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How Negative Cash Flow Can Make You Money

Ok, so I just read a blog (on another site) that was posted by a certain Hawaiian friend of mine that was warning against Alligator Property. It's a great blog.

In it, he explains how an Alligator Property is basically a property that you buy, thinking you're going to have positive cash flow, but end up having unexpected costs put you in a Negative Cash Flow situation. This sucks. But, let me put a silver lining on the situation. And, for the sake of an example, I'll use actual numbers from a rental property of mine.

I have a property that is worth about $175,000. I paid $124,000 for it 3 years ago. I have a HELOC taken out on it that I've charged $17,000 to. The PITI (Principal, Interest, Taxes, Insurance) on the property is $950/month. The HELOC is about $200. And, I'm paying $135/month for association dues. I'm paying $1285/month to own that property. My renter pays me $850/month. OUCH!!

I know. I can hear your thoughts as they enter your mind. Trust me, I can't wait for the lease to be up so that I can raise rent. But, in the mean time, look at it this way.

I'm paying $435/month out of my own pocket to hang on to that property. In my neighborhood the property is appreciating about 15% each year. So, this year, for example, I'll make around $25,000 in appreciation. And, the interest on my loan is tax deductible, as is the depreciation (I'm just learning about depreciation, so if anyone wants to write a blog, I'd be grateful). Assuming I'm paying about $700/month in interest, and I'm in a 25% tax bracket, that means that I'll get about $175/month back. So, $175 x 12 = $2,100. Add that to my $25,000 and I get $27,100. Devide that number by 12....and you get $2,258/month. I'm trading $435/month for $2,258/month. Anyone still saying "OUCH!" ? The end math dulls the pain of the "negative cash flow". Slowly, the HELOC will be paid off and the rent will be raised, bringing me into a positive cash flow situation, but right now, I'm ok to just hang on and collect my equity money.

(Keep in mind that this may not be the case if your area is not appreciating sufficiently)

Remember, just because your monthly budget is in "the red", it doesn't mean that your income is.

Real Estate is such a great investment. We are absolutely blessed to do what we do.

I hope this makes sense to you all and helps someone.

Thanks for the comments and the grades.

Abe

Posted by Abe Loper on 02/15/2007 04:38 AM

Comments (24)

renters, investment, cash flow, landlord

24 Comments on How Negative Cash Flow Can Make You Money

FEB

2007

Abe, I'm with you on this one. I've got properties that don't generate a positive cash flow each month, but because appreciation is there, I don't mind being in the red a bit. It's important to do the numbers and make sure it's working for you. You've obviously done that. I know being in the black is a better situation but being in the red isn't always bad, as you point out.

Makes perfect sense to me Abe.

Also, a negative cash flow on one property can also be used to offset taxable income on others and you still reap the appreciation & tax benefits of all the properties.

I go buy the golden rule. Make your gold when you buy. I want cash flow and equity going into a deal. Since I don't know what will happen tomorrow.

Jeff ... I agree

Abe - you have to be careful with those calculations. There is no guarantee that you will get the personal mortgage tax deduction on these properties because it isn't your primary residence. Technically it is only good for primary and some 2ndary properties with first mortgages and HELOCs if used for the right purposes. Commercial and rental properties are usually excluded. That is partly because rental income is treated differently on your tax returns.

Plus you're falling prey to what I call the Jackpot Syndrome of real estate... there are so many people out there just wanting the appreciation that they are willing to ignore the negative cash flow because when they sell they'll "hit the jackpot"... but in the meantime they are hurting themselves. If you take the negative cash flow and show how much different the equation would be with POSITIVE Cash flow, then you'd see the benefit of leveraging properly to get it. Also, in this market, many people are finding out that appreciation can evaporate in an instant!

