Cash on cash vs cashflow positive

[vnwind]

Hi

I am looking to buy a property in Calgary that can generate some positive cashflow. However, I saw couple posts from investors who concentrate on cash on cash return rather small amount of cashflow so I am curious what is the reasonable rate for cash on cash return for Calgary market because it seems impossible to find anything higher than 4 % on a 400K house



Thanks for any helps or insights

Cheers

 

[Thomas Beyer]

Cash flow is a function of leverage. If you pay all cash, with no mortgage, you can cash-flow all day long in Calgary. 20% down deals with cash-flow in Calgary are very very rare. Budget a more realistic 30-35% down for safe cash-flow. Cash-flow is usualy re-invested into the asset for upgrades or to bridge vacancies. So a $200/month cash flow for 24 month, or roughly $5000 can easily be swallowed in a 1-2 month vacancy plus new appliances plus new carpet.



More here: http://myreinspace.com/threads/what-is-better-cash-flow-or-higher-roi.26596/

 

[vnwind]

Thanks Thomas for your input. You always has great answer. I am a beginner and can only afford 20% down at this time. So if cash-flow deals rare and hard to find in Calgary, does this mean Calgary market is not a good place to buy investment property? What other number should I look at that makes sense to invest in Calgary market.

As much as i want to invest somewhere else but I feel more comfortable to have my first property in Calgary.

Thanks again

 

[Thomas Beyer]

There is no cash-flow in highly levered real estate. The cash-flow exists only to allow you hold for 5 or 10 years to create equity through mortgage paydown and usually, through value appreciation. All cash flow usually is used up to pay for the odd vacancy and for property improvements. Smaller towns are better for cash-flow but far riskier. Edmonton and Red Deer are also far lower priced than Calgary.



20% down with cash-flow in Calgary does not exist, unless you do creative strategies such as



a) student housing with 4-6 beds rented or

b) furnished houses/THs or

c) rent-to-own or

d) houses with basement suites plus garages, i.e. three income streams per property.

 

[RedlineBrett]

[quote user=vnwind]o if cash-flow deals rare and hard to find in Calgary, does this mean Calgary market is not a good place to buy investment property? What other number should I look at that makes sense to invest in Calgary market.


REIN looks at buying opportunities when they rank investment markets. Calgary is #2 to Edmonton right now, but it has been at or near the top for the majority of the last 10 years.



It is very difficult to buy cash flow 'off the shelf' in Calgary. So just looking on MLS and buying something and then putting in renters seldom yields cash flow @ 20% down, unless you are looking at a fourplex or bigger. To spend less and get cash flow usually means you have to take on some form of risk.



You need expert knowledge on your side, or develop this knowledge yourself! Find a realtor that has a strong understanding of the different kinds of tenant profiles and rental districts in Calgary. There are townhouses that can yield modest cash flow all over town... but they usually need a bit of work prior. Illegal suites have always worked, but there is risk there. My personal advice to young people starting out is to purchase an owner-occupied property where you can rent out the part of it you don't need. So rooms to friends or a secondary suite usually. Learn how to deal with tenants, repairs, neighbors etc while using your ability to pay for your own cost of living to subsidize your investment. This will help to make up for the mistakes you'll make. Your first property is as much about your education as it is about the financial performance. Usually the former is much more valueable

 

[Cory Sperle]

[quote user=RedlineBrett]My personal advice to young people starting out is to purchase an owner-occupied property where you can rent out the part of it you don't need. So rooms to friends or a secondary suite usually. Learn how to deal with tenants, repairs, neighbors etc while using your ability to pay for your own cost of living to subsidize your investment. This will help to make up for the mistakes you'll make. Your first property is as much about your education as it is about the financial performance


I couldn't have said it better. Many folks talk about doing it, but the ones that have sacrificed something, ie, their own living space, or their own cash, first typically do well if they stick with it.

