How People Get Rich With Real Estate, Part 2: Cash Flow Is NOT King

King or not?

Some people love it.  Others hate it.

But regardless of how you feel about it, real estate remains one of the most effective ways to build wealth for the “retail” investor.

I have previously deconstructed the precise way people get rich with real estate.

Building wealth with real estate

But in today’s post, I would like to take it a step further and discuss the danger of focusing on cash flow as your primary deal metric.

Let’s dive in.

Show Me The Money

Let’s start things off with a little example.

Assume you are looking at a nice $500k property.  It can be a detached house, a multi-family, an industrial warehouse, or even a strip mall.

In real estate, it doesn’t matter what rocks your boat – even if it’s office buildings in a post-Covid world!

What matters is that the property is selling for $500k and carries a 4% cap rate (if you don’t know what a cap rate is, please read this).

In turn, that 4% cap rate means that the property spins off a neat $20k of NOI (net operating income) a year.

Intrigued, you run some numbers.

For simplicity, let’s assume an interest-only mortgage.

On a 90% LTV (bear with me) mortgage with a 5% interest rate, the annual interest payment works out to $22.5k.

Which, in turn, means that the property is a dud.  Full stop.

How come?

Well, it’s because even if you were to raise rents (and therefore, NOI) by 2% a year, you still end up out of pocket every single year for the foreseeable future:

Real estate - no cash flow

And so, you pass.

This, by the way, is one of the most frustrating aspects of real estate investing.

You look at hundreds, perhaps thousands of properties – only to pass on 99% of them.  And the only way to succeed is to enjoy the process of looking under the hood on property after property in order to score that elusive home run.

But I digress – so let’s get back to our example.

Black Magic

Suppose you were to make a small tweak to your assumptions.

Instead of going full Gordon Gekko (or Elon Musk) here, let’s dial back the leverage from 90% to a more conventional 50%.

The annual interest payment comes down all the way to $12.5k – and voila, you just hit the jackpot!

After-tax, the property now cash flows to the tune of about $6k a year.

Real estate - lots of cash flow!

“Baby, I’ve still got it”, you whisper to yourself as you pick up the phone to call your broker.

And this, my friends, is why I absolutely hate cash flow as the PRIMARY metric for evaluating the attractiveness of a property.

Head Fake

It’s the same house (or strip mall), with the same tenants and same rent roll.  Same location, same prospects and problems.

So no, we haven’t magically created any value here out of thin air.

As a matter of fact, we DESTROYED value.

Let’s have a look at the returns (as measured by IRR) in the first scenario below.

Returns with no cash flow

Sure, you are bleeding cash for five years straight.  But assuming a 3% price appreciation (in line with long-term inflation), you actually make out like a bandit when you sell.

Together with the down payment, you’ve invested a total of $57k – and cleared $128k in net proceeds.

That’s an IRR (time-weighted annualized return) of 18.4%.  Well north of what even the magic money machine can deliver.

What about the second scenario, the one with reduced leverage and amazing cash flow?

Well, the IRR on that one lands at 8.1% only.  The fact that you’ve put a $250k down payment absolutely decimates your returns.

Returns with cash flow

Now, let’s be clear – 8% is a healthy return.  But not enough to compensate you for the risk and challenges of investing in real estate.

Furthermore, when it comes to reaching early retirement, compounding your money at 18% vs 8% is the equivalent of racing a rocket ship against a Russian potato-powered Lada.

Love And Hate

Now, don’t get me wrong.  I LOVE cash flow – and you should, too.

In fact, proper cash flow should be the number one objective of any property you buy (with some limited exceptions).

First of all, it’s much more predictable than price appreciation which may or may never happen.

You just make sure the rents are in line (ideally, below) market and you’ve got enough of a contingency for any unexpected expenses.

Second of all, cash-flowing real estate is one of the best ways to achieve early retirement.  Nothing like seeing $20k land in your bank account every month while you spend your days relaxing on a nice beach somewhere.

But rather, the point here is that you should NEVER focus on cash flow at the expense of other metrics – including total annualized returns.

Show me a property, and I will show you a way to make it “cash flowing”.  Which, by the way, is what many brokers do with inexperienced buyers – and how people end up losing their hard-earned initial capital.

Instead, what you really want is to find a property that generates solid returns – all while spinning off healthy cash flow every year.

And more often than not, it requires looking at a hundred duds before you hit gold.

As always, thank you for reading – and happy (real estate) investing!


About Banker On Fire

Enjoyed this post?

Then you may want to sign up for our exclusive updates, delivered straight to your inbox.

