When is Negative Cash Flow OK?

by Paul Hecht30 Jul 2012

I recently attended a Real Estate conference in which I was a guest panelist with many of Canada’s brightest investment experts.

An audience member posed a question that was followed by a heated debate on the panel. The question was, “Is it ever okay to buy a negative cash flow property?”

A relatively simple question on the surface however the debate on the panel was anything but that and one that I’d like to share with you. Many of the experts answered very quickly “never,” yet other experts answered “yes,” including myself.

Just to clarify, we were referring to monthly cash flow, which is income minus expenses equal cash flow. Income is from rent, laundry, parking and anything else you can charge for. Expenses include mortgage(s)/debt payments, property tax, insurance, repairs and maintenance, property management, vacancy allowance, utilities and other miscellaneous ongoing costs. If the income is equal to all the expenses, then the property is said to break even. If there is more income than expense, then the property is said to have positive cash flow and if the expenses exceed the income, then the property is deemed to have negative cash flow.

Many areas within Canada currently have negative cash flow simply because the rent in that area does support the current price. This is often seen in markets where the price has increased faster than rents and/or there is a high supply of rental inventory providing many options for tenants. If you have negative cash flow, then you as a landlord are paying some of the expenses every month with your personal income. This creates four outcomes:

1.    It puts your entire portfolio at risk. In the event that you lose your job or current income, you can no longer support your negative cash flow, which often leads to the immediate sale of your investment property (especially if you have a small or no reserve fund at all.) Job losses often happen when markets slow. When the job market slows, so does the real estate market, making a sale even more difficult. This has happened many times in history and history tends to repeats itself. Many have lost their jobs and all their investments because of negative cash flow. If the investment supports itself and is not supported by your income, then you can lose your job and still keep your investments. Positive cash flow gets you through the downturns.

2.    If any of your expenses such as repairs and maintenance suddenly increase, then your negative cash flow increases putting further stress on your job and/or personal income. You have no wiggle room. Not being able to repair your property causes further deterioration that decreases the value of your asset. With negative cash flow, this can be a huge burden even if you have a job.

3.    It limits your ability to grow your portfolio. When an investor is seeking to acquire more properties, the lender will look at how much income is generated from the current real estate compared to the expenses. If the property shows negative cash flow, the lender may decline the loan or give you less money as they now have to use your job income as part of the qualifying. On the other hand, if the income exceeds the expenses, the lender is more likely to keep giving you money to continue to buy more income real estate.

4.    When the mortgage matures and comes due for renewal, the existing lender may not renew if the negative cash flow is too high. Alternately, they may renew as long as you reduce the mortgage balance to a level that supports the existing income. If that were the case, you would need to come up with a lump sum of cash to reduce the mortgage balance.

The panel experts whose primary strategy is to buy existing rental property and hold them long term adamantly answered “never,” for valid reasons. On the other hand, there are certain situations when it is okay to buy negative cashflow properties.

When re-developing a property to a higher and better use or standard, the objective is to change the current cashflow. Renovating to a higher standard and / or adding amenities allows you to charge higher rent. And by replacing old inefficient systems such as heating, cooling, windows, insulation, roof, etc., you can also decrease the ongoing expenses.

For example, an existing property that breaks even at $1,000/mo, yet is currently rented for only $900, would show negative cashflow and not be suitable for the investor looking only at the current cashflow. However, it may be the perfect candidate for the investor seeking to change the existing cashflow.

Here’s how. A $30K renovation would cost an extra $150/mo at today’s rates. In this case, you would need $1,150 to break even. However, if you could rent that unit for $1,450/mo after a renovation, then your cashflow would be positive by $300.00/mo. Plus, your ongoing maintenance costs should also be reduced providing even more positive cashflow.

Another circumstance when negative cashflow is not important is when an investor is changing the use of the building such as converting an existing rental building into individual condominium units for resale. The investor is looking at the overall profit and not concerned with what the unit can rent for.

If an investor is flipping a house or assigning a contract, again the cashflow is not the primary objective since they are not planning on holding the property long term. In this case, the investor must be very cautious as the market can turn and the investor can end up holding the property if they are unable to sell it. If you are flipping, I'd highly recommend you flip properties that can support themselves, just in case.

At the end of the day, most experts support the idea of positive cashflow when holding real estate long term for many of the reasons above. However, if your strategy does not rely on the existing monthly cashflow and your plan is to either change it or use an alternate strategy all together, then yes, there are times when it’s okay to buy a negative cashflow property.


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