 

[Matt Crowley]

[quote user=vnwind]Hi

I am curious what is the reasonable rate for cash on cash return for Calgary market because it seems impossible to find anything higher than 4 % on a 400K house



Thanks for any helps or insights

Cheers




I think that Thomas, Brett, and Cory are correct and giving great advice.



You are actually on the right track thinking of a 4% cash on cash return...if you go in all cash for the building.



The big additional cost is the cyclical expenditures that Thomas is talking about - the rotating big ticket costs like carpet, roof, furnace, hot water tank. They will eat through cash flow.



Before a mortgage, you are probably looking at around 35% of revenue going towards maintenance, property management, accounting, legal, cleaning, and vacancy. Let's say the maintenance covers all the ongoing cyclical expenditures.



Here's one of my legal secondary suites (without a mortgage)



Revenue $2700

- Expenses ($945)

Cash Flow $1755



Annual cash flow: $21,060



Asset value today: $425,000 (owned without a mortgage)



Cash on cash yield: $21,060/425,000 = 5%



So, when your friend is talking about 4% as a target for cash on cash yield, that is probably about right....if you own the asset without debt. I do a fair bit of real estate asset comparison with my job and we call this the "unlevered return" (because you have no leverage). It works great because you look at the inherent income-producing ability of the asset before the debt kicks in.



In the last magazine, Don discusses something he calls the "cash on cash PLUS" formula. In this case, he assumes you have a mortgage. His formula can be simplified:



Cash on cash PLUS formula =

(Monthly cash flow + month principal pay down)

/ (all cash initially invested in purchase of property including capital improvements)

 

[Thomas Beyer]

[quote user=SweetZone]Annual cash flow: $21,060



Asset value today: $425,000 (owned without a mortgage)



Cash on cash yield: $21,060/425,000 = 5%
This is also referred to as a CAP rate, or yield.



So, if you can borrow at 3% and the asset yields 5% (plus equity upside from higher rents down the road), why not buy as many assets as you can ? That is really the PrestProp story from 80K to 80M. Not a smooth line, obviously, and many mistakes and cash-flow issues along the line, but in the end you borrow (and JV) to invest, and as long as the yield of the asset is greater than the borrowing cost by 1-2% (or more) you will come out OK eventually. That is not cash-flow, of course, as you have to amortize the mortgage and pay for upgrades along the way, so either sell an asset once in a while to create that cash and/or work another job for cash-flow while building your networth.

 

[Matt Crowley]

[quote user=ThomasBeyer][quote user=SweetZone]Annual cash flow: $21,060



Asset value today: $425,000 (owned without a mortgage)



Cash on cash yield: $21,060/425,000 = 5%
This is also referred to as a CAP rate, or yield.



So, if you can borrow at 3% and the asset yields 5%, why not buy as many assets as you can ? That is really the PrestProp story from 80K to 80M. Not a smooth line, obviously, and many mistakes and cash-flow issues along the line, but in the end you borrow (and JV) to invest, and as long as the yield of the asset is greater than the borrowing cost by 1-2% (or more) you will come out OK eventually. That is not cash-flow, of course, as you have to amortize the mortgage and pay for upgrades along the way, so either sell an asset once in a while to create that cash and/or work another job for cash-flow while building your networth.




Yes, Mr. Beyer, exactly!



Personally, I'm still learning the business and where I create the most value it (to my surprise, it's not with a toolbelt!) I'm finding my big value creator is due diligence about the purchase: location, tenant profile, capital expenditures, cost to upgrade, upgrade plans, legal suite expertise, and ability to manage.



We completed a deal with our second joint venture earlier this year and I probably will not take on another until some time next year.



The discipline we are working on is becoming experts in the legal secondary suite market in Edmonton (Mill Woods specifically...and only a few neighborhoods in there). I think we have made good progress.



We are building our portfolio very similar to how you describe it here. I'd be too bored to retire anyway and I like my job.



