Why Does It Cashflow?

[Dustin T]

The general consensus in my area is that if you only have to negatively feed your investment by a couple hundred per month, you're doing good. Folks out here regularly will finance a rental at $1200, 1400, or more per month, and rent it out for $800-$1100 feeling pretty good. If they break even, they feel like they hit the jackpot!

When I tell them they should look for properties that cashflow they get angry and defensive and tell me that those properties are "cheap for a reason". Well I've been to Texas and see properties in low crime areas where salaries are as good as in my area, and the property is 1/2 price.

within a 2 hr drive of my house, I found another one that would rent for $650/month. I can afford to put 20% down (it's a $45,000 house) easily and even with a 10% property management company fee my monthly mortgage+fee only is about $325. Mean's i'm cash flowing just over $300/month before maintenance.

So what am I missing from this equation? Before I jump in head first, what should I be looking for? House was recently fixed up quite a bit, good windows, floors, counters, etc. I need to check the roof and foundation but most of the houses in this particular region that I'm looking at will cash flow, yet the local investors I talk to won't even consider it. why? Am I missing something?

[Jon Holdman]

If you pay $200K for a house that rents for $1000, you're betting on appreciation, plain and simple. Historically, appreciation has almost exactly tracked inflation, except for major disruptions (great depression, easing of lendering after WWII, and the 2000's bubble). People also get sold the "tax advantage" bill of goods that they can somehow offset their normal income with the passive losses from their crap real estate deal.

To answer Dustin's question, with rent of $650, you can estimate expenses at $325. To break even, your payment must be $325 or less. A payment (just P&I, T&I are in the $325 expenses) of $325 a month at 6% for 30 years will cover a loan of $54K. So, that's the most you could pay and be break even.

Now, you'll say what about my down payment. Fine, assume 25% down. Now you can pay $72K. That's $18K investment that returns exactly zilch.

If you put down 25%, $13,500 on that $54K house, your payment will be $244, giving you $81 in cash flow on your $13,500 investment. That's 7% cash on cash. Yee haw!

Now, if you get some appreciation, maybe this works out. If not, at least you're not too bad off.

OTOH, pay $200K for $1000 in rent, put 25% down, and you're in the hole $400 a month. Rent $1000, expenses $500 leaving you $500 in NOI. Subtract off the $899 payment and you're $400 a month, $4800 a year in the hole. If the house appreciates 3% per year for 10 years, its worth $269K. That gives you a $69K gross profit. But wait, it will cost you 8% to sell, $21,500. And it cost you about 3% to buy, about $6,000. So, the actual profit drops to $41,500. That's subject to long term capital gains.

Now, if you're listing to the promotors of such deals, they told you the depreciation would allow you to offset ordinary income with your passive loss. If you can afford a $400/month loss, you probably can't. That's because if your AGI is over $100K this offsetting phases out and its gone over $150K. Further, depreciation decreases your basis, which increases your gain. Still further, gains up to the amount of depreciation taken are subject to the 25% depreciation recapture tax. So, even if you can save some on taxes while you're losing that money, you have to pay most of it back when you sell. So, that's why I ignore this aspect all together.

OTOH, that $41,500 is a real gain on the deal, and is subject to long term capital gains at 15%. So, that's about $6000 in taxes, reducing your profit to about $35K. Too bad you had total losses of $48K while you held this property. Somebody made money on this deal, just not your friends.