Buying Real Estate for Cash Flow: The Numbers

By
David
– April 15, 2011Posted in: Real Estate, Strategies

This post is the second in the series: Buying Real Estate for Cash Flow.

In the prior post (Buying Real Estate for Cash Flow: Does it Work?) the point was made that in most scenarios real estate doesn’t produce net positive cash flow. Instead, the most significant gains come from holding for appreciation and whatever minor cash flow is just there to hold the deal together until you can sell for a substantial profit.

In this post we’ll look at the numbers behind why real estate does not produce much positive cash flow and why the only gains are likely to be from appreciation.

In most neighborhoods, rents from real estate don’t produce positive cash flow and the net cash flow is quite negative. These are neighborhoods most people would feel comfortable living and raising a family in. Houses in entry-level neighborhoods have a better chance of producing some cash flow.

Right now, the real estate market is recovering from the greatest boom and bust in history. Prices in many areas are much lower than 5 or even 10 years ago. The best deals appear to be in areas built during the past 10 years (the bubble years from 2002 to 2008) when prices were high, loan qualification was easy, and buyers had very small down payments. These types of properties are primarily in bubble markets like Phoenix, Las Vegas, and all over Florida.

Below is a picture of a typical, 2004-built, 1500 s.f. single family home.

Phoenix 3 bedroom 2 bath home

Phoenix 3 bedroom 2 bath home

There are quite a few investment groups buying these properties to hold or resell to individual investors.

The question is:

Do these houses produce much cash flow?

The surprising answer is NO.

Here are the typical numbers:

Bubble peak price: $350,000
Today’s purchase price: $90,000
Repair work (paint, carpet, etc.): $10,000
Year built: 2006
Size: 3 Bed / 2 Bath, 1350 s.f.

You might see a pro forma like this:

Purchase price: $100,000
Rent: $800/month
Property taxes: $100/month
Repair allowance: $50/month
Insurance: $50/month
Management: $50/month
Mortgage at 75% LTV: $350/month

These numbers seem to suggest passive cash flow of $200/month!

Sounds great, right?

However, chances are, it isn’t going to produce one cent of cash flow for you. Here’s why:

There are far more expenses than just those listed above.

Here’s a short list additional expenses not in the pro forma:

  • Your time and travel expenses to review the property
  • Accounting/bookkeeping
  • Income tax preparation
  • Vacancy (however short the period is between tenant turnover)
  • Leasing (marketing, advertising, lease commissions)
  • Tenant damage (it will happen at some point in time)
  • Insurance deductible (should you ever have a claim – this is an out of pocket expense)
  • Landscaping
  • Licenses, fees, HOA, etc.
  • Capital expenses (rentals tend to get beaten up and things wear out, so reserving $50 month won’t be enough to cover these expenses)

In conclusion, while properties today are much more attractively priced than just 5 years ago, most won’t produce much positive cash flow and the reason is in the numbers.

P.S. If you don’t like this example, just change the numbers and it still won’t produce true cash flow. Even if the rent was $1000/month, this type of property would see its best gains from appreciation, not cash flow.

Be Sociable, Share!
Tags: , , , ,