It's All About Cash Flow

I had a conversation with a buddy of mine this week and we weren’t really talking about real estate specifically, just investing in general.  But that led to a discussion about some real estate that he bought several years ago when the market was flying high – much like it is now. 

He told me that he learned a valuable lesson when investing in real estate and that was to focus primarily on cash flow that the property is providing versus the potential appreciation.  That may not sound like rocket science, which it isn’t – and this guy was not a real estate professional.  It is simple common sense.  However, he, like many others, forgot that real estate is a commodity and can drop in value just like it can go up.  He had based his returns on his properties increasing in value, not worrying so much about the fact that he was barely breaking even on a monthly standpoint (rents received versus cost of owning the homes and carrying loans).  When the market turned, he got stuck not only paying a monthly tab, but doing so on properties that were worth far less than what he paid for them.

The real estate market in Nashville is flying high right now and I believe it will continue to do so for at least the next couple of years.  But we don’t need to get caught up in the exuberance of the situation and buy long term investment property (or allow our clients to do so) solely on the basis of the expected appreciation.  Granted, a flipping situation is a little different.  But someone buying a property to rent it out needs to make sure that the cash flow works.  In other words, there is more money coming in on a monthly basis than is going out.  And Ideally that number needs to produce a return that is an adequate cash return (amount received above expenses is earning a decent return based on the initial amount invested).  With the requirement of at least 20% down payment for most rental property loans, getting the rental income to exceed the payment is typically doable.  But it needs to be enough overage that there is a return for the money invested.

Sometimes we forget these basic principles when the market is doing so well.  And many times, the market appreciation bails buyers out of less than stellar decisions.  But this is also how investors get burned.  So just a reminder of the lesson my friend learned the hard way.  Investing in rental real estate is all about cash flow.  There are many other benefits - primarily appreciation and tax deductions.  But if the property won’t cash flow, it likely needs to be passed on, if the purpose of the purchase is the long term rental benefit.