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Maybe Cash Flow Isn't King in Real Estate?

Recently this topic seems to be popping up over and over again...

Most real estate investors graduate from Stage 1, "I want to make a Million Dollars by yesterday" to Stage 2, "OK, I realize this is work like anything else and I want to educate myself about proper real estate investing."

The lag between Stage 1 and getting to Stage 2 varies from investor to investor.

Some people get caught in Stage 1 for years and face the endless treadmill of frustration always searching for the quick and easy money.

We have news for those people ... there ain't any.

It takes a sophisticated investor to capitalize on a good opportunity and make, what may seem, like "quick and easy" money.

The reality is that it took that person years to develop the skills to pull it off ... and the process to get to that point wasn't easy.   There were battle scars involved in getting to that point.

When you realize that real estate investing is like any other business then you spend your time and energy learning to master the craft - just like anything else.

And often you end up singing the mantra of "Cash Flow, Cash Flow and more Cash Flow".

It becomes your "Cash Flow Song" that you sing to yourself daily.

The song includes phrases like, "the more cash flow the merrier" and "cash flow is king!"

That's what we did anyway.

We sang the cash flow song all day long ... and we still do.

Positive cash flowing real estate is obviously the way to go.

It's easy to hold onto properties that pay for themselves through good times and bad times.

But along our journey, we noticed that this belief in positive cash flow sometimes distracted us from two even more important points:

1. That "Exit Plans" are critical to long term survival.  

2. And that "Ownership" trumps cash flow.

We now think the words "exit plans" and "ownership" should be added to the cash flow song.

Let us explain...

Recently a real estate investor cornered us and aggressively pitched us on the idea that his duplexes were much better investments than our single family homes.

Well, first of all, to each their own.  There's no single right answer to investing.

But upon questioning him about his management of these properties we uncovered that the utilities were "shared" and that this often caused problems between the tenants who argued about who had to pay what.

That wasn't the important discovery though.

Shared utilities are often a sign that a property is "non-conforming".

A non-conforming duplex can mean that the city has grandfathered the property and its fine to operate it as a duplex as long as the use of the property doesn't change.

Or, it may mean that the city doesn't allow them and will actually enforce by-laws to make you, the landlord, convert the property back to single family use.  And you may even have to spend the time and money to find the tenants new places to live.

And in this case, it was the later.  The city isn't completely aggressive about it, but they get out there and enforce their by-laws occasionally.

The city even posts some risks and warnings on their website:

Risks of an illegal or unsafe basement apartment:

Increased liability – You, as a homeowner, are responsible for meeting established standards for a second suite. If anything, such as a fire, happens, you would be liable, because you failed to meet the requirements.

Loss of insurance coverage – Building a rental unit in your home is a major change to your home. If you don’t let your insurance provider know that you have changed how you are using your home, you could, in fact, make your coverage “null and void”. (This means that you would no longer have any insurance coverage.)

Limited damage recovery – An insurance policy does not cover the costs for rebuilding your home to meet current standards. Your insurance company is only required to cover the costs of restoring your home to the state that it was in when you bought your policy, before any damage.

Prosecution -- If you do not meet City codes, you are breaking the law. You run the risk of being charged and can face fines of as much as $50,000 -- or even a year in prison — for each charge.

Financing – Banks and other lenders don’t generally consider income from an unauthorized basement apartment when you try to qualify for a mortgage loan.

Tenants – You are a landlord. You must maintain your basement apartment in good operating order and you must follow all fire safety laws. Tenants may apply to reduce their rent if the unit fails to meet municipal health, safety, maintenance and property standards.

Tenant insurance – Your homeowner’s policy will not cover property that a tenant of an unauthorized apartment owns.

This is important information.

You see, although that particular property cash flows very nicely we don't have the flexibility we need with them.

If for some unforeseen business or personal reason we need to sell the property quickly, for whatever reason, we may not be able to.

We may have to somehow get one tenant out of there ... which can be tricky of course, and then convert the property back to single family usage in order to make it attractive to the largest pool of buyers possible.

During the last decade, Canada has been a real estate investors dream ... and its caused some investors to get lazy.  They miss the big picture, which is LONG TERM THINKING.

Many people have forgotten the chaos of the early 1990's when GST came out, NAFTA came into effect and interest rates were rising like an oil gusher.

That essentially froze the real estate market.

And the only properties that were selling with any ease were the very nice little single family starter homes.

We know this because our family was caught holding the bag when the floor under the market fell out and we were eating negative cash flow like it was going out of style.

