Why Does It Cashflow?

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Why Does It Cashflow?

Dustin T
WA · Member since 2008 · 77 posts · 0 votes

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?

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Jon Holdman
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
16y

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.

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  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    I said in my original post that the property 'would' rent for $650 per month. That's an understatement. What I meant to say is that the property is CURRENTLY rented for $650/month with a 1 year lease.

    0Reply
  • Michael Rossi
    Real Estate Investor · OH · Member since 2008 · 4k+ posts · 1k+ votes
    16y


    Sorry, but in the real world you won't be ANYWHERE NEAR $300 per month, not even close. I would STRONGLY suggest that you read one of the sticky threads about the 50% Rule (top of the landlording and general forums). You need to understand this stuff before you spend any money!

    Good Luck,

    Mike
    1Reply
  • Timothy W.
    Attorney · Raleigh, NC · Member since 2008 · 4k+ posts · 1k+ votes
    16y
    Originally posted by Dustin T:
    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".


    Same reason fat chicks in spandex get angry when a trully fit girl comes around - group denial mentality. You'd learn more about the fundamentals of real estate investing from a corn farmer in Iowa than one of these cognoscenti.

    Tim

    1Reply
  • Malhar B.
    Investor · Atlanta, GA · Member since 2009 · 35 posts · 49 votes
    16y

    INCOME
    Rent... $650 per month

    EXPENSE
    Mtg - 20% dwn, 7% int, 30 yr fx... $240/mo
    Property management... $65/mo
    Taxes... ???
    Insurance... ???

    Simple maintenance issues... you may want to escrow an amount for these also.

    What about vacancy allowance?

    Lots of things to look out for... 50% and 2% rule are great basic rules... Lots available on the forums on these rules.

    Not sure if this property will cash flow that well once you add the additional costs.

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    thanks for the feedback guys! I have read the 50/2 rules a number of times and just went through and reacquainted myself.

    I realize the net cash flow won't be $300/month. However, as I crunch numbers I still appears to have a positive flow.

    The comparrison I was making, is to those people who are constantly 'investing' in real estate where the RENTS aren't even making the mortgage. Much less the utilities, maintenance, etc.

    The majority of the homes in my area sell for over $200k. Typically, a $200k home will rent for around $1,000 if you lucky around here.

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y
    Originally posted by MikeOH:

    Sorry, but in the real world you won't be ANYWHERE NEAR $300 per month, not even close. I would STRONGLY suggest that you read one of the sticky threads about the 50% Rule (top of the landlording and general forums). You need to understand this stuff before you spend any money!

    Good Luck,

    Mike

    Question for you, with a rent of $650, what sale price would you look for on a property typically, just rule of thumb/statistical, etc? I realize they would not all be the same.

    0Reply
  • Rich Weese
    Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
    16y

    Dustin- you answered your own question! You can't play the 50/2% rule in your area at the present time. However, You can play that game in MANY other areas. Just enter a thread and ask for some deals . BP members will FLOOD you with deals. TX, FL TN, IN MI and others. Get ready for the barrage. Rich

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    question on the 2% rule.

    means that rents = about 2% of loan, or 2% of total purchase price? The house I'm looking at I could pay cash for, but I don't want to put all of my cash into my rental, just enough to get the loan down, the PMI gone, etc and leave myself with cash to handle repairs, unexpecteds, and to build a downpayment for the next one.

    Originally posted by Rich Weese:
    Dustin- you answered your own question! You can't play the 50/2% rule in your area at the present time. However, You can play that game in MANY other areas. Just enter a thread and ask for some deals . BP members will FLOOD you with deals. TX, FL TN, IN MI and others. Get ready for the barrage. Rich

    yeah, in my area the price of entry is too high for me and the the rents don't come anywhere near break even on average. The houses cost about 5 times as much as the one I listed above at $45k, but the rents are often the same or maybe 50% more.
    0Reply
  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    16y

    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.

    2Reply
  • Rich Weese
    Real Estate Investor · the villages, FL · Member since 2008 · 5k+ posts · 3k+ votes
    16y

    Dustin- Jon is pretty accurate on everything stated.

    2 caveats-

    1. People "in the business" don't have the same limitations on losses etc.so get a RE license and work the hours necessary

    2. NEVER sell- Do 1031 tax deferred exchanges and you avoid ANY recapture. Let your inheritors worry about the recapture. Just continue to exchange or re-fi and pay NO taxes EVER!!!

    This isn't a bloank promo for buying on potential appreciation. I'm not a fan of that, however, I'm also not a fan of buying CRAP just to get the cash flow... Differing views. Rich.

    1Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    ha! Jon that's a great post, thanks! :)

    Those numbers are exactly what I wanted to see. I've been reading through more of your's and Mike's posts elsewhere too and picking up what I think are good numbers. While MIke posted above that I wouldn't cash flow at the number I mentioned, I think applying the 50% rule tells me that $650/month rent on a $45k asking price is a decent deal. And with 11,250 down(25%), I'm looking at $101 postive flow, or a ROI of 10.7% on my $11k down... correct?

