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Updated over 8 years ago, 03/21/2016
How the deposit affects cash flow
I hear so much about how important it is to have positive cash flow when analyzing a property to buy and hold. What I don't hear is how the deposit you put down on a property affects the cash flow (by directly affecting the amount of money you need to borrow), and how that should affect your analysis.
For example, let's say I have $20,000 to buy a $100,000 property, but can qualify for a low interest FHA loan that only requires a 3.5% down payment ($3,500). Since my mortgage payment will be relatively high, let's say this causes my analysis to show a negative cash flow.
On the other hand, imagine if I had chosen to put the entire $20,000 as down payment. My mortgage payment would be lower, so let's say it's enough to provide me with positive cash flow.
So what's the difference? Should I turn down the deal just because I plan on only putting 3.5% down, just so I can keep extra cash on hand? Why does the deal suddenly get better when I tie that $20,000 as equity into the house? Whether my $20k is in cash, or is tied up in equity, why should that affect my decision based off of the cash flow rule?
What if I was paying 100% cash for the property? Of course the property is going to cash flow better than if it had a mortgage. But the deal may actually be terrible if you calculate it with a mortgage.
What am I missing here?
Hey @Matt Donley, you are spot on with you assessment. The way I approach it is to do all the numbers assuming 100% financing. That way you kind of have a worst case scenario and can compare each deal strictly on its intrinsic value rather than just saying 'I need $100/door'. Once slight caveat, though. If you go in with a 3.5% FHA you will also have to figure in PMI for the life of the loan or until you refinance. With 20% down you won't have that added expense. Hope this helps.
@Will Chamberlin your approach makes sense, and thanks for the validation. I feel like the cash flow rule is less applicable the more money you put down, because it doesn't give you any real valuable information about the deal. If I spend a million cash on a property that produces $100/mo cash flow, it's obviously a bad deal, but using the cash flow rule blindly shows otherwise. There must be some formula to use with the cash flow rule that could provide an apples to apples analysis on a property no matter how it's financed.
You probably hit the nail on the head by saying you always look at it through the perspective of 100% financing. Maybe that's the ultimate way to run the cash flow analysis, but you are raising the bar on what you'll accept as a good deal, possibly leaving opportunities on the table which may have otherwise worked out as good investments. I guess it comes down to what the individual investor wants to accept as risk.
You do need to add in PMI, but the deal that works with 20% down and doesn't work with 3.5% has some issues, and I'm not sure if ever call it a good deal, ignoring appreciation. That'd be somewhere around a 5 or 6 cap, which is pretty low and you should only buy that if you're speculating. Nothing wrong with speculation, but you'd want to add in potential appreciation in rents and property values to your numbers (and realize you're taking on more risk)
@Wes Brand it sounds like what you're saying is the cash flow rule is just one of many tests you need to run on a property in order to evaluate its potential. When you look at cash flow in and of itself, it's essentially meaningless if you ignore other factors such as cap rate, appreciation, etc.
You make a good point about saying if it works at 20% down, but not at 3.5%, it's probably a bad deal to begin with. And maybe my example is flawed, yes PMI needs to be factored in, etc, I'm just trying to illustrate the point that cash flow calculations completely ignore equity, and I think that's flawed. Maybe it would become clearer for me if I actually ran an analysis on a property myself from multiple financing perspectives and see where cash flow lands at the different options.
I'm very much new at this, still learning ;)
I'm not familiar with a cash flow rule. I've certainly never evaluated a property by looking at only cash flow. I evaluate investments by looking at money I'm spending vs money I'm getting back. ROI and cap rates. I can see where you might come down on cap rates in exchange for a better class of tenant, or because you think the area will go up in rents, though that's not for me right now. Cap rate being the return assuming no financing, and ROI being the cash on cash returns.
I think your edging towards an aha moment here. These are the iterations one goes through to formulate their strategy and assess risk. Some only buy investment properties with cash and avoid leverage. Some leverage to the hilt. The latter is generally assuming no major downturns in the market.
I'm a true buy and hold guy. I want to use moderate leverage, purchase 1 big ticket rental a year ($400-$700k range) and hold onto them for 10 years. Right now I'm looking to purchase my 2nd property using a HELOC from my first, with no money out of pocket. That HELOC certainly puts a strain on Cash Flow or COC but if I'm still cash flowing $500-$700 a month and COC is over 8% (not my cash just a barometer against other investments) I'm good. I tend to lean a little heaver on total ROI assuming 2-3% appreciation. If total ROI is in the 30-40% range in 10 years I'll have a valuable asset.
