Roughly speaking, there are two ways to get positive cash flow from a rental property:
The precise formula is that your loan-to-value ratio multiplied by your annual constant must be lower than your cap rate to get positive cash flow.
The capitalization or cap rate of a rental property is its annual net operating income divided by its price. For example, a $1,000,000 property with $60,000 of net operating income per year has a cap rate of $60,000 ÷ $1,000,000 = 6%.
Net operating income is the gross income minus the operating expenses, but not the mortgage payments. Another way to define cap rate is that it is the cash-on-cash return you get when you have no mortgage on the property.
The annual loan constant is the sum of the annual mortgage paymentsboth principal and interestdivided by the mortgage balance. In a 30-year fixed rate mortgage, the annual loan constant is a little higher than the mortgage interest rate at the outset of the mortgage term. For example, the annual constant on a 30-year fixed rate mortgage at 7.25% is 8.14% initially.
The shorter the remaining term, the higher the constant. In the case of an adjustable-rate mortgage, the worst-case lifetime cap payments should be used because of the inability to know whether rates will increase after closing.
The loan-to-value ratio is the total mortgages on the property divided by the value of the property. The typical homeowner has an 80 to 90% loan-to-value ratio right after purchasing a house.
Seattle has an excellent apartment building consultant named Mike Scott (www.dsaa.com). He says that true cap rates in his area were about 7.8% on average in 2001. Such a building with a 30-year, fixed rate 7.25% mortgage would have a negative cash flow7.8% - 8.14% (annual constant calculated above) = .34% of the gross income would be the negative cash flow.
The average operating-expense ratio of a residential rental property is 45% plus or minus about 2%. That is, the operating expensestaxes, management, utilities, insurance, etc.will consume about 45% of the gross income. That percentage applies all over the U.S. for all types of residential property including those where the owner pays all utilities and those where the tenant pays all utilities. (The more expenses the tenant pays, the lower the rent must be, so the landlord’s operating-expense ratio stays the same.) For confirmation, see the annual income-expenses analyses put out by the Institute of Real Estate Management and the National Apartment Association as well as by local apartment association and private business studies.
When I use the national ratios from the Institute of Real Estate Management or another source, many investors claim to be much smarter than those managers. Yeah, right. Ok. Let’s use your very own tax return from last year to see how much your cash flow really was.
Get out your Schedule E (Rent and royalty income) from your last federal income tax return. Subtract your “Rental and royalty expenses” from your “Rents received.” Then subtract your total mortgage payments for the year including both principal and interest, not just the interest you deducted on your tax return.
Then get out your Form 4562 (Depreciation and amortization) for the same tax year. Identify all the assets “placed in service” that year, not counting the purchase of the whole building itself but counting improvements to the building like a new roof, pavement, refrigerator, etc. Total the “basis for depreciation” of each of those assets, not just the depreciation you were allowed to deduct that year.
Here is it restated as a formula:
Rents received (Schedule E)- Rental expenses (Schedule E)- total principal and interest mortgage payments (12 x monthly payment) - total basis (cost) of all improvements and replacements added that year (Form 4562) = true cash flow
Value of your time
A lot of small investors do all or almost all of the work involved with managing, repairing, and improving the property. That’s fine, but you cannot count the money you save not hiring outsiders as cash flow from the building. You would have gotten that same cash flow if you had hired yourself out to do that work for other people. Or if you had spent that time earning extra money at your normal job or business.
Similarly, if you had invested in stocks, bonds, or commodities, you would not have had to spend time managing, repairing, or rehabbing those assets. So considering the money you saved by doing all your own work on the property to be investment return from the property turns comparisons with truly passive investments like securities into apples-and-oranges logic fallacies.
The true return on the property is the profit you made after deducting an appropriate amount for the value of the time you spent finding, negotiating the purchase, negotiating the financing, managing, and rehabbing the property. The compensation you got for your time is best judged by dividing your true cash flow by the number of hours you spent. If that number exceeds the amount you would have been paid by a third party for doing the same work on his property, the excess is your return on your investment of capital in the property.
In other words, step one is to deduct the amount you earned on your time by working on the property. Step two is to divide what’s left, if anything, by the amount you invested in the property, including down payment, closing costs, finding costs, and capital expenditures for purchase of components, appliances, etc. that do not wear out in a year or less. That is your true return on investment or positive cash flow from the property as opposed to positive cash flow from a second job that would have paid the same if it were someone else’s property.