I see our investing strategy like a long-term low-yield railroad. We build our suites to attract stable-family tenants. Going legal makes sense for us because it creates long-term portfolio stability. After we renovate, we have created an equity buffer and have significantly increased the income producing potential of the property. It's a lower yield because there is more cash involved up front. But there is a whole lot less risk operationally: the tenant profile improves substantially and the biggest ticket items are resolved. When the market takes a breath, these suites will still be full and when the market recovers they will be among those in highest demand. Long-term, safe and steady.



At this point, we would like to develop one or two more suites on our own to really nail down our system. Right now, I'm putting in the time to earn the experience. My thought is to do everything I can to improve the product on my own before taking in larger-scale...I am definitely reading your posts diligently to learn what I can!

 

[MonicaPaslawski]

Informative, common sense - thank you once again - I learn a lot from these posts as my business develops!



Monica

 

[flyingsquirrel]

I always thought that the extra cash from cash flow is for the downpayment of the next property.

I guess it is a trade off here. More appreciation or more cash flow.

It surely put the landlord under pressure when the cash flow is low, especially when the rent is of a high ratio of your working income.

If you make $3000 a month and the cost of the place is $2000, you will not survive long before the bank foreclosure your property, if it is vacant.

people die in long run. Be careful.

 

[Thomas Beyer]

[quote user=SweetZone]I'm finding my big value creator is due diligence about the purchase: location, tenant profile, capital expenditures, cost to upgrade, upgrade plans, legal suite expertise, and ability to manage.
Well stated. Asset acquisition is a core skill to build wealth !



The other one is to raise money from JV partners as you need money to buy more assets ! Work on that skill, too.

 

[REQRentals]

[quote user=ThomasBeyer][quote user=SweetZone]Annual cash flow: $21,060



Asset value today: $425,000 (owned without a mortgage)



Cash on cash yield: $21,060/425,000 = 5%
This is also referred to as a CAP rate, or yield.



So, if you can borrow at 3% and the asset yields 5% (plus equity upside from higher rents down the road), why not buy as many assets as you can ? That is really the PrestProp story from 80K to 80M. Not a smooth line, obviously, and many mistakes and cash-flow issues along the line, but in the end you borrow (and JV) to invest, and as long as the yield of the asset is greater than the borrowing cost by 1-2% (or more) you will come out OK eventually. That is not cash-flow, of course, as you have to amortize the mortgage and pay for upgrades along the way, so either sell an asset once in a while to create that cash and/or work another job for cash-flow while building your networth.


I understood the above was the concept of positive leverage: That if every hundred dollars you borrow makes you 5 and only costs 3 then you make money on every dollar you borrow.



And if you borrow 80 of every 100 dollars invested all the better.



So if you are borrowing at 3% to invest in a fund that has sufficient scope and diversification to reliably pay the 5% you come out with a reliable 2% margin plus the equity side etc......



But borrowing at 3% for a single rental with a target 4% cap seems a slim margin. If you do not meet the 4% target for any reason and the cost of borrowing ends up higher than the cap rate you are losing money on every dollar you borrow:



And borrowing 80 of every 100 invested.



Negative leverage.



And one reason the value of income producing property is highly sensitive to interest rates.

 

[Matt Crowley]

[quote user=REQRentals][quote user=ThomasBeyer][quote user=SweetZone]Annual cash flow: $21,060



Asset value today: $425,000 (owned without a mortgage)



Cash on cash yield: $21,060/425,000 = 5%
This is also referred to as a CAP rate, or yield.



So, if you can borrow at 3% and the asset yields 5% (plus equity upside from higher rents down the road), why not buy as many assets as you can ? That is really the PrestProp story from 80K to 80M. Not a smooth line, obviously, and many mistakes and cash-flow issues along the line, but in the end you borrow (and JV) to invest, and as long as the yield of the asset is greater than the borrowing cost by 1-2% (or more) you will come out OK eventually. That is not cash-flow, of course, as you have to amortize the mortgage and pay for upgrades along the way, so either sell an asset once in a while to create that cash and/or work another job for cash-flow while building your networth.


