely heavily on appreciation for their returns? Yes and no.
Rent to Own deals typically have short, fixed terms. If you have a 2 year deal and one of those years suffers from negative growth, you have a potential problem and your returns will suffer. It boils down to two key factors: First, do you have positive cash flow? Second, did you use reasonable, conservative appreciation rates?
If you have positive cash flow, you can ride out any market storm. Buy-out agreements mean that you do not have to sell at a loss; you can wait for the market to turn around. In the worst case scenario, it may take a while but in the meantime your costs will be covered, you will still be earning cash and the mortgage is being paid down. Will you make as much money as you had projected? No you won’t. But if the worst case scenario is a small profit, that’s not a tragedy. Will the tenant buyers be happy about having to wait longer to buy? Of course not, but no one is happy in a bad market. The goal is to put a Plan B in place that minimizes the downside.
As for the appreciation estimates, if they’re unreasonably high then you have little hope of getting those inflated values in a reasonable period of time. The tenant buyers will be frustrated (or furious) – as they should be – and the people who put the deal together in the first place will lose credibility. Keep the increases reasonable and find a good, stable location to minimize the risk.
Here are our rules when considering another property for our portfolio, whether it’s a Rent to Own property or a buy and hold:
1. Strong positive cash flow is required. This is not negotiable. Ever.
2. Location, location, location. Buy in an area with strong economic fundamentals.
3. Expect conservative appreciation rates in a good area but it’s not a tragedy if it doesn’t happen.
If however you have super deep pockets and you don’t mind speculating then go ahead and buy solely for appreciation. The people who indulge in these kinds of investments are the ones who are looking for excitement and thrills from their portfolio.
If we want thrills, we ride a roller coaster. When it comes to real estate investing, we’re with Don Campbell: Boring is good.
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