If you’ve ever read anything about investing in real estate you’ve inevitably come across the term “positive cash flow” but what if a property has “negative cash flow”? Does that mean it’s a bad investment?
First off, when most people talk about “positive cash flow” this is under the assumption that typical lending practices apply.
These would include:
- an 80% loan-to-value (LTV) mortgage at typical lending rates
- a 20% down payment (either cash, or more borrowed funds. Borrowed funds for down payment means more interest paid)
On top of all of the other typical monthly expenses such as taxes, insurance, maintenance and utilities, which are fairly static for the most part, the amount of interest paid each month will usually make or break a “positive cash flow” for any investment property.
However, if you’re talking to an investor who has the full lump sum to pay for the property, or perhaps even just has a little bit more than the minimum of 20% to put down on an investment property, the interest payment portion of the monthly expenses will drop and the resulting net monthly cash flow will improve significantly so “positive cash flow” and “negative cash flow” are two very relative, and often deceiving terms depending on the financial abilities of each specific investor.
For the longest time, many Guelph investors rental analysis went a little something like this:
“Positive cash flow” = Good.
“Negative cash flow” = Bad.
It kept the equation very clear and there was zero room for confusion.
However, with Guelph’s increasing real estate values and difficulty in finding a property with “positive cash flow” does our mindset need to change if we are going to continue to invest in Guelph real estate and survive in the long run?
If you look at cities like New York, Hong Kong, Tokyo, or even Vancouver and Toronto, for instance, market rents for properties in these areas haven’t supported the typical expenses to produce a property with a “positive cash flow” for a very long time, yet investors are still purchasing these homes, sometimes even having them sit vacant, because they know real estate is such a precious and reliable commodity.
I realize not everyone can operate like an overseas investor with millions of dollars to dump into vacant properties, but would the world’s wealthiest people still be investing in real estate near these major city centres if they felt real estate was an overall bad investment? Probably not.
Now, if we are assuming you’re an investor and you’re working under the typical lending practices of an 80% LTV mortgage and 20% down payment (either cash or borrowed), just because the monthly rents may not fully cover the monthly expenses does this mean you shouldn’t purchase that property?
Let’s find out!
Below is an example of a property with a “negative cash flow” and you can be the judge of whether or not the investment still makes sense.
First off, let’s assume you’re going to purchase a home in Guelph for $500,000 with a $100,000 down payment (cash or borrowed) and the property is “losing” $250 per month in “negative cash flow”.
Let’s also assume you hold this property for the entire length of a 25-year mortgage and at the end of the 25 years, the property is worth the exact same amount as you bought it for. That’s right, no appreciation or depreciation, just $500,000 – the same value you purchased it for 25 years ago.
After the 25-year period your initial $100,000 investment would look like this:
– $500,000 property is now owned outright
– $400,000 increase in equity (tenants paid your entire 80% LTV mortgage amount)
– $75,000 cash flow loss over the 25-year term ($250/month x 12 months x 25 years)
– $325,000 net equity increase.
So after 25 years, your $100,000 has turned into $425,000 and you’re up by $325,000 overall.
Let’s take it a step further.
– $325,000/ 25 years = $13,000 per year
– $13,000 per year overall equity increase / $100,000 initial investment
= 13% annual ROI
All of the sudden, that property with “negative cash flow” doesn’t look so bad!
If somebody said to you, “Give me $100,000 today and in 25 years I’ll give you $425,000 back ” wouldn’t you do it?
Better yet, if you put a sign on the front lawn of a home worth $500,000 today that said “Buy it now for $100,000!” would you not agree people would literally be kicking in the front door just to sign the papers? It may sound silly, but isn’t this exactly what every real estate listing is offering you right now? You can buy a home today for 80% off it’s current market value, you just have to wait 25 years for the tenants to pay off your mortgage until you own it outright.
I’m sure you can agree that, in the long run, investing in that property would still make sense. Right?
Clearly, “positive cash flow” would be ideal but are you not missing out on major long-term opportunities by not purchasing real estate now because the property is not “making money” or “breaking even” on a monthly basis?
Also, assuming the properties value remains static at the end of the 25 year term is a very generous assumption.
What if the property value was up by even an extra $100,000 at the end of that 25 years? Clearly the potential to make a lot more money exists the higher the value of the real estate is after the 25-year period.
As time goes on I think we will start to see more savvy investors decide to continue to purchase investment properties in Guelph based on things like neighbourhood, location, economics, long-term potential, and type of property as opposed to basing their decisions solely on “Does it make an extra $100 per month?”.
Call me crazy, but this is where I see things going.
I realize not everyone will agree with me on this one, but I can assure you there are people that are still continuing to invest in Guelph real estate right now despite the monthly cash flow because they understand they’re investing for the future, not to make a couple extra hundred dollars per month, and they’re okay sacrificing a few short-term losses for a major long-term gain.
If “positive cash flow” is something you’re still stuck on and the numbers are already pretty close, you could consider putting more money down or amortizing your mortgage from 25 years to 30 years to reduce your overall monthly interest expenses. Another way would be to maximize your monthly rents by finding a property that needs work and taking the time to bring it up to above average standards or adding an additional living unit.
All in all, I would say investing in Guelph real estate is still one of the safest and most reliable investment vehicles there is and having that long-term mentality is critical to any investors overall, long-term success – especially when it comes to real estate.
Until next time, Happy Investing!