I understood the above was the concept of positive leverage: That if every hundred dollars you borrow makes you 5 and only costs 3 then you make money on every dollar you borrow.



And if you borrow 80 of every 100 dollars invested all the better.



So if you are borrowing at 3% to invest in a fund that has sufficient scope and diversification to reliably pay the 5% you come out with a reliable 2% margin plus the equity side etc......



But borrowing at 3% for a single rental with a target 4% cap seems a slim margin. If you do not meet the 4% target for any reason and the cost of borrowing ends up higher than the cap rate you are losing money on every dollar you borrow:



And borrowing 80 of every 100 invested.



Negative leverage.



And one reason the value of income producing property is highly sensitive to interest rates.







It is definitely a good observation. I think you have noticed here a flaw when you hear talk about "leverage" in real estate. The underlying, functional asset if purchased with 100% cash will yield about a 4% coupon. That is before appreciation of the property or rents.



Now borrow 50% of the funds...your 4% return grows to around 8% on equity invested.



Now borrow 80% of the funds...the same 4% asset earns 20% on equity invested.



Leverage increases the sensitivity of returns, and always enhances the downside greater than upside.



This is just like the "diversified portfolio" that you were talking about. The "optimum portfolio" that financial planners refer to basically has reduced the historical, statistical variation of the stocks chosen in the portfolio to equal the variation of the market index with at least as large of a historical return.



Once they choose that basket of stocks it is the "optimum portfolio" for everyone! The "riskiness" of the portfolio - sometimes described as its "beta" is now just the amount of debt (or leverage) that will be used in purchasing stocks.



The margin is small on real estate but the control you get with it is really quite exceptional
/>

1. call option: small down payment, ownership and control of entire asset

2. keep 100% of any income earned: no pass-through payment owed to the bank no matter how much you increase the rental income of the property

3. put option: if the market goes up or goes down you will not owe more to the bank the what the remaining mortgage balance is

4. minimal pre-payment penalties (especially on SFH): this is very expensive option to purchase on financial markets when it comes to mortgage backed securities and collateralized mortgage obligations



There are lots of other obvious ones...but as far as an alternative investment asset, real estate appeals to me because of asset control and ability to create to an information advantage. Even on a 2% margin, I think there is a lot of opportunity.

 

[Thomas Beyer]

[quote user=SweetZone]Even on a 2% margin, I think there is a lot of opportunity.
Indeed. Think of it more as a 100% margin since you borrow at 3% and invest at 6%.



Related post here: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-26733-133015-What_is_better_cash-flow__or_higher_ROI_.html

 

[vnwind]

Thanks everyone for sharing your opinions and they are great. I learn so much from these

 

[REQRentals]

I appreciate the equity side of leverage but that is distinct from cash flow leverage or margin (making a return in excess of the cost of borrowing from the borrowed funds)



The example above of the property producing 4% and adding a 50% mortgage seems to confuse the 2.



Agreed if you have a 50% mortgage you will have only 50% equity in the deal and hence double any gains in value by leverage.



You will not double the 4% rate as suggested because there is a cost to borrowing the money.



For example if it costs 4% to borrow, your 4% "coupon rate" on invested equity will remain exactly the same no matter how much you borrow as you are neither making nor losing on the borrowed funds.



If it costs 3% to borrow and you net 4% then your return on equity will increase marginally with each borrowed dollar. But it will not double unless the cost of borrowing is zero.



If you can leverage the cash flow at a sufficient margin then as Thomas points out you can produce infinite leverage on equity as it is possible to hold the deal without any equity in it at all.

 

[Matt Crowley]

[quote user=REQRentals]I appreciate the equity side of leverage but that is distinct from cash flow leverage or margin (making a return in excess of the cost of borrowing from the borrowed funds)



The example above of the property producing 4% and adding a 50% mortgage seems to confuse the 2.