    0Reply
  • Josh Green
    Financial Advisor · Tampa Area, FL · Member since 2008 · 956 posts · 214 votes
    16y

    Dustin, keep in mind that the rule is calculated using 100% financing. By raising your down payment you are essentially just buying your cashflow.

    Can't run the numbers for you right now as I'm on my iPhone and sitting In a dentist chair. If someone hasn't beat me to it, I will run when I get home.

    0Reply
  • Jon Holdman
    Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
    16y

    I get different numbers. With $11,250 down, you're financing $33,750. At 6% for 30 years, I get $202.35 for the P&I. Subtracting that from the $325 NOI estimate leaves $122.65. On $11,250, that's a 13% cash on cash return.

    Lets take this a step further, too. Assume the improvements are 80% of the $45K price. That makes your monthly depreciation $109.09 ($36,000/27.5/12). NOI is estimated at $350. Interest the first month is $168.75. That leaves net taxable income of $47.16. So, you will actually owe a little tax on the income from this property. I find that to be the case on most good investments.

    I really like Rich's "never sell" strategy. Buy one property a year that's at least break even. Pay extra and pay it off in 15 or 20 years. Once its paid off, refinance whatever amount will still be at least break even using a 15 or 20 year amortization schedule. Now you have a wad of cash. You only have live on that cash for one year before you can refi the next one. No taxes at all on that cash. And your heirs get a stepped up value when the inherit your property.

    Of course who knows what taxes or estate law will be like when you die. Or, for that matter, in 2011. If there was ever a good year for rich people to die 2010 is that year.

    1Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    Thanks Josh. Enjoy your dentist :P I'll check back tonight!

    0Reply
  • Josh Green
    Financial Advisor · Tampa Area, FL · Member since 2008 · 956 posts · 214 votes
    16y
    Originally posted by Dustin T:
    ha! Jon that's a great post, thanks! :)

    Those numbers are exactly what I wanted to see. I've been reading through more of your's and Mike's posts elsewhere too and picking up what I think are good numbers. While MIke posted above that I wouldn't cash flow at the number I mentioned, I think applying the 50% rule tells me that $650/month rent on a $45k asking price is a decent deal. And with 11,250 down(25%), I'm looking at $101 postive flow, or a ROI of 10.7% on my $11k down... correct?

    looking at this from a strictly 50% rule standpoint you look like this:

    purchase price: 45k
    rent: 650
    operating expenses: 325
    noi: 325
    payment (30 yrs @ 7%): $300

    cashflow: $25 (325-300)

    down payment does not affect the scenario at all. :)

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    Thanks Jon and Josh (ane Mike and everyone else too) for the replies.

    in summary then, on paper of course without looking at an inspection report, would you say this is the type of deal you look for?

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    another thought I just had. using the 50% rule, the first thing I could look at is:

    1/2 of rent = mortage + cashflow.

    so if rent is $850, I have essentially $425 to spend on mortgage + expected cashflow.

    would you consider that correct?

    I was just looking at another property which I thought may have potential. But comps rent for about $800-875. the house is a asking price of $72k. even with 20% down, 50% of the rents would be the mortgage which means zero cashflow after expenses, vacancies, etc. Only thing I'd gain on this property is maybe a tax write off.

    0Reply
  • Josh Green
    Financial Advisor · Tampa Area, FL · Member since 2008 · 956 posts · 214 votes
    16y
    Originally posted by Dustin T:
    another thought I just had. using the 50% rule, the first thing I could look at is:

    1/2 of rent = mortage + cashflow.

    so if rent is $850, I have essentially $425 to spend on mortgage + expected cashflow.

    would you consider that correct?

    I was just looking at another property which I thought may have potential. But comps rent for about $800-875. the house is a asking price of $72k. even with 20% down, 50% of the rents would be the mortgage which means zero cashflow after expenses, vacancies, etc. Only thing I'd gain on this property is maybe a tax write off.



    not quite....remember, you figure the mortgage payment assuming its a 100% loan (no down payment).

    so in your example:

    72k purchase price
    850 rent
    425 noi
    425 op exp

    payment: 480 (72k @ 7% for 30 yrs)

    cash flow:-$55/month

    0Reply
  • Dustin T
    OP
    WA · Member since 2008 · 77 posts · 0 votes
    16y

    So when you are looking at such deals, you make sure that it jives with the 50% rule at full price, and then do you still make a down payment?

    0Reply
  • Josh Green
    Financial Advisor · Tampa Area, FL · Member since 2008 · 956 posts · 214 votes
    16y

    exactly dustin.

    personally, i think its better to put down as little as possible so that you can spread the money over several deals.

    0Reply
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