You can also follow me on Twitter or Facebook, or share the post using the buttons above.

Banker On FIRE is a London-based M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.

Find out more about me and this blog here.

If you are new to investing, here is a good place to start.

For advertising opportunities, please send an email to bankeronfire at gmail dot com

13 thoughts on “How People Get Rich With Real Estate, Part 2: Cash Flow Is NOT King”

  1. Are you always counting on property appreciation as the way to make money in real estate? If so, doesn’t it make it more critical when in the market cycle you buy? Do you think now is a bad time to buy with the run up in property values and anticipated increased interest rate suggest lower property returns for some years to come?

    I’ve casually looked but it seems like it’s very difficult now to buy cash flow positive properties with 10-20% down in desirable areas (like where I live on the west coast) compared to the past.

    1. Banker On FIRE

      I guess there are two parts to your question.

      As far as price appreciation goes, I don’t like to rely on anything above 3% (i.e. long-term inflation) to deliver my returns. As you say, price appreciation comes and goes, but cash is always there.

      At the same time, cash flow is a metric that’s easy to “massage” hence you need to look at any investment on a total return basis as well.

      The second question is whether now is a good time to buy. Based on the deals I’m seeing in the market, the answer is “not yet”. Asking prices haven’t yet rebased in line with the higher interest rates, hence I am holding off for the next 6 months or so to see if the situation changes.

      Hope this helps!

      1. I recently sold a flat that had zero appreciation over 14 years.
        It did however provide me with north of 30,% ROI PA over that period.
        There’s lots like that in small towns in Central Scotland

          1. No it was leveraged at 85%, £65K cash price £12K in and + fixed rate 4% which reverted to +2% after 2 year Rented for between £450 back in 2008 to £605pm .when I sold it last year.
            Target tenants are on benefits so you research Local Housing Allowance make it easy for them, or no credit checks, no deposit.
            There are literally hundreds of 2 bed properties in Scotland between £30K and £50K that make it a low cost entry to real estate

          2. Banker On FIRE

            Sounds like an excellent deal.

            I have never done a deal in the UK but it sounds like there may be opportunities there still!

  2. Good article. From my perspective what many private real estate investors (with blogs) get wrong is exactly this concept:
    (1) They focus on cashflow – which is understandable given liquidity is a key priority for many individuals – i.e. it makes no sense to acquire deeply negative CF apartments and then losing your job in a market downturn
    (2) Their “metric” is mostly a simplified ROI-perspective such that they calculate: equity cash outflow of $100 equity at acquisition and cash inflow of $120 over time providing them a 20% return. This is correct but only half the truth. It would be better to (i) factor amortization in – i.e. your equity return decreases over time given that amortization is basically equity and (ii) factor in the time until exit.

    Calculating an IRR from acquisition until exit is (one or the only?) correct way to measure your true returns.

    Best
    Harald

    1. Banker On FIRE

      Fully agree and well-articulated.

      IRR is my go-to metric and it’s one I suggest everyone learns, even though it’s not as intuitive as the headline cash on cash metrics.

  3. Pingback: Weekend reading: Think first if a windfall flies into your life - Monevator

    1. Banker On FIRE

      Very specific to jurisdiction, structure (corporate vs individual ownership), and holding horizon.

      That being said, they definitely impact your returns, contrary to what many brokers would like you to believe!

  4. Your entry cap rate + NOI growth rate = unlevered IRR (4% + 2% = 6% in your example above). If your debt cost is below this it will always be accretive to returns.

    I’d strongly caution against using a property appreciation p.a. assumption. I’d suggest your starting point should be returns based on entry and exit cap rate remaining the same.

    If your ‘property appreciation’ assumption is above your NOI growth rate you are effectively underwriting cap rate compression. It’s fine if you want to do this but make it explicit with an exit cap rate assumption and justify it to yourself. For example, you wouldn’t inflate the EV of an operating business by an appreciation assumption to derive an exit value.

    The question of exit cap rates is particularly vexing currently given the rising rate environment. Cap rates arguably need to move 1:1 with risk free rate to maintain the same spread (potentially offset by higher rental growth).

    1. Banker On FIRE

      Fully agree.

      If anything, makes sense to underwrite some cap rate expansion (50-100bps) to see what returns look like in that scenario.

      There’s also the challenge of NOI not growing in line with inflation. For example, in rent-controlled jurisdictions max rent increases are unlikely to be tracking inflation this year, weighing on NOI against the backdrop of higher interest rate costs.

Leave a Reply