Agreed if you have a 50% mortgage you will have only 50% equity in the deal and hence double any gains in value by leverage.



You will not double the 4% rate as suggested because there is a cost to borrowing the money.



For example if it costs 4% to borrow, your 4% "coupon rate" on invested equity will remain exactly the same no matter how much you borrow as you are neither making nor losing on the borrowed funds.



If it costs 3% to borrow and you net 4% then your return on equity will increase marginally with each borrowed dollar. But it will not double unless the cost of borrowing is zero.



If you can leverage the cash flow at a sufficient margin then as Thomas points out you can produce infinite leverage on equity as it is possible to hold the deal without any equity in it at all.




You are right again, and I should have made my assumption more clear.



Leverage is defined as total asset divided by equity or TA/E. For example, if we buy a house 100% equity we have a leverage ratio of 1. If we borrow 50% of the funds we have a leverage ratio of 2. Equivalently, if we borrow 80% of the funds we have a leverage ratio of 5.



Return on asset is defined as Net income / Total Asset or N/TA. The return on asset is what is earned as net income in consideration of all expenses against the property (including taxes and interest).



Return on Equity ROE is thus:



ROE = TA/E * N/TA



In actuality, the calculation of net income is directly influenced by charge of interest. The greater our interest, the lower our net income.



You are right that I did over-simplify the above description.



The dangerous oversimplification is that whenever we can borrow at 3% and have a return on asset for 3.001% we should borrow...but it doesn't all come down to return on equity if your gross return on an entire 20-unit building is $30 per month (another good observation).



At the same time, interest on debt is tax deductible, which actually decreases the effective cost of debt:



effective cost of debt = (rate of debt) * (1 - effective tax rate)



As we add more debt, we also increase the present value bankruptcy costs...as they become more probable...



In most cases, however, you will usually increase your return on equity by increasing leverage. This has absolutely nothing to do with the unlevered (no debt) productive return of the asset.



If your effective cost of debt < effective cost of equity, you will increase your return on equity by taking on more debt (although not as quickly as the simplification I used above...that's just to keep things simple).

 

[Thomas Beyer]

[quote user=SweetZone]Return on Equity ROE is thus:



ROE = TA/E * N/TA


Return of equity is actually usually referred to as ( cash-flow plus principal pay down ) / cash invested, as opposed to cash on cash return which is merely measuring the cash-flow over equity invested. The principal pay down is critical, but not ( yet ) cash.

 

[REQRentals]

Fortunately all of these things can be expressed on spreadsheets where their meanings are less ambiguous. A rose by any other name .



However I would return to the point I started with which was to question purchasing a self managed asset with a 4% target cap.



And how it differs from a managed investment or REIT with a 5% pay-out to investors.



Before you pay a 5% return to investors the asset has to make enough to justify its operation as a business (to pay staff and operating costs, make allowance for asset maintenance and improvements, provide a return to the manager etc.....).



Why would you view a self managed asset any differently, namely:



a) The money you invest has to make a return commensurate with risk and other factors. If you can get 3% at the bank then why cross the street to get 4%.



b) The work you put in has to be compensated (if you can get 5% from a managed investment or REIT why bother working for it).



The idea is not to knock to real estate as an investment but rather an observation on the cycle and its effect on investor mentality towards cash flow



In Canada where we have had a sustained bull market everyone is focused on the equity side. As a result they accept lower and lower cash returns in anticipation of making it up from the gains and mortgage pay-down (which is a distinct element of cash flow apart from cost of borrowing).



At the other end of the cycle in the States (or anywhere else) it pays very well to rental property. If you cannot depend on the back end you need to get paid as you go along.



The contrast is no longer so stark but it still exists.



Cash flow is not the only thing but it is a big thing. It has to support your operations and financing and everything else.