We had it for breakfast, lunch and two scoops for dinner.

And it tasted like crap.

So for us, having a very clear and well-defined exit plan is crucial to every single real estate decision we make.

And that brings us to our next point....ownership versus cash flow.

We go into every single investment, whether it be a flip or a lease/option or a regular rental with the mentality that we're owning the property FOREVER.

So if we're doing it a flip it better be on a property that we can rent out easily if the market changes during our renovations.  And that property better be in an area that meets our criteria.

Same for lease/options.

Same for everything.

Because when we go into each property thinking we may own it forever we don't get caught up in the hype of "this property cash flows at $1,000 a month and we gotta have it!".

That's a rookie mistake.

So if our "flip" doesn't work out we can rent the property for a monthly amount that we're comfortable with and be happy adding it to our real estate portfolio.

Although "cash flow" is at the top of every investor's mind we always supplement it with the idea of "ownership".

Would we be comfortable owning the property through any type of real estate market?

If the answer is yes, then we proceed.  If not, we bail...no matter the cash flow.

All it takes is to lose a good tenant and then the cash flow that was glorious on day one turns into a negative cash flow that may be difficult to turn around.

And if the property gets shut down by the city, or the property isn't in an area that can attract equal quality tenants easily, then, to us, it's not a good investment.

Please don't think this applies to only non-conforming duplexes.  This thinking applies to absolutely everything.

For example, if you're buying 5 condos in downtown Vancouver or Toronto to make a quick flip ... what happens if there are 40 other investors in the same building all doing the same thing?

What's your exit plan then?  There are likely many other options but you'd better run the numbers and cover those bases before you get in.  No?

So the next time you hear someone singing the "cash flow song" add the words "exit plan" and "ownership" to the lyrics.

It makes for a nicer tune and it may save you a lot of grief one day.

Until next time ... Your Life. Your Terms!

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0 comments on “Maybe Cash Flow Isn't King in Real Estate?”

  1. Hi Tom,

    Very well said. Tony and I were talking to a real estate investor(not from our group), and we were told the same thing. That multi units are better than single family homes, because if one of the tenants leaves then 2 or 3 tenants are still there to pay for your mortgage. He also said that we should not get into 4 or more units as it will then be considered commercial rental property. He tried to convince us to go into multi unit rental, I think he knows his business well. At the end though, he said that Tony and I do not seem to know the rental business well. Although we acknowledge that there are a lot more to learn in this business we thought we're not doing badly and we have more advantages, as we have the whole Rock Star team to help us......

    Thanks,
    Marilou

  2. Great article and good points.

    My wife and I have a triplex, a duplex and a townhome in our rental portfolio... hopefully we'll add some more properties this year. So I can safely say that we've had a good taste of several types of investments.

    I must say that the most stable investment by far has been the townhome, which also happens to be the easiest to manage. It's a starter home in a decent area, it's cash flow positive and is a very simple building so maintenance is almost nil. It's also almost doubled in value over the past 5 years. We sometimes forget we even own it, and the only vacancy we've had in 5 years is the 6 week reno project we undertook when we bought the place. Finding tenants is easy because we learned from our own renting days that not being a greedy landlord yields MASSIVE benefits in terms of the quality of tenants... they know their rent is fair, so they don't bother us, we don't bother them.

    While our multi units are bringing in more money, they're costing us a lot more. Tenant management is a bit more difficult because sometimes there are issues between tenants, tenants don't view the building as "their house", so they don't really do anything to maintain it, etc. While we still think we made the right choice in getting the multi units, our next investment will definitely be what we call our "bread and butter" properties.

    Cheers
    Paul

  3. Tom,

    The point that you raise about Loss of Insurance coverage is very important.

    A real life example exists when and if someone's house burns down. If they had installed a basement apartment without a permit, or with out the approval and concurrence of their insurance company, potentially the insurance will be null and void.

    How scary would that be?!

    -Neil.

  4. Thanks for this great submission to the Blog Carnival

    You bring up some excellent points here, but you forgot one little thing, basement tenants tend to be much lower quality...If someone's leaving garbage around, smoking pot in the house, not paying rent...it's usually the basement tenants.

    PLUS - you often get tenant infighting that you don't have to deal with when you have a single family in residence. Whole houses rent faster to better people.

    For the properties I manage, for owners that tend to be more impressed with peace of mind, I recommend that they rent these houses out as a single family dwellings. Problem solved.

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