Negative cash flow

The curse of most real estate investors is negative cash flow ("NCF"), the unfortunate circumstance where a property's expenses exceed the income the same property can provide its owner. As a real estate attorney I hear complaints and pleas for help almost every day from owners suffering from NCF issues.

Properties which generate NCF are commonly called "alligators" for good reason. Their owners must "feed" them monthly with cash not provided by the property otherwise they will be eaten alive. The choice is continual and accelerating NCFs, default on the mortgage and subsequent foreclosure, or allowing the property to fall into disrepair and ultimately unrentable condition.

NCF can be defined many ways, especially under some highly technical formulas such as when a property's annual mortgage loan constant exceeds the property's capitalization rate or cash-on-cash investment return, but most investors view it this way:  I got more money going out of my pocket than coming in.

It is truly frustrating to own an alligator. Being a real estate owner especially of rental properties where tenants are involved is really running a full-time business where you are on call 24 hours a day, every day. There are all the normal obligations you can count on, like doing scheduled maintenance, and those you can't, like emergency repairs or dealing with tenants who sometimes disappear in the middle of the night. It is sad when you work hard to keep and find good tenants, spend time and money maintaining a property in prime condition, do all the paperwork, comply with all the laws and required obligations, and be a good landlord and property owner towards what result?

You lose money, month-after-month, with no end in sight from the very start of your investment. 
Is losing money every month really the way to get rich? Investors have a ton of excuses, devices, and escapes they can use from alligators and NCF. Some are:
 

All these approaches try to tame the alligator once the decision is made to own it or if it is already owned. By the way, all these approaches really fail. They may temporarily tame the alligator but in reality what they really do is defer costs or minimize future income or equity gains. You aren't merely borrowing from Peter to pay Paul. You are paying interest and/or equity to Peter for the right to borrow from him. 

The best way to tame alligators is to never own one in the first place. Most normal businesses work on the concept of buying at wholesale prices and selling at retail ones, profiting on the spread. First, some definitions: "Wholesale" means "the selling of goods in large bulk or quantity." "Retail" means "the selling of goods in small quantities, especially to the ultimate consumer. Wal-Mart may buy 50,000,000 cans of peas at wholesale prices and sell them for a profit at retail prices one can at a time, generally to their ultimate consumer, the people who eat them. How does this relate to real estate? And how does it concern NCF? Some recent real estate authors have taken to using the term "wholesaling" when describing the process of buying and quickly flipping real estate properties, profiting on the spread between the below-market price paid and the market price sold. But is this really "wholesaling"? Of course not. The below market price paid is really a "below retail market price paid" since all the properties (normally single family homes) being offered are priced at or near retail prices. What these authors are suggesting is something like this. Go to Wal-Mart when peas are on sale (selling below the usual retail price) and buy a case of them and then sell them at the normal retail price to someone who needs them. No way is this really buying wholesale and selling retail! This is really buying at retail and trying to sell above retail because the sale price really represents a temporary but recurring aberration of the established retail price. 

Buying wholesale and selling retail is the key to huge profits in real estate and completely eliminating NCFs. How does one buy wholesale and sell retail in real estate? Obviously large homebuilders and developers do. They create huge quantities of items and sell them to the ultimate consumers (people and families looking for a place to live) at retail prices. But how do average investors buy wholesale and sell retail? They do it by shifting the paradigm of properties, by taking one property and creating multiple interests in that property that can be sold at retail prices. A common example will illustrate the paradigm shift. Take a normal apartment building which is valued as all income properties are on their net cash flow. A property which can generate $20,000 cash after expenses (not including mortgage costs) is worth $200,000 to an investor demanding a 10% capitalization rate from his investments. 

But what if an investor buys this building based on income property valuations and then successfully converts the apartment units to condominiums? What is the value of his investment then? Much higher. That is why condo conversion is so popular with apartment building owners. You are buying wholesale at bulk prices and selling retail to the ultimate consumers, the condo buyers looking for a home. The paradigm has shifted from income property valuation to multiple retail properties which are valued using market price criteria like recent sales, square footage comps, and other measures. 