@Wes Brand When I refer to the "cash flow rule", I'm just referring to the idea that you should never buy a property that results in negative cash flow. Not sure if it's accepted as an "official" rule, sorry if that was confusing. I actually found a Bigger Pockets article that discusses a scenario similar to the one I brought up https://www.biggerpockets.com/renewsblog/2015/01/2...
What it comes down to is reducing risk. If your property is negative cash flow, that could mean you won't be able to handle payments when things go bad. I think that's the moral of the "cash flow rule." It's about flexibility, options, and managing risk.
I wouldn't buy at negative cashflow but you'll find some people who will. They're usually counting on appreciation to make up the difference. For example, in SF if you bought a negative cashflow place 3 years ago you'd be very positive now. (3 years ago rents were ~2600 for a 1 bed, now they're ~3500)
@Brad Saari It seems like the way I assess a property's cash flow really needs to tie into my overall strategy and risk tolerance, just as you have explained your own strategy. Your cash flow may be lower, but it fits your overall goal of building equity.
@Matt Donley Yep, and some will say my approach is flawed but those folks generally go for volume based doors where cash flow is king. If you have a $100k investment in a sketchy area that doesn't cash flow that's trouble. You have no hedge against short term risk, the loan pay down will be minimal and appreciation will be flat. Unless the area gentrifies, whole other topic :)
When you make a (large) downpayment you are essentially purchasing your cash flow up front. Running the numbers based on 100%financing makes a lot of sense when evaluating a deal.
For most of us investing our personal capital controls how quickly we can accumulate real estate and build wealth. I look at CASH ON CASH RETURN.
Franklin
Hi Matt, I'll just add my two cents here. I think the guys that look at the cap rate, ROI, cash on cash return (all similar metrics) are spot on. When someone says they wont purchase something that negative cash flows, that is one of the most basic rules to investing and most people on BP already assume it. All good deals will and should cash flow.
You need to compare your potential deals with an apples to apples approach instead of just asking "does it cashflow". I use a cash on cash return which works on financed and non financed deals. A rough calculation would be yearly NOI divided by your total cash investment (all in cash outlay for financed properties or all cash deals). For my all cash deals I like to see 12-15%. If I finance the deal the returns go up because my cash outlay is a lot smaller. I think if you use this approach you will quickly see the difference in the good deals and bad deals. The hard part of the calculation is making sure you get a good NOI estimate. This requires the most work as you need to determine realistically what you will get on rent and pay out on the expense side. Let me know if you have any questions.
Originally posted by @Ronnie Woolbright:
When someone says they wont purchase something that negative cash flows, that is one of the most basic rules to investing and most people on BP already assume it. All good deals will and should cash flow.
That simply is not true. A more sophisticated investor knows initial cash flow is only required by poor people and poor investors.
They are speculating that they have the ability to keep squeezing rent each and every month. If they can't the cash flow stops! I can sit back without lifting a finger can add tens of thousands of dollars in appreciation without the hassle of tenants, toilets and trash. If I choose to rent then the extra income is just gravey.
Originally posted by @Will Chamberlin:
Hey @Matt Donley, you are spot on with you assessment. The way I approach it is to do all the numbers assuming 100% financing. That way you kind of have a worst case scenario and can compare each deal strictly on its intrinsic value rather than just saying 'I need $100/door'.
This is a great answer, and is how I have started analysing my deals. I believe it was mentioned in podcast 165, and I couldn't believe that I hadn't been doing that all along. Great way to find proper deals.
@Account Closed @Matt Donley
"initial cash flow is only required by poor people and poor investors". Bob how does that help the person that initiated this post in any way? Are you saying you are allergic to cash flow? If you want Matt to know the secrets of life perhaps post something that will help...tips for finding undervalued properties, how to add forced appreciation, areas that appreciate well, etc etc. Simply saying cash flow is for suckers is not productive.
I always run it as 100% financed, easy numbers to work with, and safer. Things I look at when doing deals:
1. At a glance; I want to figure out the gross cap. This at least lets me know if the income to property cost is right. If this don't work out, it's not worth learn more and I turn down the deal.
2. If gross cap is good. I dive into the net cap to insure it is cash flowing. Lots of times this is where bad management has run the rental into the ground. Don't expect to unload utilities or basic operations cost, however late pays, evictions, and run down units are easy to fix.
3. Finally LTV/Market value at closing without improvements. Leave plenty on the plate to insure you can get out if something goes sideways, plus that's your bonus profit after cash flow.
