1st Dimension: Cash Flow

By: Mark Frentz
www.akerahomes.com
mfrentz@akerahomes.com

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Disclaimer

I have no idea how long I will be on the current topic of the multidimensional nature of real estate because I can think of 10-12 topics I would like to cover off the top of my head. Let's see where it takes us:) While I am covering these topics feel free to add your own ideas and thoughts. We can dialogue about all of these topics and I will be intentional about not covering every facet of each topic because my purpose is to get wheels turning rather than giving encyclopedic entries and sub entries. I hope that works for the majority of people reading the blog.

Cash Is King

The first topic is Cash Flow. When I hear people talk about real estate I most often hear comments about appreciation. “We're at the beginning of a rise in the market”, “When the property is worth _____ and I refinance, I can purchase more property”, and “My total holdings are worth _____” are all examples of how many people think first and foremost about appreciation when focusing on real estate. While I will cover appreciation in my next blog and have nothing against it, by the end of this entry I hope you will see that it isn't the most important aspect of long term wealth creation through real estate and focusing on appreciation actually gets a ton of potential investors in trouble at some point in their carrier because, in the end, appreciation cannot be counted upon in real estate! If you are counting on appreciation in real estate you are not an investor, you are a prospector (ie.gambler; think of a mining hat and dirty, unshaven face beside a river with a pan of sand in your hand).

The reason I place cash flow as the single most important aspect of getting into a real estate deal is that regardless of what the market does, if you are making money each and every single month you can hold the property long enough for it to generate true wealth for you. Let's play out a few scenarios.

1. The market continues to move up and everyone is happy with their investments
2. The market is stagnant
3. The market is going through a down turn in the normal real estate cycle or, even scarier, we have another time when few people can handle debt loads like 2007-2008 in Calgary (and across North America).

Without Cash Flow

In the first scenario everyone is happy and looks like a genius. In this type of market it is very difficult NOT to do well in real estate no matter how many mistakes you make. It is the equivalent of when the stock market is rising and every individual investor looks pretty good because you can't lose at this point unless you are doing a great many things wrong. As real estate prices shoot up you can take out a HELOC and reinvest the money into other properties and continue over and over again. While this sounds fantastic in this paragraph, if you aren't cash flowing on each and every property throughout this process, you have a good chance of losing your properties.

In the second scenario what happens depends on your personal financial situation. While in the first scenario you can lose your job and still have seemingly no problems at all because you could supplement your income with the growing equity in your property, in this scenario you may be in trouble if anything happens (including rising interest rates). If interest rates rose even a little (with them being at all time lows there is a very good chance they will) would you be able to handle your mortgage payments? Will you now need to cover mortgage payments with your salary? Can you handle a cut back or downsize or layoff or retirement? Maybe and maybe not. This is a precarious position to be in. Not one that I favor at all.

In the third scenario a ton of 'investors' default on their mortgages because they had debt up to their eyeballs with no way to cover that debt load if anything goes wrong. In this scenario many people are willing to simply leave everything for the banks to mop up because they are looking for any way to cut loses. In an economic downturn or falling market it is difficult to justify putting a lot of money each year into a property that isn't costing you money as it is devalued. After 07-08 the Canadian government joined with the 5 major banks to implement changes that would protect 'investors' and homeowners from themselves. Unfortunately this affects everyone who is responsible and practices due diligence with investments just as it does those in real estate for fast money.

 With Cash Flow

Lets play these three scenarios (over simplified of course) out if you were cash flowing on your property or properties (when cash flowing properly it doesn't matter whether you own 1, 100, or 1000 homes). Keep in mind that what I mean by cash flow does not mean that your income outpaces your mortgage, taxes, and insurance. When I say cash flow it means that you are covering each and every expense that exists on a piece of real estate. Expenses include those mentioned above as well as maintenance expenses which includes future furnace, shingle, and hot water tank replacement as well as anything that can and will go wrong with a home like plumbing, as well as future reno costs (replacement of flooring and paint). What will you do when your property is sitting vacant for a month every once in a while? This is an expense that should be included with everything else mentioned. One last item (are you overwhelmed yet? If so, don't worry. There are spreadsheets and people like me to think through all these details for you). If you have a company managing your property, this would also fit into the expense column. After all of those if you have at least $100 going into your bank account each and every month you can say you are cash flowing. Now, I prefer more than $100/month and probably won't do a deal that barely cash flows because it is too close to breaking even (unless I have a long term locked in interest rate of 10 years), but for the purposes of this blog a simple explanation it will do.

