Guest Article by Ray Wei of Onerent
Conventional wisdom should be questioned. Remember, at one time or another, conventional wisdom held that the sun revolved around the earth, or that the earth was flat, or that smoking was completely safe.
Even when conventional wisdom isn’t wrong, it can be limiting. For example, most real estate investors will tell you to avoid negative cash flow properties. This is good advice if you’re only in the business for a steady monthly income. But is negative cash flow always a deal breaker?
The Case for (Temporary) Negative Cash Flow
Before we go any farther, know that only people with considerable experience should consider negative cash flow investments. While these deals can be very profitable, plenty of stars need to align to make them work.
The simplest example is that of buying a property that needs updates and repairs, before it can be rented profitably. While the property will (hopefully) produce strong cash flow eventually, first the investor will need to pour more money into it, and carry the mortgage in the meantime.
Often it’s not just the property that needs some TLC though, but the neighborhood itself.
Imagine an up-and-coming neighborhood, that’s starting to turn the corner but is still littered with outdated buildings. Could you buy in now, while prices – and rents – remain low?
If you can take them on at a good price and carry them while they’re being refurbished, you’ll stand to experience significant gains. But you’ll also experience negative cash flow while you get them in shape.
The neighborhood might offer only mediocre returns now, but if you know that there will soon be a Starbucks on every corner, you might well buy in before prices and rents skyrocket.
You’ll have to be excellent at managing these sorts of projects, to make deals like this work. Do you have the management skills required to ensure the renovations are complete and the buildings are earning before you deplete your investment capital?
Speaking of capital, you’ll need plenty of cash you can funnel into supporting the buildings while the renovations are underway. And if cash flow is intermittent while the neighborhood improves, can you survive until you can justify those higher rents you have planned?
Before investing, it’s important to know exactly why the properties are priced where they are, what repairs are needed, and how much it will cost you to get them turned around.
If they’re in a good area, but were allowed to fall into disrepair by the previous owner, you’ll have a good shot of turning lead to gold. But you must know the neighborhood and the forces shaping it extremely well before you invest.
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You will also need to know the three key elements of a great real estate investment:
- Long-Term Positive Cash Flow. Of course any great investment needs opportunity for higher returns in the future. Learn to calculate cash flow accurately and you will be on the right track.
- Managed Risk. How much control do you have over the neighborhood’s development? Larger investors and developers might have a great deal of control, buying up entire blocks. Smaller mom-and-pop investors might only be able to buy a few properties. How confident do you feel that the neighborhood will continue improving?
- Low Maintenance. Maintenance means the amount of man hours you are putting in every week. You want to find a property that will not demand much personal attention. This will lower your operational costs and boost the time you can use finding more properties to invest in (or, you know, relaxing on the beach!).
While calculating the time and capital requirements, be careful of the temptation to be optimistic. Adjust for this “optimism bias” by setting aside more than you think you’ll need, to help mitigate the risk of running out of capital before the project is complete. If you think you’ll need three months, budget for six. Leave room in your budget for error and overages.
Plan for Exit Strategies
Getting into a negative cash flow deal is easy, but getting out profitably is the key to making it a successful investment.
A property may not cash flow well when you buy it, but can you change that? What can you do to make the property more appealing to prospective renters? To raise the property’s value?
For that matter, what can you do to make the neighborhood more appealing?
The trick is to get the property cash-flowing positively as quickly as possible. You can always sell properties that cash flow; it’s much harder to sell properties with a negative cash flow.
One way to manage your risk is to have multiple contingencies planned for exit strategies. Can you sell the property to a first-time homebuyer? What about to an investor? If those both fail, can you earn positive cash flow while you rent it and allow it to appreciate it?
Can you lease it as a rent-to-own, with a lease-option agreement? That can be an effective (if slower) way to sell your property, with no Realtor commission to boot.
Start thinking in terms of creating your own appreciation, through better property management, property improvements, and neighborhood improvements. What can you do to boost rents and home values in a target neighborhood? What can you do to ensure that the properties you’re buying at low prices and low rents see improvements in both?
If you buy a property with negative cash flow, make sure you have a plan and several contingencies, to make sure it reaches positive cash flow quickly!
Onerent is a rental leasing and management service for the modern owner and renter, managing over 1,000 properties across the San Francisco Bay Area, and Greater Seattle. Onerent offers free real estate education and resources on the Build with Onerent Blog. Find answers to all your legal maintenance finance and leasing questions as well as real estate news that affecting the housing market.