Buy and hold is like a slow flip, you want to earn at a higher rate than you can get on the stock market, then kick it the bonus earnings on exit.
*via my iPhone
Originally posted by @Levi T.:
I always run it as 100% financed, easy numbers to work with, and safer. Things I look at when doing deals:
1. At a glance; I want to figure out the gross cap. This at least lets me know if the income to property cost is right. If this don't work out, it's not worth learn more and I turn down the deal.
2. If gross cap is good. I dive into the net cap to insure it is cash flowing. Lots of times this is where bad management has run the rental into the ground. Don't expect to unload utilities or basic operations cost, however late pays, evictions, and run down units are easy to fix.
3. Finally LTV/Market value at closing without improvements. Leave plenty on the plate to insure you can get out if something goes sideways, plus that's your bonus profit after cash flow.
Buy and hold is like a slow flip, you want to earn at a higher rate than you can get on the stock market, then kick it the bonus earnings on exit.
*via my iPhone
Gross and net cap? Definition and how they would be a usable metric?
@Account Closed, I think @Brad Saari was asking you if you could expand on your answer. @Matt Donley made a broad statement that all good deals will eventually cash flow. You took exception to that but didn't explain why in a way many could understand.
I have some thoughts on how you might add appreciation, but I honestly am not sure what you were referring to either, especially without lifting a finger. Perhaps you wouldn't mind expanding on your answer?
@Account Closed capitalization rate, is the ratio of NOI to property value, in this case what you paid, as everything else is assumption till otherwise, however a quick way of seeing if the property falls anywhere near what you want is to do, just run the gross earnings agents the asking price "gross cap"; Say someone called up and said they have a 2BR SFH for 100k, rents are 18k a year, which is a gross cap of 18%, so it would be a deal I would want to talk about, research, call the county, and run through my excel sheets to see what the cap rate is in the traditional since of NOI (What I'm calling "net cap"). Using this process lets me make deals dictions in the matter of seconds when people call me. If the deal falls under a 13% gross cap, it's a deal that will not workout once you take in operating expenses, so I can just turn the deal down and move on.
What cap rate do you guys usually stay away from? It seems that going forward on anything under 10% is a not considered to be a "good deal".
Also when you use the "100% financing" test, what are you looking for? Are you just making sure you are in positive cash flow since you cannot really make a COC calculation.
@Account Closed yep, I'm an idiot
Look at the original question. You have added no value to this conversation with the phrase you love to use "cash flow is for poor people and poor investors."
I kind of like the idea of evaluating cash flow from a 100% financed perspective, in order to provide an apples to apples analysis on every deal you run the numbers on. Bottom line, the risk of negative cash flow is not being able to handle unforeseen circumstances. If it's positive cash flow, you have a better chance of surviving minor financial challenges.
Thanks for all your input everyone!
Originally posted by @Matt Donley:
@Wes Brand When I refer to the "cash flow rule", I'm just referring to the idea that you should never buy a property that results in negative cash flow.
What it comes down to is reducing risk. If your property is negative cash flow, that could mean you won't be able to handle payments when things go bad.
That was important to me purchasing a 6-unit MFU. Why the heck BUY red ink???
I also evaluated a 'break even point'; What occupancy was required to net 0 cash? That leads to the max concurrent vacancies that make the investment difficult.
I also favored the Cash-Flow formula:
- (NOI less mortgage+interest ) / down payment
and the variables and their impact from change is seen.
Originally posted by @Ronald Perich:
@Account Closed, I think @Brad Saari was asking you if you could expand on your answer. @Matt Donley made a broad statement that all good deals will eventually cash flow. You took exception to that but didn't explain why in a way many could understand.
I have some thoughts on how you might add appreciation, but I honestly am not sure what you were referring to either, especially without lifting a finger. Perhaps you wouldn't mind expanding on your answer?
Ronald, my response was to Ronnie Woolbrites statement. Brad took my basic and true statement and turned it into what he incorrectly heard. Fact, if you make an investment and do not have funds to maintain the property you will likely lose that investment. Not all profitable investments cash flow from day one. Even a property that cash flows from day one on paper can lose the tenant on day two and the cash flow is gone and a person (poor) without reserves will lose their investment. Fact, you can have cash flow but not be profitable. Appreciation is created by the market. You can buy a property and NEVER have cash flow but walk away with hundreds of thousands of dollars of profit without lifting a finger other than buying and selling. Does that answer your question?