I have these discussions all the time with friends, family, and many others online. There are a ton of ways to make money in real estate investing. But the only one of these ways that you should care about is cash flow.
Others may fight back against that. But cash flow is king and queen in real estate investing. No ifs, ands, or buts.
I even recently had a discussion with my podcaster-in-crime, Vijay Kini, about just this. He wanted to buy a property for the tax benefits. I told him that was a mistake. He disagreed.
So now I am writing this post to prove my point!
3 reasons cash flow rules
1. It’s money you can use right now (like right now)
Sure, appreciation. Tax benefits. Equity build up. All of these are ways that real estate investing increases your net worth and makes you money.
But let’s say that you increase your equity in your investment property by $100,000. And you now want to buy something else for $100,000. What do you do?
Well, you at least have to sell the property. Or do a cash-out refinance. Or take out a HELOC (worst option in my opinion).
If you take Option #1, you have to pay taxes on your gains. Options #2 and #3 require you to take out more debt on your property in order to use that equity.
None are easy or great options.
But cash flow…
Cash flow is money in your pocket. Each month, my cash flow goes right into my bank account. I use it to invest in more real estate. But I could use it for anything that I want.
It’s a beautiful thing this cash flow.
2. Cash flow controls your property’s (forced) appreciation
Market appreciation cannot be controlled or relied upon. But, there is another side of the appreciation coin. And that is forced appreciation.
Forced appreciation is appreciation that you control. It’s in your hands as the investor. How?
Ok, first. Your primary residence. How much is it worth?
It’s worth as much as anyone will pay for it at any given moment. That is 100% market dependent. Not in your control. Vague. Ambiguous. Arbitrary.
Now, your investment property. How much is it worth?
Your investment property is a business. Its value correlates with its net revenue and profits. The more profit, the more your property is valued at. It’s mathematic. It’s under your control.
You calculate this using the following equation:
Property Value = Yearly Net Operating Income/Market Capitalization Rate
(If you need a refresher on these and other metrics, read this post first)
Let’s give an example:
Selenid and I bought our first investment property, a duplex, for $174,500. After buying it, we did some minor repairs and renovations. Things like a new paint job, installing shelving in one unit, etc.
Then, we rented out the two apartments as well as a separate shed at above market value. We also bill back all utilities.
Our yearly projected NOI is now $19,452. Buffalo’s market capitalization is 6%. Therefore, the new value of the property is $324,195.
That is forced appreciation of over $100,000. And what created that huge increase…our net operating income which is directly related to…our cash flow!
3. Cash flow will save your @$$
The year is 2007. Let’s say you buy a property that cash flows. You buy is for $180,000. In this example, you make $1,000 each month in cash flow from your tenants.
And then…the housing market crashes! Oh no!
Your property is now valued at only $110,000. Shoot…your equity just dropped a ton! What are you gonna do? Should you sell?
You don’t care what your property is valued on the market. It’s still making you $1,000 each month. Your property value could be $0. You can afford to wait for the market to turn around. Even then, you may not want to sell.
See? Cash flow just saved your butt.
Would we love the value to go up? Sure! But we can’t control market appreciation. So we need an investing plan that doesn’t count on market appreciation.
What is that plan?..It’s a long term, buy-and-hold, cash flowing real estate investing strategy!
4. Tax benefits are great, but not as great without cash flow
The tax benefits of real estate investing are amazing.
Let’s review a partial list:
- Depreciation creates passive paper losses that offset most if not all of your income from real estate
- Accelerated depreciation can create huge paper losses in a shirt amount of time
- Real Estate Professional Status (REPS) allows you to shelter your active (W2 or 1099) income with your paper losses from real estate
This is a recipe for HUGE tax savings.
But the question then becomes, how much are you willing to pay for these tax benefits? I would argue that you should not pay for these advantages at all. You should be paid for them.
How does that work?
Well, it works with cash flow.
Let’s take another example for someone just starting out in real estate investing. You buy a property for $230,000 with the property (not including land) valued at $200,000. There is a $750 monthly mortgage payment. Other expenses bring your total monthly expenses to $1500. And let’s say that you make $1500 monthly in rent. Your property is cash flow neutral.
Your maximum tax savings with standard depreciation will come out to about $7,200. You don’t obtain REPS since you don’t spend 750 hours and 51% of your time in real estate activities.
Now you have $7,500 in passive losses that you can use to offset passive gains in other investments if you have any. And you have no cash flow putting money in your pocket.
Now, let’s say that this same property makes $500 each month is cash flow. That’s $6,000 a year. You get the same passive tax losses which offset all of your income. So your cash flow is tax free.
Now that’s better!
Granted, this is a very simple example. And many of you aren’t likely to get excited about $6,000/year. But I do! And you should. Why? Well, multiply this times 2 properties. Now 3 properties. Then tax free exchange one or 2 or them for a bigger $1M property with the greater cash flow and tax benefits.
That’s what I’m working on…
What strategy should you use in real estate investing
I hope that I’ve been able to convince you that cash flow rules in real estate investing.
With that in mind, what strategy best capitalizes and maximizes cash flow along with all of the other wealth building advantages of real estate investing?
- Buy-and-hold, cash flow positive (>10%) multifamily properties with opportunity for forced appreciation and a plan to maximize tax benefits (passively or actively via REPS)
- Market appreciation is not a part of the strategy explicitly. Implicitly, we try to buy in attractive areas that we hope (key word: HOPE) will appreciate. If it does great! If not, no big deal.
What can you do to learn more about getting started with real estate investing?! Check out these posts:
- How To Actually Buy A Real Estate Investment Property
- A Physician’s Guide to Real Estate Investing
- How to Screen & Analyze Investment Properties the Right Way
- What You Need to Know About Assets and Liabilities
- Introducing the Carpe Diem MD Short Term Rentals Course!
What do you think? Do you invest in real estate for cash flow? Have you ever bought a cash flow negative property? Let me know in the comments below!
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