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