Cash flow myth – why many investors lie…

For 20 years Canadians have been obsessed with real estate, and why wouldn’t they? Across the country prices have done nothing but go up, up, and UP… Some cities, and asset classes have done better than others, but in general you couldn’t lose on any type of real estate investment, until recently.

If you ask most Canadians why they love real estate investing, they likely won’t say ‘Because I love the thousands of $$$ I get to spend in passive cash flow!’, and if they do say that they are likely lying…  No, for most of us we invest in real estate for one reason, and that is for the massive ‘often’ tax free equity, and the Canadian boom that never ends…  The term cash flow is used in most cases to pitch investment deals to potential investors and is purely hypothetical.

So how does one measure ‘spendable’ cash flow vs. the proforma?

The cash flow argument in Canada in an interesting one. The most important metric investors should be using is cash on cash return, however this is often glossed over in Canada due to nonstop appreciation, access to cheap debt, and the ability to ‘pyramid’ your equity into several rental properties, mostly into very high leverage positions. Many homeowners with rentals were suddenly forced to sell when their ‘positive’ cash flow rentals turned negative when rates (variable and fixed) suddenly rose dramatically, forcing many to liquidate their negative cash flow alligators.

Cash flow in leveraged real estate is a myth, negative cash flow is a reality.

The reality is the cash flow component of leveraged real estate is the most volatile, and anyone with a rental with a mortgage will tell you there is no cash flow 99% of the time over the long term. You have a few good months or years, and then need a new roof, boiler system, furnace, etc. or have a few vacancies that require upgrades. This is the reason REIT’s carry low debt for the most part, so they can pay monthly distributions to their investors.  They will often have leverage 50% or lower than the total equity of their assets. With the recent run up in interest rates many REITS have slashed or cut their dividends altogether despite being in low leverage positions.

If you own (especially older) property and have a 75% or higher mortgage you simply will not have any ‘spendable’ cash flow, full stop.   Older folks who own their projects free and clear can live off the income of their properties, but pretty much everyone else relies on the equity rising to fund their deals, and often their lifestyle as well!

So why do many investors lie about it?

I believe the main reason is that it is hard to disprove on a proforma and juices up the ROI and reduces potential risk to investors, although the only predictable portion of the return is the mortgage paydown.   With such high leverage these days, mortgage paydown (and cash flow) and virtually zilch and the only possible way for the investment to generate a return is with a massive increase in appreciation – something that is far from guaranteed today.

I also feel there is a perception, especially in the days of Tic Toc and social media of Yachts, sports cars, and supermodels, that the average investor is swimming in cash, and that cash flow came from real estate.  If you study successful investors like I do the real ones don’t flaunt their wealth, they invest it.

So how can you analyze a deal to see if there is ‘actual’ cash flow?  Well on a multifamily apartment building you need to have at least $100 in ‘free’ cash flow per suite each month after all expenses, and your mortgage. This does NOT account for deferred maintenance items (this will be covered in another blog piece) hence on a 20 suiter you would need $2000/month in ‘spendable’ cash flow – good luck finding a deal like that.

If the project you are looking at has not and can not deliver that cash-on-cash return, ask yourself ‘what is the path to that cash flow’.  Short term negative cash flow is justifiable provided you have a solid plan to get to that cash flow in the very near future.

Buying a piece of negative cash flow real estate without a sound strategy to make it positive is a recipe for disaster and will make you a motivated vendor before you can blink. Take your time, it might take 100 negative cash flow properties to find one cash cow, but it is well worth the effort.

Cory Sperle