Positive cash flow by John T. Reed Copyright 2002 by John T. Reed Seminar and home-study course ratings Roughly speaking, there are two ways to get positive cash flow from a rental property: The capitalization rate exceeds the annual loan constant where the loan-to-value ratio is normal (70 to 80%) The loan-to-value ratio is abnormally low (60% or lower) The precise formula is that your loan-to-value ratio multiplied by your annual constant must be lower than your cap rate to get positive cash flow. Capitalization rate The capitalization or cap rate of a rental property is its annual net operating income divided by its price. For example, a $1,000,000 property with $60,000 of net operating income per year has a cap rate of $60,000 ÷ $1,000,000 = 6%. Net operating income is the gross income minus the operating expenses, but not the mortgage payments. Another way to define cap rate is that it is the cash-on-cash return you get when you have no mortgage on the property. Annual loan constant The annual loan constant is the sum of the annual mortgage payments divided by the mortgage balance. In a 30-year fixed rate mortgage, the annual loan constant is a little higher than the mortgage interest rate at the outset of the mortgage term. For example, the annual constant on a 30-year fixed rate mortgage at 7.25% is 8.14% initially. The shorter the remaining term, the higher the constant. In the case of an adjustable-rate mortgage, the worst-case lifetime cap payments should be used because of the inability to know whether rates will increase after closing. Loan-to-value ratio The loan-to-value ratio is the total mortgages on the property divided by the value of the property. The typical homeowner has an 80 to 90% loan-to-value ratio right after purchasing a house. Example Seattle has an excellent apartment building consultant named Mike Scott (https://www.dsaa.com/). He says that true cap rates in his area were about 7.8% on average in 2001. Such a building with a 30-year, fixed rate 7.25% mortgage would have a slight positive cash flow"”7.8% - 7.52% = .28% of the gross income would be the positive cash flow. Operating-expense ratios The operating-expense ratio of a residential rental property is 45% plus or minus about 2%. That is, the operating expenses"”taxes, management, utilities, insurance, etc."”will consume about 45% of the gross income. That percentage applies all over the U.S. for all types of residential property including those where the owner pays all utilities and those where the tenant pays all utilities. (The more expenses the tenant pays, the lower the rent must be, so the landlord' operating-expense ratio stays the same.) For confirmation, see the annual income-expenses analyses put out by the Institute of Real Estate Management and the National Apartment Association as well as by local apartment association and broker studies. Liar' statements When I attended CCIM courses, the brokers who taught them called the property income-expense statements prepared by sellers "Liar' Statements." That' because they typically show operating expense ratios of around 30% rather than the correct 45%. (Liar' statements also contain

next year' hoped-for rents rather than current rents.) When I attended IREM courses, the property managers who taught them called the property income-expense statements prepared by brokers "Liars statements," for the same reasons. It should be noted that both CCIM and IREM are subsidiaries of the National Association of Realtors'®. Now that you have learned this, you may be tempted to express your contempt for the next 30% operating-expense ratio statement that is handed to you by a broker or seller. That would not be prudent. Yes, it is a liar' statment. Yes, you know it. But no, you should not say it. Calling the seller or broker a liar is not conducive to successful negotiations. Just accept the liar' statement without comment and throw it in the trash when you get away from him. Then reconstruct a correct operating statement. My Residential Property Acquisition Handbook shows how. If it looks like you can do the deal you need, make an offer. If not, try to maintain cordial relations in case you encounter that seller or agent again. If the person lying about operating-expense ratios is a guru, however, feel free to call him the liar that he is. Idiot' statements Liar' statements are caused by a conscious attempt to mislead buyers. Idiot' statements arise from ignorance. Beginners tend to ignore or overlook many expenses like vacancy and collection loss, management (or the value of your time if you plan to manage the property yourself), replacement of items like roofs and hot water heaters, repairs, and so forth. Because of their ignorance, they come up with operating expense ratios of 30% or less just like the liars. I have had a number of arguments about this with beginners. Several have contacted me a year or so later to admit, "You were right. I underestimated the expenses." Well, duh! There are only several dozen annual studies on the ratio. The real estate world has not been waiting for some beginner to come along and tell us how much it costs to operate an apartment building. True cap rates To get the true cap rate on the property you are considering, get the true current annual rents, not projected rents. Then multiply that number by 100% - 45% = 55% to get the annual net operating income. Divide that number by your purchase price to get your cap rate. If that number is greater than your annual mortgage constant, you will have positive cash flow. In general, you will find that true cap rates on apartment buildings are around 6% to 8%. Since mortgage interest rates are 7.25% or higher, most apartment buildings have negative cash flow. True cap rates on single-family rental houses are significantly lower"”like 4% to 5.5%. That' why virtually all rental houses with normal loan-to-value ratios have negative cash flow. Low loan-to-value ratio No matter what your cap rate, you can get positive cash flow by having an abnormally low loan-to-value ratio. Achieving positive cash flow that way is like playing tennis without a net. For example, to take an extreme case, consider a mortage that is only 10% of the value of the property"”like a $100,000 mortgage on a $1,000,000 building. Bragging that you have positive cash flow on that building is like bragging that your high school football team beat a junior pee wee youth football team. Of course, you have positive cash flow! Your mortgage payments are so tiny a chimpanzee would have positive cash flow with that property. What' difficult is having positive cash flow when your loan-to-value ratio is 70%. Similarly, it is deceitful for an investor to brag about positive cash flow when he has an adjustable rate mortgage. In effect, he has made himself an insurance company. The lender is his policyholder. The positive cash flow is essentially the "premium" being paid by the lender for the insurance. But if market interest rates go up, the borrower will have to pay the lender' "insurance claim" (higher payments), which will cause a worse negative cash flow than if the borrower had gotten a fixed-rate mortgage at the outset. Gurus" strategies for positive cash flow Most real estate gurus are just salesmen who know little about real estate investment, but who want to part you from your money. The people they target are either beginners or relatively new investors. Relatively new investors have enough experience to know what I just said above, that almost all normal rental properties have negative cash flow. As a result, bad gurus often encounter the objection, "I do not want to buy your multi-thousand dollar information product because I will get negative cash flow if I follow your advice." Because they are salesmen, they need a way to overcome that objection. One way they do it is to issue liar' statements of their own"”namely by saying that you can expect operating-expense ratios of 30% when you buy rental property. Another tactic they advocate is accruing interest. To a novice, that sounds like a trick that sophisticated real estate investors must use to avoid negative cash flow. In fact, accruing interest simply means borrowing more money each month to conceal the fact that the property is losing money. Borrowing money to cover losses is a debtor' death spiral. Bad gurus do not mind charging you thousands of dollars to send you into a death sprial because they are sociopaths. Pay more to rent than to buy Would-be investors should consider positive cash flow from the tenant' perspective. In order for a single-family rental house to have positive cash flow, the tenant must pay more to rent the house than he would have to pay to own the same house. That is obviously a stupid thing to do. And that' why you almost never see it. How you achieve positive cash flow ethically in the real world So how do you achieve positive cash flow ethically in the real world? You need to buy in the rare market where high cap rates are the norm. Such markets are usually severely depressed like Anchorage or Oklahoma City in the late 80'. The reason tenants are willing to pay more to rent than they would have to pay to own in such markets is that they believe property values are falling or level, in which case not owning is a good idea in spite of the high rent. Even then, the positive-cash-flow situation is typically a brief window that lasts only six months to a year. Positive cash flow is so rare and so desirable that it attracts out-of-area investors. Their coming into Anchorage or Oklahoma City or wherever drives the prices up so that high cap rates are no longer available. The other way to achieve positive cash flow is to make a bargain purchase like at a foreclosure auction or out of probate. In that case, your have a low loan-to-value ratio, even though your loan-to-purchase-price ratio may not be low. When you achieve a positive cash flow through a bargain purchase, you generally should sell out soon because your extraordinary amount of equity will result in your return on equity being low. Return on your investment is interesting to look at initially, but after purchase, you should switch to looking at your return on current equity. Dividing current net operating income by past purchase price is a misleading apples-and-oranges comparison. Return on investment (down payment and closing costs) will be high initially and climb higher if you bought right. But return on current equity (current market value of building less current mortgage balances), which is the correct denominator, will show a low and falling rate of return. That tells you to redeploy your money to where it can earn a higher return. Why invest in real estate then? A number of people who read this article said it is saying that investing in real estase never makes sense because it is never profitable. No. It does not say that. There are four possible financial benefits to investing in real estate: "¢ appreciation "¢ positive cash flow "¢ tax savings "¢ amorization of the mortgage Most investors today expect to get most of their return from apprecation. Consequently, they are willing to accept little or no cash flow or more commonly, negative cash flow. Tax savings were drastically curtailed if not eliminated by the Tax Reform Act of 1986. Amorization (pay down) of the mortgage is a pittance in the early years of a loan. I do not agree with the notion that you should accept negative cash flow because appreciation will more than pay you back. But that is why most investors do accept negative cash flow. So the guru who told you that real estate investment was a way to pick up extra cash lied to you. He told you that because it was what you wanted to hear, not because it was true. In fact, owning rental property almost inavriably has the exact opposite effect on your cash flow. It takes your current annual cash flow and confiscates part of it to feed the rental property. Only if you buy on a bargain basis or increase the value of the property significantly can you get positive cash flow from a rental property. Can that be done? Yes. Is it easy money? Hell, no! Is it passive income? Hell, no! You will earn every penny of it. If you are still interested, buy my pertinent books. If you do not want to work hard and take risks, get out of real estate altogether before you get hurt. John T. Reed, a.k.a. John Reed, Jack Reed, 342 Bryan Drive, Alamo, CA 94507, Voice: 925-820-7262, Fax: 925-820-1259, www.johntreed.com

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