Also... remember you are a mortgage broker. Rental income is only calculated at 75% by most lenders due to vacancies etc. Negative cash flowing properties can SERIOUSLY hurt your ability to prove enough income down the road. It is one of those grey areas in stated income loans... especially if the rents you're getting don't match market rents per an appraiser

"Remember, just because your monthly budget is in "the red", it doesn't mean that your income is. "

That's like telling a moderate income family to trade their weekly paychecks for an annual lump payment. You might be behind on bills for a few months but look at what you get for Christmas!

A negative is a negative. If one part suppliments that great, but what if both parts are negative...

You'll soon be wearing a barrel.

David,

You're not wrong in anything you say, but it doesn't make my point any less valid. In regard to your paragraphs 4 and 5, ... Would you trade $435 a month for a $25,000 lump sum "for Christmas"? (Notice, I left out the tax benefits, just to appease your concern regarding some rentals and commercial property...which you mentioned in paragraph 1.) I sure would. Heck, that's a 401K, IRA and CD do. You put money away at the expense of your monthly budget in order to let it grow so you can take it out later. People that are fully convinced that a dollar in hand is better than five later are more than welcome to that mentality because it just frees up the better long term investments for people who are willing to make sacrifices now for the sake of the future.

In regard to your 3rd paragraph, you make the assumption that I need to get another loan and will be hurt by my rent or my 75% calculation. I'm fully aware of how those issues affect one's ability to borrow more money. But I'm not talking about buying more houses. I'm talking about having AN investment property.

In reference to your 2nd paragraph, you seem to be forgetting that I explicitly stated that having positive cash flow is better. I wrote the blog not as a statement concerning the BEST way to buy and hold property, but as a comfort to those who may be in a similar situation to mine.

David, your statements are valid, but they're simply not relevant in a conversation that is supposed to be discussing the "silver lining" of a negative cash flow. The reason a blog like mine is needed is because the points you make are obvious and we're all acutely aware of them. Everyone knows that paying money isn't as good as getting paid. That's why they need someone to explain to them that sometimes, even when their paying money, they're still getting paid. Some people see their house like a vending machine, wanting to get something out of it as soon as they put money in. I see my house as a savings account. My money goes in, grows, and then can be taken out later, at a much greater return.

Thanks for the comment. It makes for good conversation and it allows people to see how firmly my original statements hold up to scrutiny.

Good luck my friend.

Abe

Luke,

I'm gonna give you the benefit of the doubt and assume you didn't read my whole blog. If you had, you would have seen that I made a point to say...

"(Keep in mind that this may not be the case if your area is not appreciating sufficiently) "

Obviously, if both parts are negative then you won't have a benefit.

Great work figuring that one out.

"a negative is a negative"...Really? I guess, then, you don't advise putting any money away in savings or for retirement.

Abe,

To buttress your POV, there are investors in and around the UofM campus in Ann Arbor that are all right with a small negative cash flow for a period of time. In talking with these investors, they are counting on the appreciation to more than make up for the small monthly hits they take. In essence, they are utilizing these properties as CD's.

Granted, they buy these properties with cash......but the same principal can apply if the rates of appreciation are higher with leveraged properties.

Abe, with negative cash flow how are you able to build anymore wealth? What happens if something happens and you need to sell?

I agree with your math. However unfortunately in Florida many people did that loan at 100% and the property went backwards. now you have to say ouch!

With negative cash flow (in this scenario) you ARE building wealth. And the negative cash flow isn't necessarily taking ALL of your extra money. many investors will have multiple properties that are cash flowing fine and one that isn't. Or, some people will just consider the negative cash flow on their rental to be part of the mortgage on their primary residence (for budgeting purposes) and then use their other money for investing in other opportunities.

If something happens and you need to sell.....then you sell. People have to sell for all sorts of reasons and how well your cash is flowing makes no difference to a buyer. If the buyer is gonna occupy the property it's particularly irrelevant. And, if they're going to rent it out then they're going to be in a different mortgage, not to mention that as the new owners they'll have the right to change lease contracts at the time of possession.

Neither are a problem.

