What areas are currently cashflowing

[Frankie Paterno]

Good Morning,

What areas are still cashflowing and I can scoop up and hold? Is Ohio/Indiana/arkansas over-saturated now? Looking to network with realtors and investors in the game! Cash ready. 

[Eric Fernwood]

Hello @Frankie Paterno,

You're focusing on day-one cash flow, but you'll likely hold a property for as long as you live. Therefore, you need to adopt a longer-term perspective.

Real estate is a long-term investment. ROI and cash flow only predict how a property is likely to perform on day one of a lifetime hold. I believe that what happens beyond day one, is far more important than day one. I will explain my thought.

The goal of real estate investing is financial freedom. Financial freedom isn't just about replacing your current income; it's about maintaining your desired lifestyle for the rest of your life. This requires an income that meets four requirements. (Click to enlarge.)

As you can see, financial freedom has two primary dependencies. The first is the investment city or location. All long-term income characteristics are determined by the city. The second is a reliable tenant segment. In this post, I will focus only on the location requirements.

Rents Rise Faster Than Inflation

Inflation erodes the value of money over time, causing prices for goods and services to rise. To maintain your current standard of living, your rental income must increase faster than inflation. If rents don't outpace inflation, you can't achieve financial freedom—no matter how many properties you own.

For example, let's say you buy property in a city where rents increase by 2% annually, while inflation averages 4% per year. How will your financial situation look after 5, 10, and 15 years? I will assume an initial rent of $1.000/Mo.

• 5 years: $1,000 x (1 + 2%)^5 / (1 + 4%)^5 ≈ $907
• 10 years: $1,000 x (1 + 2%)^10 / (1 + 4%)^10 ≈ $824
• 15 years: $1,000 x (1 + 2%)^15 / (1 + 4%)^15 ≈ $747

So, every year, the amount of goods and services you can buy will decrease, even though rents increased each year. The problem is that rents did not increase faster than inflation.

What if you buy in a city where rents increase by 8% per year?

• 5 years: $1,000 x (1 + 8%)^5 / (1 + 4%)^5 ≈ $1,208
• 10 years: $1,000 x (1 +8%)^10 / (1 + 4%)^10 ≈ $1,459
• 15 years: $1,000 x (1 + 8%)^15 / (1 + 4%)^15 ≈ $1,761

The amount of goods and services you will be able to afford increases over time.

Investing in cities with high rent growth rate decreases the number of properties you will need to reach financial freedom. For example, suppose you need $5,000/Mo to replace your current income and the cash flow from each property is $300/Mo. How many property will you need?

With limited rent growth:

• $5,000/$300 ≈ 17 properties.

What if you buy in a city with 8%/yr rent growth? Assuming a $2000/Mo starting rent and a $1700/Mo expense:

• Year 0: $2,000 x (1 + 8%)^0 - $1,700 ≈ $300: $5,000 / $300 = 17 properties
• Year 1: $2,000 x (1 + 8%)^1 - $1,700 ≈ $460: $5,000 / $460 = 11 properties
• Year 2: $2,000 x (1 + 8%)^2 - $1,700 ≈ $633: $5,000 / $633 = 8 properties
• Year 3: $2,000 x (1 + 8%)^3 - $1,700 ≈ $819: $5,000 / $819 = 6 properties
• Year 4: $2,000 x (1 + 8%)^4 - $1,700 ≈ $1,021: $5,000 / $1,021 = 5 properties

While the above is over simplified, the concept is sound.

Sufficient Income

You'll need income from multiple properties to replace your current earnings. If you invest in a low or no-appreciation location (i.e., cities without significant and sustained population growth), every investment dollar must come from your savings.

As in the prior example, if you require 17 properties and each property costs $250,000 and your only acquisition cost is a 25% down payment, how much capital will you need?

• 17 x $250,000 x 25% ≈ $1,062,500

Over a million dollars in after-tax savings is impossible for most people. However, what if you purchase property in a city with high appreciation?

In such a location, you can use cash-out refinancing. So, how much will it cost to buy your first property? Let's assume a $400,000 property with a 25% down payment.

• 25% x $400,000 ≈ $100,000

If the appreciation rate is 8%, how long will you need to let the property appreciate until a cash-out refinance yields the needed $100,000? I'll assume no principal pay down and simplify by assuming the next property will also cost $400,000. This isn't realistic because all properties are appreciating in such a city.

• After one year: $400,000 x (1 + 8%)^1 x 75% - $300,000 ≈ $24,000
• After two years : $400,000 x (1 + 8%)^2 x 75% - $300,000 ≈ $49,920
• After three years: $400,000 x (1 + 8%)^3 x 75% - $300,000 ≈ $77,914
• After four years: $400,000 x (1 + 8%)^4 x 75% - $300,000 ≈ $108,147

So, after four years, you can use the proceeds from a cash-out refinance to buy your next property. Then, you will have two properties appreciating at 8% per year. Using cash-out refinancing, you can grow your portfolio with minimal additional cash from savings.

Lasts throughout Your Lifetime

Your rental income depends on your tenants maintaining similar wages throughout your lifetime. However, all non-government jobs have a finite lifespan. On average, companies last about 10 years. Even large corporations, such as those listed on the S&P 500, survive for an average of only 18 years. Consequently, every non-government job your tenants currently hold will eventually end. For tenants to continue paying comparable rent, new companies must move into the city and create replacement jobs with similar wages and skill requirements. This means the location must possess the right characteristics to attract new businesses.

If the city fails to attract new companies, soon only low-paying service sector jobs will remain. As average incomes decline, city revenues fall. Cities then have no choice but to reduce services. This service decline leads to increased crime and an exodus of those who can afford to move away. The result is a downward spiral of falling average incomes and further cuts to city services—a financial death spiral from which few cities ever recover.

Where Are You Most Likely to Find Properties With Initial Cash Flow?

Cities with declining or stagnant populations have lower-cost properties and higher initial cash flow. This is because rents follow prices. Today's rents reflect property values from two to five years prior. This lag between rents and prices results in higher initial cash flow. Conversely, cities experiencing significant, sustained population growth have rapid appreciation and rent growth. Because rents lag behind prices, current rents reflect lower prices from the past. The result is lower initial cash flow. Consequently, you must choose between immediate cash flow or future rapid rent growth and appreciation. You cannot have both.

Summary

Frankie, to achieve financial freedom, you need to evaluate investment locations based on their likely performance over the next 30+ years, not just day-one cash flow. I hope this post provides insight into the self-defeating reality of investing in low-cost locations with static or declining populations.