Positive Cash Flow is one of the most talked about and most misunderstood subjects in real estate investment. As the term “nothing down”, “positive cash flow” fascinates investors, since it is often associated with “passive income”, or making money without actively having to work for it.

Positive cash flow, though, is easier said than done. In most competitive real estate markets (like South Florida) it is very difficult for a residential property to produce positive cash flow at normal to high LTV (loan to value) ratios (80% or more). Plus, even if you can get it, it is far from the hands-off, laid back way of acquiring wealth we’ve been led to believe, since it requires getting involved with property management (hardly a trouble-free endeavor).

To illustrate the point, let’s start by defining positive cash flow. Positive cash flow is the amount of money left after you deduct the cost of the loan used to finance the property from its net operating income. Net operating income, in turn, is the gross income (the amount received for rent) minus the operating costs: taxes, insurance, maintenance, association fees, etc. You should also include among the operating costs a reserve for vacancies and a reserve for capital replacements (for example, replacing the A/C or installing a new roof).

As a rule of thumb, the operating costs of a residential property (including reserves) add up to 45% of the gross income.

Let’s look at an example. Let’s suppose that you live in South Florida and are the proud owner of a 2/1 + 2/1 duplex for which you just paid $300,000 (not unusual in this part of the country). Let’s say that, for simplicity’s sake, you obtain an interest only loan at 6%, for 90% of the purchase price, or $270,000, and put $30,000 down. Your monthly interest payment will be: $270,000 * .06 / 12 = $1,350.

Now let’s calculate the gross rent. Each of the two 2/1 fetches $900, for a total of $1,800 gross monthly rent.

Following our rule of thumb, your monthly operating expenses will be 45% of gross rent, or 0.45 * 1,800 = $810.

Your net operating income is $1,800 - $810 = $990

Now, we are ready to calculate our positive cash flow: $990 - $1,350 = -$360.

Oooops! What happened there? That is a negative number…. We have “negative cash flow”!

Unfortunately, this example is not farfetched. It reflects what hundreds of “investors” have been doing in South Florida for the last two years. Basically, people were paying $30,000 of their hard earned money for the privilege of losing $360 a month…

Others didn’t put down any money but got upside down in debt with 100% financing, making their cash flow situation even worse.

Others may brag that they do get positive cash flow (or something close), but they are probably using one of those Adjustable Rate Mortgages (ARMs) with a low “teaser” rate of, say, 1% for one or two years, to adjust to market rates thereafter. These buyers will find themselves with a big whole in their wallets once their rates adjust, and they can’t raise the rents enough to make up for the difference.

For most of these “investors” the plan is to live with the negative cash flow for a couple of years, ride the “appreciation wave” and sell the property to another “investor”.

However, as you probably already know, appreciation can slow down or stop altogether (as it appears to have happened in South Florida after the November 2005 peak), and interest rates can go up (as they also have).

The question is: who is going to buy these properties from these “investors”? Probably nobody with common sense and a $4.99 pocket calculator. Perhaps a “greater fool” will step in, but that is also unlikely, now that the market boom seems to be over and the masses of beginners lured by the promise of easy money are leaving real estate in droves.

But let’s look at another example. Suppose that you find a single family house with three bedrooms and one bathroom in a modest neighborhood; the market value is around $200,000 but you can get it for $135,000 because the owners are facing foreclosure and need to sell fast. You put down 20% of the market value (or $40,000) and get an I/O loan at 6% for $160,000 (caveat: you must find a bank that will lend you money based on the market value of the property, not the purchase price). With the proceeds of the loan, you pay the previous owner in full, and use the remaining $25,000 to pay the closing costs and turn the house into a 4/2, while fixing and painting it to leave it in top shape. You find a Section 8 tenant that has a $1,500 voucher (slightly above market rate) and sign a rental agreement with him/her.

Like in the previous example, your monthly cost of operating the property will be 45% of gross rent, or 1,500 * 0.45 = $675

Your net operating income will be $1,500 - $630 = $825

Your loan costs are 0.06 * 160,000 / 12 = $800

Your monthly cash flow will be: $770 - $540 = $25

Now, let’s say that after three years you decide to sell, and that during that time properties have appreciated at normal rates of 5% per year. The house will now be worth $231,525. Your profit will be

Sale Price – Loan Balance – Down Payment + Positive Cash Flow for Three Years

231,525 – 160,000– 40,000 + 900 = $32,425

(We’re not considering selling closing costs in the equation to make it simple)

Your Return on Investment (ROI) will be:

Profit / Amount Invested = 32,425 / 40,000 = 81% in three years, or 22% per year.

Also, you could have chosen borrow the down payment from private lender, in exchange for 10% per year interest payable when you sell the property. In that case, you would still make a $20,425 profit after three years without any of your own money invested.

Summary:

In conclusion, positive cash flow is very hard to achieve at normal to high LTV ratios (80% or higher), unless you buy way below market and/or increase the value of the property in some way. Positive cash flow, however, is not an end in itself. Cash flow can be very small, negligible or even negative, but what really matters is your ROI (return on investment), which, like in this last example, can be very attractive even if cash flow is marginal.