Why does cash flow play an important role in successful real estate investments?
Cash flow is essentially the movement of money. It’s the net amount moving in and out of your account, which can lead to either a negative cash flow (meaning expenses are higher than income) or positive cash flow (meaning your income exceeds your expenses). There are many ways to invest in real estate with different cash flows. Some choose to invest using cash, others use bank leverage. This all affects your investment’s cash flow, so let’s take a look at 3 different cash flow scenarios when it comes to investing in real estate.
1. Investing in real estate with cash only
| Property type | office | ||||
| Property price | 300 000 | ||||
| Loan amount | 0% | ||||
| Investment length (m) | 120 | ||||
| Market growth | 4,5% | ||||
| Rental yield | 6,5% | ||||
| Indexation | 2,0% | ||||
| IRR | 10,1% | ||||
As an example, let’s use a commercial office space with the moderate price of 300,000€. If you buy this property in cash you have to put down 300K of your own money. Yes, that’s a big expense, but what you get in return is 1625€ per month as income, which will increase by a 2% index (related to inflation) every year going up to 2000€ over 120 months (10 years). You will also earn a profit from capital gain, but it will stay on paper until converted into real money when you exit your investment.
Risk scenario
In the case of a market downturn, you will still keep your rental income. If a tenant gets into trouble with payments you might need to decrease your rental rate by 10-20% to quickly get a new tenant, but you will survive and most importantly you will keep making money. The market will eventually recover and you can get back to your projected levels of income.
Summary
By investing in a rental property with cash only you will have a safe investment with a stable cash flow and a good tolerance towards market shake-ups. You get about 10.1% of total profitability and a stable 1625€ monthly income, which can be used to cover expenses and to reinvest.
2. Geared investment: 50/50
| Property type | office | ||||
| Property price | 300 000 | ||||
| Loan % | 5% | ||||
| Loan amount | 50% | ||||
| Investment length (m) | 120 | ||||
| Market growth | 4,5% | ||||
| Rental yield | 6,5% | ||||
| Indexation | 2,0% | ||||
| IRR | 12,0% |
Now, let’s suppose there is a bank that is willing to give you a loan for the purchase of this commercial property worth 300,000€. The first question is “how much money do you want to take from the bank?” In this investment scenario, let’s say you take 50%, which is 150K out of your pocket, paying a moderate 5% interest on the loan for 10 years. The good news is that you only need to put down 150K to buy the property. However, now you have a monthly expense of 1590€ to pay back the loan on the property. As a trade-off you will only receive 35€ from the rental income as monthly cash flow, which will gradually grow to 360€ per month over 120 months (10 years).
Risk scenario
If something happens to the real estate market, your cash flow would turn into a negative one and you would need to put more money down to cover your mortgage expenses. Any adjustments to the rental price can potentially result in a negative cash flow, which means that in order to keep this investment and gain from capital growth at the end, you will need to continually add more of your own money to this investment to keep it afloat.
Summary
You get a 12% IRR and you ‘walk a fine line’. You finance only half of the purchase, but you’re also sacrificing on rental income by paying a hefty mortgage. If something goes wrong, you will need to add personal finances to the project. This also makes the property selection criteria a lot stricter and demanding. If you come across a property that is safe to invest in with this setup, you’ll most probably only have a few hours or days at best to close the deal. That’s definitely not enough time to go through the process of a bank loan evaluation.
3. Geared investment: 80/20
| Property type | office | ||||
| Property price | 300 000 | ||||
| Loan % | 5% | ||||
| Loan amount | 80% | ||||
| Investment length (m) | 120 | ||||
| Market growth | 4,5% | ||||
| Rental yield | 6,5% | ||||
| Indexation | 2,0% | ||||
| IRR | 14,3% |
Now, in this scenario let’s suppose you have a bank which is willing to finance 80% of the property for the same 5% interest, which is quite rare these days. You would only need to put down 60K, but the monthly loan payment would be sky-high at 2545€, which is more than your monthly rental income.
Risk scenario
In this real estate investment scenario you’ll have to put down more money in any case on a monthly basis to cover the mortgage. If the economy gets shaky, you’ll have to put down even more of your own money. This investment scenario feels more like getting into slavery than becoming a sustainable investor. You also have a very realistic risk of the bank asking for an additional guarantee. If for any reason you find yourself without a tenant for a long period of time, your mortgage expenses will cause a deep hole in your finances.
Summary
With this investment option you have to understand that you would need to add more money from your pocket (920€ on top of your rental income) every month to keep it afloat. This would add up to 90K over 10 years, but would increase your IRR to 14%. Increasing the period of the loan to 20 years would help to make this kind of investment not require additional funding as you could cover the lower mortgage payments with your rental income, but it would be similar to scenario 2 in terms of risks and ‘walking a fine line’. It’s also very unlikely to get a commercial loan from a bank for 20 years and you would also not have any cash flow from rent. Also, the chances that the economy will have a correction phase within a 20-year period are pretty high.
How can I make sure my investment has a positive cash flow?
There are a lot of opinions about how to grow your investments. Some say it’s always best to use bank leverage to finance an investment. Others recommend buying real estate yourself in cash, letting professionals do it for you, or diversifying your portfolio to minimise risks and so on. The truth is, you can argue about methodology, but you can’t argue with math. So it’s important to do the numbers and figure out how to receive the best possible positive cash flow from your investment without taking too much risk.
Take all the cash flow risks into consideration
You need to take various risk assertions into consideration. What happens if the economy goes south? After all, you are making a long-term investment, so you have to consider the different possibilities of economic developments. Also, what happens if there is a market correction for the next 3 years? Will you survive with a heavy mortgage? All the cash flow scenarios above entail risks, and each has its own profitability and silver lining.
So what’s the conclusion?
If you are looking for a stable regular or even passive income you should be very cautious with loan financing because this will incur added mortgage expenses. Financing a real estate investment with a loan can give you a better return in the long run, but the price you pay is the loss of monthly passive income. Going for the maximisation of equity using bank leverage and other financial instruments, you should be well aware of the risks you are taking. This can lead to an increase in income, but it is also what has to lead a lot of famous people to go bankrupt: Trump Entertainment Resorts, General Growth Properties, etc.
Reinvest24 takes its investments very seriously and we evaluate risks and different development scenarios very carefully. Our goal is to maximise the income from real estate investments without taking too much risk and potentially exposing our investors to negative scenarios. Keeping a healthy, positive monthly cash flow from a property is what will really generate real profit over time. This is especially true when dealing with property that is owned for a long-term period.
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