Should you ever invest in properties with negative cash flow?

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Conventional wisdom should be questioned.

At one time, conventional wisdom held that the sun revolved around the earth. And that the earth was flat, and that smoking was completely safe.

Even when conventional wisdom isn’t wrong per se, it can be limiting. For example, some investors only consider properties or passive real estate investments that cash flow well from Day 1.

But is negative cash flow always a deal breaker?

Usually, yes. It depends on how you know the property will cash flow well in the future — and when.

When to Consider Delayed Cash Flow

When we vet group real estate investments in our Co-Investing Club, we always ask:

“When will cash flow distributions start?”

Sometimes the real estate syndicator forecasts them to start almost immediately, within a quarter of buying. In other deals, cash flow distributions might not start for two or three years.

That doesn’t necessarily prevent our Club members from investing in the deal. But in those cases, we all double down on making sure the business plan makes sense.

New Construction & Development

It takes months or years to put up a new building. That goes for single-family homes as well as apartment complexes and other commercial properties.

Which, of course, means that you can’t expect any cash flow during that time. And that doesn’t make new construction a bad investment.

But the cash flow numbers have to make sense before you buy the land and start construction. What will your all-in costs be? What market rent can you expect, and what cash flow yield will you earn? How much will the property be worth upon completion?

If you don’t have firm answers to those questions, don’t invest.

In-Fill of Vacant Lots

We recently invested in a portfolio of four mobile home parks in the Co-Investing Club. It included 63 vacant lots that need to be in-filled with new mobile homes.

The same questions apply as with new construction. Our members felt certain about the market rent for mobile homes in these vacant lots — and certain that the local demand supports this new supply. We felt confident about it because the same sponsor owns another park five minutes away, with full occupancy and a waiting list for entry.

And hey, it didn’t hurt that the portfolio of parks already cash flows well, even with those vacant lots.

Value-Add Renovation Projects

When you buy a fixer-upper, you need to renovate it before you can rent it out and start collecting cash flow.

All the same principles apply. You delay taking cash flow in order to improve the property and earn the maximum possible rental income.

By improving the property, you force appreciation and higher market rents. You can then enjoy strong cash flow until the day comes when you decide to sell, and on that day you walk away with a tidy profit.

In fact, this is precisely how the BRRRR method works. If you want to chase infinite returns on real estate by pulling your cash out with a refinance, you need to put up with a period of negative or minimal cash flow while you renovate the property.

Highly Leveraged Properties

The lower the down payment on an investment property — or the higher the LTV of a refinance loan — the thinner your cash flow will be.

If you leverage a property to the hilt, you have less cash tied up in the deal (or none), but you pay the price in cash flow. And maybe you don’t mind, as long as you break even for the first year or two. Your rental property mortgage payment will stay the same after all, even as rents rise. Those rising rents will disproportionately boost your cash flow.

Just don’t lock yourself into negative cash flow, counting on rising rents to eventually bail you out. If you take this route, still insist on positive cash flow, even if it’s lean.

Further, dig deep into the local market fundamentals to make sure population growth (demand) will exceed new housing supply over the next few years. Confirm local housing starts and permits for all types of housing, including single-family homes and multifamily properties.

Avoid Speculation & Chasing “Appreciation Markets”

It drives me crazy when real estate investors talk about “appreciation markets” as opposed to “cash flow markets.”

Look no further than Phoenix and Austin for poster children of so-called “appreciation markets” in the late 2010s and early 2020s. Sure enough, they both crashed and burned in 2022 and 2023.

Austin saw home prices drop 11.57% over a year. Phoenix property values lost 6.96%. See our interactive map of cooling real estate markets for details.

Now imagine that you bought a property there in 2021 that lost money each month. You were counting on future appreciation to carry your investment.

You’d be doubly screwed today, having lost money both on monthly cash flow and on lower property values.

Yes, real estate values usually go up over the long term. But you can’t count on appreciating property values to carry your investment. Make sure you earn at least a little money on cash flow each year.

Exit Strategies & Contingency Plans

Among other upsides, positive cash flow gives you the luxury of waiting out bad real estate markets so you can sell well. It leaves you flexibility.

You can further manage your risk with multiple contingencies planned for exit strategies. Can you sell the property to a first-time homebuyer? To an investor?

You could potentially offer owner financing to sweeten the deal, perhaps with a wraparound mortgage. To minimize default risk, you could structure it as an installment contract so you don’t relinquish ownership until the buyer is ready to take on their own loan.

Along similar lines, you could lease the property as a rent-to-own with a lease-option agreement. It proves an effective (if slower) way to sell your property, with no Realtor commission to boot.

Forecasting Cash Flow Accurately

Reality check: your cash flow on a rental property is not “the rent minus the mortgage.”

Use a rental cash flow calculator to run the numbers before buying any investment property. Include irregular but inevitable expenses like repairs, maintenance, vacancy rate, and yes, property management costs. Even if you plan to manage the property yourself, your labor is a cost you need to consider. And the day may come when you are no longer willing or able to manage the property yourself.

If you invest in passive real estate syndications, pay close attention to the cash flow forecasts. Pay particular attention to the underwriting assumptions. How fast are they forecasting rent growth? What about expenses such as insurance premiums?

Don’t invest in any deals without a clear and conservative plan for reaching positive cash flow. It may not happen in the first year or even the second, if the property requires extensive renovations or new construction. But the business plan for getting there should make perfect sense, and forecast modest rent growth with high expense growth.

Or you can play it safer and invest in properties that cash flow well from Day One.♦

Have you ever invested in a property with negative cash flow? How did it work out for you?

About the Author

G. Brian Davis is a real estate investor and cofounder of SparkRental who spends 10 months of the year in South America. His mission: to help 5,000 people reach financial independence with passive income from real estate.

This article originally appeared on SparkRental and was syndicated by MediaFeed.

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