Would You Buy A Property With Negative Cash Flow
There has been a recent Toronto Star article about warnings that residential real estate doesn't make sense anymore as the rents aren't rising to meet the carrying costs of the investment.
Here’s an excerpt from the article:
“…real estate experts are warning that the investment scene will shift in less than five years as the cost of condos continues to climb at the same time Toronto tenants show signs of hitting a wall when it comes to paying for an apartment.
That will have significant cash flow implications for property investors because rent won’t cover the monthly carrying cost of those units, said Shaun Hildebrand, president of market research firm Urbanation.”
So the question is, would you buy a property that has a negative cash flow? Continue below to read why I would suggest you should do it.
Here’s the Toronto Star article: "Condo prices are set to put many investors in the red as rents fail to meet carrying costs, experts warn"
Negative Cash Flow
Cash flow—it’s a term real estate investors eat, sleep, and live for. Maybe it’s used in reference to bigger sums of cash flow, as in flipping, or more often it’s used in terms of the monthly cash flow that a rental property does (or doesn’t) bring in. Either way, cash needs to be flowing in for a real estate investment to be a win...or does it?
The first question every investor should ask when they are shopping for an investment rental property is whether or not it will cash flow.
The second question every investor should ask, should they find out a property isn’t expected to cash flow, is if there’s no cash flow, where will my returns come from?
There are two scenarios where negative monthly cash flow may be able to be made up:
1. House appreciation
2. Long-term gain (Equity)
Breaking Down The Numbers
There are several great APPS that you can download or websites you can use to determine a property's cash flow. I use this app that you can download from the App Store (I receive no financial benefit nor endorse fee for this specific app...I just simply like using it.)
I selected a previously sold property in downtown Toronto in September 2019 in the popular rental area of 112 George Street.
- 600-699 square feet
- 1+1 bedrooms
- Maintenance Fees $434.38
- Property Taxes $2,540.53
- Purchase Price $695,000
Potential Investment Property Broken Down
Using the real example with a downpayment of 20% downpayment or $139,000 your monthly fixed payment would be $2,276.00 amortized over 30 years. Property tax of $212 plus monthly maintenance fees of $434.00 and a rental income of $2,500.00/month would yield you a negative cash flow of $423.00/month.
A search of all 1+1 rental units in the building over the past 18 months shows a range between $2,400.00 to $2,650.00 per month. Using an average cost method I determined the realistic rent you could realize would be $2,500 or more dollars per month.
A bad investment you might say...Why would you drop $139,000.00 to lose $423.00/month?
If you look at your principle mortgage payment in year one it comes out to $12,052 annually with an average monthly cost of $1,004.33 minus your negative monthly cash flow 423.00 nets you $581.33.
I refer to this as your forced savings. Like setting aside a $100.00 per month into a 'just in case' fund you might have for unexpected expenses or for future plans such as retirement, travel, school, etc.
By investing $423.00 per month (the negative cash flow) you grow your equity by $581.33 per month. If you choose to accelerate your payments Bi-Weekly you can decrease the interest paid resulting in an overall increase in your net equity growth.
So if you didn't purchase a negative cash flow property you would miss out on capital appreciation in our Toronto market. Is it reckless of me to suggest that Toronto home prices are going to continue to rise...speculative perhaps and I do believe they will continue to rise especially over time.
As a background, Canada has strong immigration, a strong economy, for the most part, a diversified cultural and economic footprint, and let's face it Canada is a very politically safe country. WE are a very safe place to invest in.
The rental market will remain strong. Housing demand is very strong and in particular Vancouver, Toronto, and Montreal. In Toronto, there is an even greater demand to live in the core. Many people are no longer prepared to face longer commute times, traffic congestion, and simply wish to enjoy a more urban lifestyle.
it is safe to say that house inflation (the rate of appreciation) will continue to grow at the rate of core inflation and according to the Government of Canada the national annual rate of house appreciation is 4.6%.
Taking a look at the amortization table for the above example you can see over a 5 year period the amount of Principal repayment (capital appreciation) will be $63,741.00 (assumption: you secured a fixed 5-year rate). So what's the cost? Investing negative cash flow of $423.00/month X 12 x 5 years = $25,380.00. The net equity gain would be $38,361.00. Would it make sense to invest in something that was guaranteed to make you a 151% return on that investment?
