Here’s a little real estate investing secret that few rental property investors know: The fancier and more prize location of a property, the worse the cash flow. In fact, most “prize” properties are going to have negative cash flows. And that’s not a smart way to invest your hard earned cash equity dollars.
Consider the options
Let’s look at an example. You want to buy about $500,000 worth of real estate, and with a 25 percent down payment plus costs, you’ll need about $150,000 in cash to close the deal. You have two choices:
- A swanky downtown San Diego condominium for $500,000, or
- Three nice moderately priced boring suburban $165,000 condominiums.
Now most people would think location, location, location and want to buy the prize downtown. That’s because their only investment criteria is that they want to buy real estate in hopes that it will go up in value. And the problem with that strategy is that they are totally missing the most important piece of rental property investing — the cash flows the property can produce.
Immediate cash flow
In reality, moderately priced cash flow positive condominiums are the best location, location, location, and here’s why.
A $500,000 downtown San Diego condo would probably generate negative cash flows of about $1,000 per month. That’s $12,000 per year — ouch — on a $150,000 cash investment or negative 8 percent return on the investment.
A moderately priced $165,000 suburban San Diego condo would probably generate positive cash flows of about positive $250 per month. Multiplied by three condominiums — so apples to apples on the $500,000 investment — is positive $750 per month. That’s positive $9,000 per year on a $150,000 cash investment, or positive 6 percent return on the investment.
See the difference? You can allocate your hard-earned $150,000 of equity into either a fancy prize property with negative cash flows of $12,000 per year, or into moderately priced properties with positive cash flows of $9,000 per year. That’s a difference of $21,000 per year on $150,000 equity investment into $500,000 of real estate.
If you’re hoping appreciation in value will make up the difference on your negative cash flow property, good luck with that. To be fair, over long periods of time, most real estate should appreciate in value about the same percentage each year. But as you can see, cash flows can be very different, and that’s where you earn your wealth!
You might assume that because rents increase and mortgages stay constant, the fancy prize property would turn positive one day. This is true, but it would take about 40 years until the fancy prize condominium owner really got their first dime of positive cash flow.
Think that through and pencil out your real estate deal before you take the plunge. Some properties are just much better wealth-building investments than others, primarily due to the cash flows.
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Leonard Baron is America’s Real Estate Professor® – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! 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.