Yeah Matt, that's what I've heard. In David's defense, he told me about a situation that he saw play out in FL and that's why he responded the way he did. Like I said, this isn't ideal. You always want to make properties cash flow. But if you can't, that's no reason to have a fire sale. It can still be a good investment.

"And, if they're going to rent it out then they're going to be in a different mortgage, not to mention that as the new owners they'll have the right to change lease contracts at the time of possession.
Neither are a problem."

I'm confused here. Are you saying that a new buyer can change the terms of an existing lease just because they're the new owners???

Yes. They absolutely can. The lease is not between a renter and a property, but between a renter and an owner.

Abe-

I have a fellow realtor friend that feels the same way you do. However, one thing that has always concerned me is: doesn't the depreciation get recaptured when you go to sell? I have had rentals in the past and had negative cash flows, when I went to sell I remember something happened with the depreciation getting rolled back in.

John, that's a good question. I don't know that answer. I mentioned in the blog that I'm just learning about depreciation and what it does/means/implies/etc. When I admited that shortcoming I was, unfortunately, dead serious. I don't really know much on the topic. If you have anything that you'd like to share with me, I'd be happy to hear it. Or, if you know of a blog that I can be directed toward that explains it. Otherwise, I'm sure I can google it. ;)

"Yes. They absolutely can. The lease is not between a renter and a property, but between a renter and an owner."

Actually I believe a lease, while between a renter and an owner, also encumbers the property with that lease and a new owner can't come in and change the lease game plan until it expires. While a lease is between a tenant and an owner it also encumers the property.

That's basic real estate 101

"Q: We have a 12-month lease on a home that has six months remaining on it. Our landlord sold the house last month and we were advised in writing that our deposit was transferred to the new owner. Is our original lease still valid? Can we or the new owner cancel the lease?

A: Griswold: Your lease is still valid and you and the new owner must honor the terms and conditions unless you mutually agree to a change or a new lease."

Jim,

I maybe that's the case for residential properties, but commercial real estate (more than 6 residential units) must be different. I'm talking to people here in Chicago that have bought many, many multi-unit buildings and insist that they have, and may, change the rent after taking possession of the property.

Must be a Chicago thing Abe, a lease is a lease pretty much all over absent any terms to the contrary in that lease.

You have me curious now; we have a couple of CCIM's in the office, I'll check with them about how it works here.

I just got off the phone with a guy who was "sold" into a similar scenario. All was well until the market here in Vegas flattened out. Now he is looking at foreclosure and a considerable net loss. I think it works in the right market but great care should be taken.

As an investor, I don't want to go broke while getting rich. Positive cash flow is esential to any investment.

As a real estate agent who works with investors, this is not an investment strategey that I would recommend to my clients. I want them to make money so they have more to invest.

Too many deals like yours could cause one sink faster than the Titanic.

"I'm talking to people here in Chicago that have bought many, many multi-unit buildings and insist that they have, and may, change the rent after taking possession of the property."

Correct; you can change month to month rents at anytime consistent with any state or local landlord or tenant laws that require notice.

However if you have an existing lease with a tenant, residential or commercial, that specifies a monthly rental figure, that lease and monthly rental amount would need to be honored by any new owners until its expiration.

I checked with a couple of commercial guys in my office that have the CCIM designation in commercial real estate and also a rental manager. They say a lease is a lease just like a deal is a deal and can't be changed or modified without full consent of both parties.

FEB

2007

Banking on property appreciation in a bubble market is dicey...ask the dot com guys. Values are up in 30-70% in a little as 3-4 years in some places...obvious "irrational exuberance" if I've ever seen it. Classic bubble...and bubbes burst...they don't "soft land".

Sell why values are still high...end your cashflow problem.

Reinvest your profit shorting builder and mortgage stocks...you'll make a fortune.

Rob K. Blake

Jim,

Great work on the sleuthing. There's a good chance that the comments my advisors were making were due to month-to-month rental situations.

Rob,

I do agree with you, but the best way to make money is to sell when the bubble is closest to bursting. I don't think that the Chicago market is close yet. Not remotely.

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