I’ve run across this situation and question several times over the years.
Here is the scenario. When it comes to investing in a property that may not currently cash flow positive (after all operating and financing expenses), but is a good value investment and has a good potential to cash flow positive in the future, should I put more money down to make it positive cash flow or put less down and have negative cash flow?
This issue is even more noticeable now with rapidly increasing interest rates. Finding positive cash flowing properties has become rarer than in previous years, so many real estate investors are sitting on the sidelines. They choose not to invest because there is a negative cash flow or low return on investment, that is less profitable than a GIC return or a stock dividend. One of the flaws in this is not considering the real cost of NOT deploying those investment dollars.
Is it all about the numbers? NO! But many investors only look at the immediate cash flow situation. Is that the correct way to look at it? Not really, as there are many more considerations to investing in a property. Is it a consideration? For sure it is!
It can become even more complicated due to issues that lie beyond just the property and its performance. These complications lie with the investor.
Investor Psychology
There is a psychology behind the investor’s choices and purchases (investments). It is important to understand what thoughts and risks are in an investor’s comfort zone vs his/her desires. The big consideration beyond the property is risk tolerance. There is no such thing as a risk-free investment, so every investor needs to be clear about what are the risks they are willing to accept.
Here are just a few of the risk tolerance categories for you to consider:
- Your Money invested (cash or borrowed)
- Vacancy, Repairs, and Maintenance
- Your Time frame (for returns and holding period)
- Management of your Expectations
- Your Personal Involvement (time and energy)
- Your Investor Knowledge Gap
- Distance of the property(s) – lack of control
- Your Peer Pressure and Opinions
- Negative cash flow over time
- Your Overall fear and other potential roadblocks
- Changing Market Conditions
- Overall Trust in Others
Investor Objectives
There are performance circumstances of the actual investment property to consider, which may also affect an investor’s psychology and objectives in investing.
Here are just a few circumstances:
- Taxes
- Time and Timing
- Amount of Potential negative Cash Flow
- Property Value Appreciation
- Return on Investment
- Exit Strategies
As a real estate investor, understanding your objectives, the various implications of the investment property and strategies employed, and your risk tolerance are invaluable and will serve you well. I say this a lot and it is worth repeating “The Success of the Investment has More to do with the investor than the investment”.
This is why some investors do well with investing in properties that initially exhibit negative cash flow.
Cash Flow Case Study
Here is a scenario where we look at a property and the differential between investing in a property cash flow and the implications of funding the down payment to remove negative cash flow.
For this example, it is assumed that the investor is buying it below replacement cost, market and assessed values, thus creating instant equity. Any appreciation potential is not considered, even though there would be.
In this example, we are using the basic information from a real condo in Edmonton that was recently acquired through a real bank-owned foreclosure by an investor.
- Low rise condominium complex with elevators and exercise room built in 2014
- Construction quality for owner-occupiers (not rental stock, but rentals are permitted)
- Two large bedrooms and two full bathrooms plus flex room – 850+ s.f.
- Finishes and amenities include, granite countertops, tile and wood floors, four full-sized appliances plus in-suite laundry
- Property has already gone through the foreclosure process and was now being sold by the lender.
- Tax assessed value $203,000 (2023) comparable units on market 2 at $210,000
- Purchased for $165,000
Let’s look at the details of the down payment and the cash flow and compare what would happen with using higher mortgage interest rates and real cash, not borrowed funds, for the down payment.
In this example with identical scenarios except for the effects of a greater down payment, you can see that to have the property’s cash flow breakeven after all rent and expenses, one would need to fund the down payment by an extra $23,925.00. This is a significant amount compared to the actual 20% down payment. We are assuming that the investor had $60,000.00 to fund the down payment and associated costs.
For demonstration purposes, let’s assume that rents and expenses stay flat. If we were to take negative cash flow and assume it stays the same for 5 years, that amount would total $8,488.08. This $8,488.08 is significantly less than the increase in the amount ($23,925.00) of down payment needed to bring the property to breakeven cash flow by $15,436.92.
The point I am trying to make is if you were to put even $10,000.00 instead of $8,488.08 into an account (not even an interest-bearing account) you would be able to service that negative cash flow for Five years and would have been able to use the remaining $13,925.00 differential for another investment.
I understand that this is a simplified example, as operating expenses and taxes can increase, but I have taken this into consideration, as rents can increase also, especially in Alberta. If you would like to understand or discuss the details to this comment, or if you are interested in finding investment opportunities like this, please feel free to schedule a Meeting.
If the “down payment versus cash flow” decision is to be made purely from a math perspective, keeping the down payment lower and putting aside the necessary funds in an account to service the negative cash flow is more economically efficient.
However, if we go back to understanding the psychology of the decisions, then the investor also needs to balance the math with his/her risk tolerances.
Again it is worth repeating “The Success of the Investment has More to do with the investor than the investment”.
When it comes to real estate investing, what are your areas of discomfort and how can you overcome them?
I have helped many new and seasoned real estate investors since 1995, so please feel free to email me with your questions or schedule a Meeting to discuss your personal real estate investing goals.
