Smart Investing – A Tale of Two Townhomes

At the height of the real estate boom, some people purchased rental homes without looking at whether the rental income was enough to cover all the expenses — including the mortgage — and provide positive cash flows to the investor.

Going forward, investors should first be concerned about making sure that the properties they buy pay for themselves. For example, if one invests $35,000 in cash equity to buy a $125,000 property, they should buy what gives them positive cash flows and more importantly a positive cash-on-cash return on their money.

Beware, because many properties, even with today’s lower prices, do not pay for themselves. In these cases the owners end up taking money out of their bank accounts on a monthly basis to cover the negative cash flow properties they have purchased.

Covering negative cash flow from your other savings is not a good investment strategy. Here’s why – look at these two townhomes. One in a moderately priced area of San Diego and one is a fancy luxury townhome:

The first property “moderately priced” property pencils out a nice positive 7.03 percent cash-on-cash return on my money.

Although the rent is higher on the second “fancier” townhome property, it has significantly negative cash flows on operations of $8,400 per year. That person is investing $137,500 of cash equity to still be negative on operations, or an investment return of negative 6.11 percent.

And going forward, the chart below estimates that this property will be negative on cash flows for over 10 years.  Not only are you investing an $137,500 down payment, but continue to add to negative cash flows for over a decade. You will have over $192,995 into this property before the property begins to make money.

The question you should ask yourself is, “Why didn’t I just buy a cash flow positive property?” like the moderately priced townhome?

This is just one example and you need to put the property specifics into your analysis, do some research on realistic rents, area vacancies and expenses to make your own decision.

Just realize, that in general, prize properties are no prize. It’s the moderately priced properties with decent rents compared to the purchase prices that have positive cash flows and are the real prize.

Leonard Baron, MBA, CPA, is a San Diego State University Lecturer, a Zillow Blogger, the author of several books including “Real Estate Ownership, Investment and Due Diligence 101” and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.

Note: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinion or position of Zillow.