When I attended CCIM courses, the brokers who taught them called the property income-expense statements prepared by sellers “Liar’s Statements.” That’s because they typically show operating expense ratios of around 30% or less rather than the correct 45%. (Liar’s statements typically contain next year’s hoped-for rents rather than current rents and last year’s expenses with many expenses left off completely.)
When I attended IREM courses, the property managers who taught them called the property income-expense statements prepared by brokers Liars statements, for the same reasons.
It should be noted that both CCIM and IREM are subsidiaries of the National Association of Realtors®.
Now that you have learned this, you may be tempted to express your contempt for the next 30% operating-expense-ratio statement that is handed to you by a broker or seller. That would not be prudent. Yes, it is a liar’s statement. Yes, you know it. But no, you should not say it.
Calling the seller or broker a liar is not conducive to successful negotiations. Just accept the liar’s statement without comment and throw it in the trash when you get away from him. Then reconstruct a correct operating statement. My Checklists for Buying Rental Houses and Apartment Buildings shows how. If it looks like you can do the deal you need, make an offer. If not, still try to maintain cordial relations in case you encounter that seller or agent again.
If the person lying about operating-expense ratios is a guru, however, feel free to call him the liar that he is.
Liars statements are caused by a conscious attempt to mislead buyers. Idiots statements arise from ignorance. Beginners tend to ignore or overlook many expenses like vacancy and collection loss, management (or the value of your time if you plan to manage the property yourself), replacement of capital items like roofs and hot water heaters, repairs, and so forth. Because of their ignorance, they come up with operating expense ratios of 30% or less just like the liars. I have had a number of arguments about this with beginners. Several have contacted me a year or so later to admit, “You were right. I underestimated the expenses.”
Well, duh! There are only several dozen annual studies on the ratio. The real estate world has not been waiting for some beginner to come along and tell us how much it costs to operate an apartment building.
True cap rates
To get the true cap rate on the property you are considering, get the true current annual rents, not projected rents. Then multiply that number by 100% - 45% = 55% to get the annual net operating income. Divide that number by your purchase price to get your cap rate. If that number is greater than your annual mortgage constant, you will have positive cash flow.
In general, you will find that true cap rates on apartment buildings are around 6% to 8%. Since mortgage interest rates are 7.25% or higher, and therefore the annual constants are 8.13% or so, most apartment buildings have negative cash flow. True cap rates on single-family rental houses are significantly lowerlike 3% to 5%. That’s why virtually all rental houses with normal loan-to-value ratios have negative cash flow.
Low loan-to-value ratio
No matter what your cap rate, you can get positive cash flow by having an abnormally low loan-to-value ratio. Achieving positive cash flow that way is like playing tennis without a net. For example, to take an extreme case, consider a mortgage that is only 10% of the value of the propertylike a $100,000 mortgage on a $1,000,000 building. Bragging that you have positive cash flow on that building is like bragging that your high school football team beat a junior pee wee youth football team. Of course, you have positive cash flow! Your mortgage payments are so tiny a chimpanzee would have positive cash flow with that property. What’s difficult is having positive cash flow when your loan-to-value ratio is 70% or more.
Similarly, it is deceitful for an investor to brag about positive cash flow when he has an adjustable rate mortgage. In effect, he has made himself an insurance company. The lender is his policyholder. The positive cash flow is essentially the “premium” being paid by the lender for the insurance. But if market interest rates go up, the borrower will have to pay the lender’s “insurance claim” (higher payments), which will cause a worse negative cash flow than if the borrower had gotten a fixed-rate mortgage at the outset.
Gurus strategies for positive cash flow
Most real estate gurus are just salesmen who know little about real estate investment, but who want to part you from your money. The people they target are either beginners or relatively new investors. Relatively new investors have enough experience to know what I just said above, that almost all normal rental properties have negative cash flow. As a result, bad gurus often encounter the objection, I do not want to buy your multi-thousand dollar information product because I will get negative cash flow if I follow your advice.
Because they are salesmen, they need a way to overcome that objection. One way they do it is to issue liar’s statements of their ownnamely by saying that you can expect operating-expense ratios of 30% when you buy rental property. Another tactic they advocate is accruing interest. To a novice, that sounds like a trick that sophisticated real estate investors must use to avoid negative cash flow. In fact, accruing interest simply means borrowing more money each month to conceal the fact that the property is losing money. Borrowing more money to cover losses is a debtors death spiral. Bad gurus do not mind charging you thousands of dollars to send you into a death spiral because they are sociopaths, that is they have no conscience about ripping you off.