Do you think the investor who converted his apartment building has a NCF on his investment? No way. His original apartment building may have had a NCF but after his conversion he has made a substantial profit and may even own a few condo units in his building free-and-clear for rental purposes, a common result for such investors. This wholesale-to-retail concept is especially true for land investors who generate the most profits spreads possible in real estate. There is an old saying among land investors and developers that says: "You buy land by the acre and sell it by the foot." It is very true. Land is sold by the acre and then developed and leased to businesses or sold to homeowners by the square foot. Just think about the wholesale-to-retail spread potential there for just one moment. An acre is approximately 43,600 square feet.

 How many times can that bulk amount be divided again......and again......again......into retail sized pieces for sale to the ultimate consumer? Land investors who hold their land waiting for cities to grow towards them have NCFs on their properties. But land investors who use the techniques below ubderstand the following: Quick and true wholesaling profits are possible which reduce or completely eliminate mortgage costs in a property and land, unlike improved real estate, has few other costs than mortgage and taxes. Quick paradigm shifts are possible when raw land is converted into whatever end result is desired, such as land zoned for residential or commercial uses. Land boughtis not held for investment. It is bought and quickly sold, sometimes even sold before it is bought! Only buy-and-hold investors have to cope with NCFs. Say, for example, I buy a twenty acre parcel of land where the minimum lot size is two acres. Land engineers tell me that after taking into setback and other zoning rules into account I can build six homes on this former piece of farmland. Assume I have a purchase money mortgage. Will I have a NCF that needs to be fed every month on this investment. NO WAY! The mortgage is based on the original farmland value, not on the new higher value of subdivided land. Two, three, four or more of the lots can be sold for wholesaling profits, eliminating the mortgage and leaving the balance of the lots as free-and-clear holdings. Any homes constructed on the remaining lots will almost certainly have positive cash flows as rentals (should I choose to go this route and build them) since the land was obtained for free. Or I can sell all six lots for cash or notes and not worry about NCF since no ownership interest or mortgage liability exists on the property at all!

There are many more variations possible but the basic concept is simple. You eliminate NCF in real estate by: Buying wholesale and selling retail, not by buying slightly below retail and looking for someone who does not understand that below retail prices exist all the time. Shifting paradigms, converting one type of property into another or changing its current use. Quickly converting your investments from cash to real estate and back to cash, avoiding all the problems with tenants, repairs, and long-term management which are a drain on cash flow. Retail businesses call this "turning inventory" and the faster it is done the more profits get made.

This approach completely ELIMINATES NCF from the very start of an investment, including the potential of NCF which most investors fail to even consider. What if you are a very lucky investor who has a $100 positive cash flow on a single family home. That is after the mortgage and all monthly costs are paid and the tenant's rent is received. 

  What if the hot water heater explodes and the basement floods, creating a $2,400 repair and damage bill? You just bought yourself a NCF for the next two years.   What if your tenant skips out without paying the rent? An instant NCF, for who knows how many months.   Does your calculation of monthly cash flow including a "sinking fund" provision for routine repairs, annual maintenance, and required repairs? Where does the money come from to pay for painting, driveway patching, a new stove, deck washing, roof repairs, air pump and furnace maintenance, and all the rest? YOU KNOW they WILL be required but are they being factored into the monthly cash flow statement?

I could go on but my point is made. A positive cash flow is often a real NCF in disguise or one just lurking around the corner. Over the last twenty years, property values in the United States have risen far faster than the income these properties can generate. This almost guarantees a NCF under any traditional purchase. Many real estate gurus stress the bargain prices available in foreclosures, at tax sales, or available from motivated sellers, but even a 20% discount from absurdly high retail prices may not be enough to guarantee (stress GUARANTEE) the absence of a NCF and all those bargains the gurus suggest finding really do not routinely exist at all. The only way to absolutely avoid alligators is to not hang out where they live and breed. And that is in retail markets. Why does this make land investing the best type of real estate investing? Because unless you are buying single building lots for a vacation home or personal residence, land investors never shop retail.p   

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