Why is Positive Cash Flow so Important in a Buy and Hold Investment Property Portfolio?
With increasing mortgage interest rates, operating costs, insurance rates, and property taxes, monitoring cash flow could very quickly take a front seat in many real estate investors’ portfolios. This situation could be even more significant for those investments that are heavily leveraged.
When Cash Flow May not be as Important
As Canada is one of the most popular countries in which to invest and live due to the economic strength and stability, personal freedoms, climate, etc., there is a constant demand for housing. Many investors look to park their money in a safe haven and Canada more than fits that bill. These investors are looking for preservation of capital at a minimum.
The importance of positive cash flow seems pretty self-explanatory. However, when we consider that many property investors investing in the very expensive Greater Vancouver area, you may have few questions as to why it doesn’t seem to be as important to them. Let’s address this.
Not all buy and hold investors appear to be concerned with positive cash flow from their properties. So why is that? In my experience, these investors are mostly focused on the property’s appreciation component, because that growth can be, as we have seen in recent months, almost exponential. In some areas, properties were increasing by double digits year over year.
Typically, these investors are financially well-heeled and have already considered and accepted the impact and cost of financially carrying the property. They will have rented the property out to offset some or all the operating costs and if applicable, financing costs. This is a unique situation and not the norm for most investors.
Vancouver’s location is truly unique in Canada. It is geographically constrained by water, mountains, and borders, so it’s easy to see why values are consistently increasing upwards over the last 45 years.
Cash Flow + Appreciation = Powerful Real Estate
In my opinion, it is not a matter of having cash flow or appreciation, but the best scenario is when you achieve both, because Appreciation = Wealth Creation and Positive Cash Flow = Sustainability and Income. The combination of these two is where the power lies. In order to create wealth in real estate, you need to be able pay the bills which means you need holding power whether the property is rented or not. Cash flow gives you that holding power needed to ride out the ups and downs of real estate cycles. Cash flow also provides you income to potentially replace your earned income through a job or career.
What Does A Bump in Interest Rates Look Like for Your Cash Flow?
For the purposes of this blog, I am not going to speak to the merits of taking a fixed rate or a variable rate mortgage here. If you are interested in seeing an excellent post on that subject, please go to this link by Keaton Kirkwood.
Let’s consider some real numbers by looking that the table below. These amounts are based upon a 25 year amortization and interest being compounded semi-annually.
Additional mortgage payment amount/$1,000
|Interest Rate||Payment||Interest Rate||Payment|
So, let’s take an example of $500,000 property with a 75% LTV mortgage at 3% interest rate, and with a 25 year amortization period and a 30% operating expense ratio to a $3,000 monthly rental income. The expense ratio would be $1,000. The mortgage payment would be about $1,775. So, at 3% interest, your net monthly cash flow would be about $225. Okay that is not so bad, you’re in the black! But at 4.5% this property is already at negative $76 per month cash flow.
Now, that might be fine for many investors as that carrying cost is about $19/week. Alone, this is not so terrible in the big picture. However, in a period of rising interest rates, there are some real considerations to address before things get out of hand such as:
- When and if can you raise the rents and by how much?
- What other expenses are likely to rise in the near future?
- How comfortable are you to carry that property?
- What is the length of time that you can realistically carry that property?
- At what cash flow threshold does it become financially and or emotionally problematic?
- Where is your breaking point? What can or will you do if you hit that breaking point?
- Are there any external forces that may work in your favour such as the economy is picking up and rents can actually be increased?
- Can you increase your cash flow by renting out another part of the property such as the parking?
- Can you cut any cost costs? If so, where?
- Who can you speak with to get advice?
Take Action Early
Do your analysis early and regularly! Hoping for the best is NOT an option. You are always better off to address any potential obstacle early to see how you can turn it into potential opportunity before it becomes a problem. Pay attention to your market conditions, both at a macro and micro level. Speak to your real estate advisor, mentors, and other real estate investors you may know. Contact your investment mortgage broker, or if you do not have one, then I recommend emailing Keaton Kirkwood to see what options are available and what suggestions they may have for solutions.