I understand that many of the Utah telemarketers who pressure you into buying bad guru seminars and “mentoring” services are drug addicts. I have heard that the “mentors” are drug addicts who failed when they tried to be telemarketers in the same company. And you believed that they were successful millionaire investors. Ha! Let me guess. You still think Easter eggs come from the Easter Bunny, too.
Being a drug addict has the same result as being a sociopath: no conscience.
Pay more to rent than to buy
Would-be investors should consider positive cash flow from the tenants perspective. In order for a single-family rental house to have positive cash flow, the tenant must pay more to rent the house than he would have to pay to own the same house. That is obviously a stupid thing to do. And thats why you almost never see it.
How you achieve positive cash flow ethically in the real world
So how do you achieve positive cash flow ethically in the real world? You need to buy in the rare market where high cap rates are the norm. Such markets are usually severely depressed like Anchorage or Oklahoma City in the late 80s. The reason tenants are willing to pay more to rent than they would have to pay to own in such markets is that they believe property values are falling or level, in which case not owning is a good idea in spite of the high rent.
Even then, the positive-cash-flow situation is typically a brief window that lasts only six months to a year. Positive cash flow is so rare and so desirable that it attracts out-of-area investors. Their coming into Anchorage or Oklahoma City or wherever drives the prices up so that high cap rates are no longer available.
The other way to achieve positive cash flow is to make a bargain purchase like at a foreclosure auction or out of probate. In that case, you have a low loan-to-value ratio, even though your loan-to-purchase-price ratio may not be low. When you achieve a positive cash flow through a bargain purchase, you generally should sell out soon because your extraordinary amount of equity will result in your return on equity being low.
Return on your investment is interesting to look at initially, but after purchase, you should switch to looking at your return on current equity. Dividing current net operating income by past purchase price is a misleading apples-and-oranges comparison. Return on investment (down payment and closing costs) will be high initially and climb higher if you bought right. But return on current equity (current market value of building less current mortgage balances), which is the correct denominator, will show a low and falling rate of return. That tells you to redeploy your money to where it can earn a higher return.
Why invest in real estate then?
A number of people who read this article said it is saying that investing in real estate never makes sense because it is never profitable.
No. It does not say that.
There are four possible financial benefits to investing in real estate:
positive cash flow
• amortization of the mortgage
Most investors today expect to get most of their return from appreciation. Consequently, they are willing to accept little or no cash flow or more commonly, negative cash flow. Tax savings were drastically curtailed, if not eliminated, by the Tax Reform Act of 1986. Amortization (pay down) of the mortgage is a pittance in the early years of a loan.
I do not agree with the notion that you should accept negative cash flow because appreciation will more than pay you back. But that is why most investors do accept negative cash flow.
So the guru who told you that real estate investment was a way to pick up extra cash lied to you. He told you that because it was what you wanted to hear, not because it was true. In fact, owning rental property almost invariably has the exact opposite effect on your cash flow. It takes your current annual cash flow and confiscates part of it to feed the rental property. Negative-cash-flow properties are called “alligators” because you have to feed them constantly or else they will eat you.
Only if you buy on a bargain basis or increase the value of the property significantly can you get positive cash flow from a rental property. Can that be done? Yes. Is it easy money? Hell, no! Is it passive income in the sit-in-a-hammock sense of that word? Hell, no! You will earn every penny of it. If you are still interested, buy my pertinent books. If you do not want to work hard and take risks, get out of real estate altogether before you get badly burned.
What about just focusing on positive cash flow properties? What are those. As I just explained, to get positive cash flow, you have to buy the property real cheap. How are you going to do that? Do you think a seller will sell cheap just because you “insist” on positive cash flow? No. He’ll say screw you! I have fifty buyers who will settle for price appreciation and put up with negative cash flow to get it. And he does. If you insist on positive-cash-flow purchase prices, you will never make a purchase. You will always be outbid by the appreciation buyers.
Basically, to participate in the market and actually buy properties, you have to outbid the market. If you outbid today’s market, you get negative cash flow. Sorry. But that’s current reality. The guru who told you otherwise lied to you because that’s what he needed to do to get you to hand him your credit card
John T. Reed.