If you are frustrated trying to find a deal that provides great cash flow, you are not alone. Unfortunately, finding a deal with excellent cash-on-cash returns in today’s market is challenging.
Basic market dynamics have been making it difficult to find cash flow for nearly a decade, and the current red-hot market is making things worse. I recently simulated cash flow for the 588 largest cities in the United States and the average (un-weighted) cash flow was -6.5%.
But there is no fear. Cash flow is just one of four ways that real estate investors generate income from rental property. There are other ways to make a great income.
Cash flow is crucial for investors looking to quit their jobs or reach retirement age soon. But if you stay in the game in the long run, there is a good return without cash flow.
Why is it difficult to find cash flow?
Cash flow is having a hard time finding a simple reason: home prices are rising faster than rents.
Because home prices are the biggest cost base that an investor faces (policy, interest, taxes, insurance), when home prices go up, so do the costs. Therefore, if the rent does not keep pace with the rate of house inflation in a particular market, the probability of cash flow in that market (or the market as a whole) will decrease.
I see a very simple example from Columbus, Ohio (which I chose randomly).
Back in 2014, the average price of a home in Columbus was $ 148,600, with a monthly rent of 95 954. By April 2021 – exactly seven years later – the average house price in Columbus was $ 244,200 $ 1,302 rent.
Both went up a lot! But housing prices rose further. When you calculate the compound annual growth rate (CAGR) for the value of the house, you get a growth rate of 7.4% for the value of the house compared to a growth rate of only 4.54% for rent. This inconsistency will have a big impact on cash flow.
Let’s see how these changes would affect cash flow if our only expense was tax and P&I. I am only using these costs because they are easy to calculate and do not vary from house to house. All we need is a house price to calculate them.
Using the BiggerPockets Mortgage Calculator, I set the monthly capital and interest amount for the middle house in 2014 and the middle house in 2021. I have also noticed that the effective tax rate in Columbus is 1.48% and the estimated tax is calculated (I know that mid-sale prices are not equal to the assessed value for most homes, but I am trying to give a simple example here).
|Monthly rent||$ 954|
|Annual income from rent||11,448|
|The price of the house||$ 148,600|
|Monthly payment and interest||$ 567.55|
|Total annual payments and interest||6,810.60|
|Effective tax rate||1.48%|
|Annual tax||$ 2,199.28|
|Total annual payments, interest and taxes||$ 9,099.88|
|Monthly rent||$ 1,302|
|Annual income from rent||15,624|
|The price of the house||244,200|
|Monthly payment and interest||$ 932.67|
|Total annual payments and interest||$ 11,192.04|
|Effective tax rate||1.48%|
|Annual tax||$ 3,614.16|
|Total annual payments, interest and taxes||$ 14,806.2|
The cash remaining after just two expenditures – P&I and taxes – was almost three times higher in 2014 than in 2021.
This is a very simple example, but this dynamic exists across almost all markets in the United States. Looking back to 2014, the average rental CAGR is 4.1%, which is great! But, compared to home prices with a CAGR of 6%, most markets in the United States do not match income with expenses.
Unfortunately, this dynamic is also accelerating late. Since the early 2020s and the Covid-1-induced frenzy in the real estate market, home prices in the United States have risen by an average of 12.8%, while the rate of rent growth has been less than half of 6.1%.
If you’re wondering why rent didn’t keep up with housing prices, this is a great question with a very complex answer.
Storm conditions are perfect for increased housing prices: low interest rates, high demand and very low inventory. In terms of the rent of things, my personal opinion is that stable wages in the United States limit the rise in rent.
As you can see from the chart above, wage growth has not recovered from the financial crisis. Experts recommend that tenants not spend more than 30% of their income on rent. If their income does not increase, then the total dollars tenants can / should spend on rent.
The chart shows that the average wage increase since 2014 is about .5%. I don’t think it’s a coincidence that rent increases at the same time (.1.1%) have been the same amount.
More pro articles by Dave
Pro and premium members get exclusive access to expert analysis, market insights and much more.
What to do about it
Let me start with what I know will be a controversial statement: You don’t need cash flow to succeed in real estate investing.
Cash flow is just one of four methods of generating returns from rental property. The other three are orthodontics (using your rental income to pay off your mortgage), appreciation (gain in property value) and tax benefits.
And while many, especially here in Bigger Pockets, preach that “cash flow is king”, this is only true for those who are willing to quit their jobs and invest full-time or who are nearing retirement age. Anyone who wants to make a return in the long run and doesn’t want to live off their investment right now should invest for your total return. You need to look at four ways to generate returns and determine which investments will help you maximize your net worth.
First, let’s look at that average deal from before Columbus. Then, I ran the 2021 numbers through BiggerPockets calculators, and here’s what I found.
Doesn’t look great. With Co 209 per month in cash flow and a CoCR of -4.8%, this deal smells bad, doesn’t it?
Well, in the case of cash flow, yes, it does. But look at that five-year annual return number.
The average annual ROI is about 16%. It’s amazing. And if you’re thinking, I’ve estimated 4% appreciation (it’s an average of 7% since 2014) and a 2% rent increase (it’s been up more than 4% since 2014). So even when forecasting declining growth, you can expect great returns with negative cash flows.
How is it going? As the value of the property and your rental income pay off your loan each month, your equity continues to grow. I recently did an analysis that shows that only repaying your loan can provide a 4-5% CAGR for a medium value property. This is great for paying your mortgage on time!
Building equity, as shown in this example, can make a great return. If you create enough equity, you can turn it into cash flow when you want to close your investment.
How? Remove your portfolio.
For example, if you raise $ 1 million in equity over the next 10 years, you can sell your portfolio and proceed to buy all cash rentals at a 7% cap rate.
With a full cash purchase, the cap rate = CoCR, so you deposit $ 1 million to $ 70,000 (7% * $ 1 million) of your accumulated equity per year. Pretty good!
This is an extreme example, but my point is that if you create equity now you will have options in the future. You will be able to decide how to adjust and re-employ your equity to adapt to your changed lifestyle and goals.
Frankly, I don’t necessarily recommend managing rental property at a loss (although you can). However, I want, I want a minimum, even a break on any investment.
To show this point, I cooked the number in the last calculator report which I humbly even showed to break.
11 per month is certainly nothing to be proud of, but about 19% annual return. Also, just because you’re starting to break even, doesn’t mean you’ll never get cash flow. If rents go up, so does your cash flow.
If you find a deal that even breaks and the market is likely to appreciate, you can create a great total return without cash flow. Look for cities with strong population growth, income growth and low unemployment rates.
So what should investors do?
The time has come to face reality. Cash flow is hard to find. If you can find it, great! Go for it! But if your market doesn’t create strong CoCRs, that’s fine too.
When I simulated cash flow for 588 markets in the United States, only 18% of them created a positive CoCR. It’s not 2010 – things have changed!
On the other hand, over the past decade more than 50% of the market has produced a 2% home appreciation rate per year. This is enough to surpass inflation and make enough profit. Moreover, 40% of the market delivers better than even 4% appreciation per year.
Your market, the strategy you want to follow, and your personal goals need to be viewed critically. Don’t avoid contracts just because cash flow isn’t great. Instead, you need to accept what the market is offering – and right now, many markets are appreciating it.