If you are a believer (please no Justin Bieber jokes here) that properties will continue to rise in price and using the figure of 4.6% year over year increase then your capital appreciation over the 5 year period will rise from a purchase price of $695,000.00 to $831,977.00 or a capital appreciation of $136,977.42.
When you add the house inflation value and the principal equity growth value your total capital appreciation over 5 years for this initially negative cash flow property amounts to $200,718.42
Is it starting to sound like buying a negative cash flow property might actually be a good over-all investment?
Mo' Money Less Taxes
Using the example above if you take the $2,500.00 per month income you will generate $30,000.00 gross.
Here is where the magic comes in. As an investment, you are allowed to offset expenses against that income. We call this the P.I.T.M. principle.
Principle, interest, taxes, and maintenance on the property. You don't get to actually write off the principal amount you paid on your mortgage however you do get to write off the interest, taxes, and maintenance fees. What you can do with the property, and seeking/using a good accountant you can depreciate your property over time resulting in deferring paying tax on income earned.
Why would you consider this? Well let's say today you are in a tax bracket over 40% and in 10 years or 20 years your asset is depreciated and you are required to pay the deferred tax on the revenue deferred. However, because your tax bracket is likely going to be lower than it is today it could have a positive effect on how much more equity you will retain. My advice here is to contact a very knowledgeable accountant who can explain the benefits and risks with you.
There is a saying that states; Time Value Of Money Is Important. Would you rather have a dollar today or a dollar 25 years from now. A dollar today is worth a lot more!
Inflation Is Eating You Alive
According to Statistics Canada consumer price index, today's prices in 2020 are 16.09% higher than average prices since 2010. The Canadian dollar experienced an average inflation rate of 1.50% per year during this period, meaning the real value of a dollar decreased.
In other words, $100 in 2010 is equivalent in purchasing power to about $116.09 in 2020, a difference of $16.09 over 10 years.
The 2010 inflation rate was 2.35%. The current inflation rate (2019 to 2020) is now 2.25%. If this number holds, $100 today will be equivalent in buying power to $102.25 next year.
In simpler terms, waiting to buy a property next year means you likely will reduce the value of your money and buying power by 2.25% For every 100,000.00 dollars it will only be worth $97,750.00 meaning you are going to have to save an additional $2,250.00 for every hundred thousand dollars in order to purchase your investment property.
If you waited for example from 2010 to 2010 the value of your saved dollars in 2010 is not worth that same value. In fact, they are worth 16.09% less.
If you're old enough (come on Boomers put your hands up) and remember at one time a cup of country-style donuts coffee cost $0.50 and today a Starbucks coffee can run you $3.00 or more.
Waiting for a cash positive investment property may not be the best solution if you consider how inflation devalues that investment by waiting.
The great thing about rent is that it doesn't stay there forever. And even then if you do have a longer-term tenant you are guaranteed rental rate increases in Ontario each year.
When a Tenant does leave, which can happen every year, your ability to re-lease the property will be at current market rates and likely at a much higher rate than the current tenant is paying. Over the time of the investment property, it is likely that the rent will increase and you will increase your equity over this time.
Taking the example above with a small rent increase of 2% per year for 5 years
- Year 1 $2,500.00 per month x 12 months = $30,000.00
- Year 2 $2,550.00 per month x 12 months = $30,600.00
- year 3 $2,601.00 per month x 12 months = $31,212.00
- Year 4 $2,653.00 per month x 12 months = $31,836.00
- Year 5 $2,706.00 per month x 12 months = $32,473.00
As you can see on a very conservative method the value of your investment is going up exponentially over the 5 year period totaling $6,121.00 more dollars. If the tenant does move out and you can rent the property for more than a 2% increase it will have an even greater impact on how much more money you're going to make.
What I am trying to express is don't discount buying a negative cash flow property because today it might be under-water and within a year or so it might, in fact, be cash neutral or even cash positive.
Understanding Your Investment
When evaluating whether an investment property is right for you there are likely a few more reasons than what I have stated in this blog.
For me, the best way to understand the true value of investing in real estate really can be broken down into these areas.
- Rental Income
- Capital Appreciation
- House Inflation Appreciation
- Cost of repair and maintenance
- Vacancy costs
- Property management
Can I monetize the property? Can I grow my equity and capital appreciation? Can I grow my house inflation? If you say yes to these 3 questions then you really should consider making an investment.