By Bruce Kellogg
The Problem For Investors
As property prices rise in many markets across the country, it is becoming increasingly difficult for investors to acquire properties with a positive cash flow. Nowadays, it is all the more important to know how to deal with negative cash flow (“NCF”). Here are a number of solutions.
Intelligent Property Selection
Although it should be obvious, the first step to avoiding NCF is to resolve to acquire only properties that don’t have it, or can be structured not to have it. Especially in strong markets, some investors adopt the position that NCF doesn’t matter because the market will bail them out through appreciation or rising rents. This doesn’t always happen! Buy intelligently in the first place!
Increase the Units
It’s pretty well known in real estate investing that the more units acquired the greater the cash flow for any given price range. For example, in Silicon Valley a 7-plex for $1.4 mil. will probably cash flow better than a $1.2 mil. 4-plex. Generally-speaking, for more cash flow, buy as many units as possible.
Buy Better Quality
It is also well known that “low-income” properties suffer from greater turnover, more vacancies, and higher maintenance expenses. They are also more management-intensive. Buy better quality whenever possible. Leave the “war zone” properties to the commando’s!
After a qualifying property is identified, structure the transaction for success. This involves the right price, the right down payment, the right entity (e.g., partnership), the right loan terms, and so on. Over the long term, proper design of the transaction is probably the most important step.
Lower the Price
Although intuitive, the first step toward reducing NCF is to negotiate a lower price. Go back and forth several times if necessary. It will benefit throughout the entire ownership period.
Set Up A Cash Reserve
When structuring the purchase, if there will be an unavoidable NCF, set up a cash reserve for the period that cash flow is projected to be negative. It could be a cash account, or a tax refund, or a note payoff, pending inheritance, whatever. But get it done!
Another approach is to designate a specific note or specific property in the portfolio that has a sufficient positive cash flow to serve as an “offset” to the NCF. But be sure to tie the two together. Don’t just say, “The portfolio can cover it.” Often, that kind of “loose thinking” can get an investor overextended as more properties are acquired.
Usually, an effective way to handle NCF is through the use of a partner. There are several kinds of these. An investor/partner could be brought in with a Limited Partnership (LP), or a Tenancy-in-Common (TIC). Or, in some instances, it is possible to partner with the seller using a Lease-Option or a Shared-Appreciation Mortgage (SAM). It is also possible to partner with a tenant using a Lease-Option (“Rent-to-Own”) or Equity-Sharing. These all work well under the right circumstances.
Creative “Carryback” Financing.
If there is seller financing in the transaction, there are several note terms that will reduce NCF. One is to delay the first payment as long as the seller will agree, perhaps a year. Another is to agree to interest-only or principal-only payments. How about accruing all payments until maturity? (That’s a risky one!) And on commercial property transactions, the Graduated-Payment Mortgage (GPM) is still possible under Dodd-Frank.
Many times when an investor purchases a property, it is with the objective of enhancing its performance. This typically involves raising rents, reducing expenses, increasing occupancy, and improving management. All of these actions will reduce NCF.
A new investment type, AIRBNB, has come on the scene, and generally offers impressively strong cash flows. This is outside the scope of this article, but the reader is advised to investigate it to see if it is for them. Start with an internet search.
Even in highly-appreciated markets, it is still possible to invest and deal with NCF. You just have to learn how, or work with an expert who knows. Because market conditions change, it is prudent to factor a possible 10-15% rent decrease or vacancy factor increase into the calculations. You don’t want to get caught short at an inopportune time. Having an unused credit line is also a good idea.
Bruce Kellogg has been a Realtor® and investor for 36 years. He has transacted about 800 properties in 12 California counties. These include 1-4 units, 5+ apartments, offices, mixed-use buildings, land, lots, mobile homes, cabins, and churches.
Mr. Kellogg is a contributor and copy editor for two national real estate wealth-building magazines: Realty411, and REI Wealth Mag.
He is available for listing, selling, consulting, mentoring, and partnering. Reach him at [email protected], or (408) 489-0131.