In the first scenario you definitely would have nothing to worry about. You are just as happy as anyone else in the real estate industry, but with the assurance that when something changes... you're still fine.

In the stagnant market... no worries. You ride it out knowing that the market will eventually rise again and that wealth through real estate is for those who plan long term.

In the third scenario... again no worries. If the market is crashing it can be a very good thing for those who have planned well. I won't go into great detail right now, but will offer a quick explanation. If the market falls as great as it did in 07-08 in the states, many people will not be able to afford homes and will be foreclosed upon. This means there will be a larger demand for rentals soon after (as there is now in Calgary as well as the US). Also, if there is a huge economic downturn not only is there more demand for a rental, often interest rates will fall as well and this can be a fantastic time to lock in at a long term lower rate. Even if everything goes wrong, you have planned ahead and can allow your investments to play themselves out even if things are a little tighter for a period of time. You lose your job? Although this is never ideal, you won't have to gnaw off your finger nails when you think about your real estate investment portfolio because it is taking care of itself. You will have a reserve fund at this time that can take care of extra expenses for a period of time (I'll explain in a later post).

Cash flow is also, in my mind, the best way to rely on real estate as a wealth generator. What happens when you own 50 doors? If each door is paying out at least $100 this means you will have passive cash generation of $5,000 each month. When this happens, do you really think you will be as concerned about your networth as the individual beside you? If you think owning 50 doors worth of real estate is impossible, you simply haven't learned enough about real estate yet! When we are a year or two into this blog, I will be shocked if you still think you cannot own 50 doors (although financing will definitely take more than a few blogs to cover).

But, But, But...

But what if the world falls apart? I know the naysayer out there is thinking this or something like it. In answer... if the world falls apart, I probably have bigger things to worry about than my real estate portfolio and am probably no better or worse off than anyone else in the middle of a world war or Armageddon.

Comparisons? HA!

Cash flow is also important because this is an area where real estate outpaces almost any other investment. What other investments can you think of that pay you cash month after month after month? Two come to my mind almost immediately. The first is a bank, either through interest on a savings account or GICs. The best return you can hope for in today's market is around 2.25% as of this writing. Can you honestly even use the term 'investment' with that kind return? The government consistently reports average inflation of 3% or higher. This means that you are actually losing money by keeping it in a bank with a GIC. I won't even go into further detail because this is obviously such a foolish thing to do with your money if you want to have it grow. If you were to even simply put your money into a physical investment, such as gold or silver, at least prices would somewhat follow inflation. Something else to consider with inflation is that both the Canadian and US governments are printing money very quickly right now. I recently heard someone tell me the US has printed more money in the last 3 years than it has in the past 30! If this is true (or even half or a quarter true) it means we are in for much higher inflation rates in the near future. Inflation is something I really want to cover more fully, so I will stop here and continue at another time.

The second investment I can think of that pays cash returns is any stock that pays out dividends. There are companies that consistently pay out a certain percentage (not guaranteed, because no real investment is) at set times throughout the year. While this qualifies certain stocks as an investment in my opinion, it does not measure up to real estate because of leverage and having someone else pay off your debt (but I again am getting ahead of myself here. I'll cover these topics in later posts). As you read through the dimensions of real estate in the coming weeks I would like you to pay attention to how many other 'investments' we hear of can do the same. For each topic I will cover here there a couple of others that can do the same, but there are fewer that can do half and I do not know of even one other investment that can do all of what we will cover (not by a long shot).

The next topic we'll focus on is appreciation (and you thought I discounted it, didn't you?)

If you would like to learn more about investing in real estate please contact me at the email address listed at the beginning of this article or go to my website at: www.akerahomes.com/investing-in-real-estate.html