Capital Cost Per $1 of Cash Flow...never hear this talked about

[Robert Easter]

Spreadsheet I am using to analyze my properties

(The Spreadsheet is protected so copy paste into your Google drive. If you need explanation on how it works shoot me an email. I didn’t make this sheet as user friendly as it can be but I am working on it)

https://docs.google.com/spreadsheets/d/1bzWCk1N1XiJy4kz7IDBC-t0IGgpByMr5VlLp6uTftTs/edit?usp=sharing

I have been watching, reading and taking in advice on Bigger Pockets over the last two years. Last year 2015 I entered into the Real estate market purchasing my first SFH cash flow property. The strategy utilized a Turnkey company out of Philadelphia to locate a suitable property, rehab the property and then place a tenant in that property. My wife and I had a significant cash hoard to buy the property and rehab it out right and it is now rented and cash flowing in spite of a few minor setbacks. In the the first month of 2016 we again purchased another SFH and self financed the purchase and the rehab. The rehab is currently underway and should come online for rental by mid March.

We are very happy about these properties prospects and potential cash flow. Since we had never purchased a home not even to live in we are not unhappy with having decided to self finance the projects. We are hoping this will give us leverage to finance further projects in the future. That being said and hindsight being 20/20 vision, I decided to run some numbers comparing a financed purchase versus a self financed purchase of the two properties and the effects that may have on cash flow. What I discovered is something I have never seen anyone speak about on Bigger Pockets (I am sure someone has discussed this I just have not seen this idea discussed at all...or anywhere in my short research period on cash flow and real estate properties.

We hear everyone speak about Cash Flow, NOI, Cap Rate or Cash on Cash returns.. however I think there is another important benchmark for investors to consider when deciding their down payment percentage and financing levels because of their effects on cash flow...

Capital Cost per $1 of Cash Flow

One of the most illuminating aspects of real estate investing is financing isn’t bad...Having spent all of my life not accumulating debt this has been a difficult psychological barrier to break through. Do I have credit cards yes… do I have balances on them No. Did I have student loans yes do I have balances on them no…gone poof, paid off. Do I have any debt ...nope, nada, zilch...so the prospect of paying for a house outright was a simple matter of “yeah I don’t want any debt servicing” but I didn’t take in consideration the cost of self financing. Since my goal was both equity and cash flow and I was new to this I instantly jumped into the Equity portion rather than letting the effects of the rehab on the property and financing build equity over time and this has hindered my growth in number of properties because I spent way too much Capital per $1 of cash flow.

So, how much capital did I spend per dollar of cash flow to get a single dollar of cash flow? In my first acquisition of property that cost was $124.68 of capital spent to generate $1 of cash flow. Had I financed the purchase price alone of $40,000 this capital cost would be reduced down to $104.52. (Calculate: Total Capital / Monthly Cash Flow = Cost of Capital per $1 of Cash Flow). For each $1 of cash Flow I over paid by $20.

--	First Property	First Property
--	UnFinanced	Financed 40K at 5% 0 Down
Purchase Price/ Financed Amount	$40,000
Rehab Cost	$32,500	$32,500
Closing	$2102.90	$2102.90
Total Capital (Door Cost)	$74,602.90	$34,602.90
Monthly Cash Flow	$598.33	$383.60
Capital Cost per 1$ of Cash Flow	$124.68	$104.52
Capital Conserved by Financing	$0	$40,000

Take for example my first property we spent $74,602 on the property in total that is purchase and Rehab. There was a $40,000 purchase price for the property and $32,500 in rehab cost and about $2100 in closing costs. Our expected monthly cash flow is $598.33. So our Capital Cost per $1 of cash flow is $145.77. It cost us $145.77 per $1 of cash flow.

Lets run the same purchase but using financing to acquire the property with a $40,000 loan at 5% interest and a $0 down payment. My wife and I will pony up the capital for the rehab costs to the tune of $34,602.90. This lowers the cost per $1 of cash flow from $124.68 to $104.52 but increases the output of cash flow with respect to capital utilized in the acquisition of the property. How is that you ask because the Cash flow went from $598.33 to $383.60? by financing I only spent $34,602.90 and have remaining in my cash coffers $40,000 with which to use for another property.

If I had financed I would still have $40,000 in my coffers to purchase a second home. Let’s say I did just that and the second home acquisition cost was the same as the first via financing as was its cash flow. Then we would have double $383.60 per month in cash flow or $767.20, which is $168.87 more cash flow than the single property we paid $74,602.90 outright for. Put another way the two financed homes would cash flow $168.77 * 12 more than the self financed acquisition for a total of an additional $2026.44 annually. And I would still have $5.590.00 leftover of my original capital investment of $74,602.90.

Now many of you are probably scoffing …”Seems like a lot of trouble for $2000 annually.” Well $2000 annually is 2% return on a $100,000. In my investments case of $74,602 it would increase the annual return by 2.7%. That is no minor amount to sneeze at in terms of cash flowing. Boosting the annual percentage from 9.62% to 12.3%.

Sweet Spot

So how do you determine this sweet spot of maximizing the cash flow to capital outlay? Once you know about what the interest rate level of your financing is (in the above case I choose 5%) you then have to play around with your down payment percentage. Again in the above case the optimal down payment to maximize the cash flow was $0.

We adjust this percentage up or down based on the effect it has on increasing or decreasing the Cash flow output to a level equal to self Financed cash flow or greater. In all all cases the cost of capital per $1 of Cash flow should always be lower with financing unless the interest rate is overly high. Personally I just plug the property information on the second tab of my spreadsheet linked above and change the down payment percentage on the first tab of the workbook and everything auto calculates. That being said I built that spreadsheet so it may not be user friendly to anyone else..

Summary

In hindsight had I known more about analyzing a cash flow property based on “cost of capital per $1 of cash flow” I would have insisted on financing my first two purchases. Having made this mistake as a new Real estate investor I wanted people to look over my work and help other new entrants into the business of real estate learn that leveraging and utilization of financing is more advantageous in many instances such as my simple example. I realize most people do not have the luxury of purchasing outright a property and financing is their only choice…but even in that choice what are the optimal level of maximizing cash flow by altering your down payment percentage?

In my situation I can revel in the fact that I have 100% equity in two homes. But my goal was twofold to attain equity in real estate and to have my properties cash flow profitably. In retrospect I placed equity in properties up higher as a goal than cash flow and consequently I have not maximized the cash flow on either of my properties by not utilizing financing. And by not utilizing financing I also have run through my cash in the acquisition of only two SFH properties.

Mistake noted, understood and will be remedied on the next acquisitions.

[Robert Easter]

@Patrick Liska Yes we always hear people speak about using other peoples money...always. However no one ever shows you the math behind the reasoning. 

It's always just stated as if it were gospel. I've actually never seen anyone back it up with numbers. And in my personal world view where I hold absolutely no debt this is contradictory to my personal way of doing business. 

However since Cash Flow is as an objective, OPM is apparently mathematically advantageous to decrease capital used per generated $1 of CF, depending of course on the interest rate and the down payment percentage.