The Commercial Real Estate Alpha Site

Just as every seasoned flipper has lost money here and there, every buy and hold investor has bought a property that just doesn’t cash flow.

We recently repositioned an apartment we had owned for quite a while with the hope that the units could rent for $895/month. Unfortunately, the apartment was right on the edge of two neighborhoods, and the lower quality one won out. We only got between $695 and $750/month.

While this apartment still cash flows at those rents, most often when you miss by as much as we did on that occasion, the property will not cash flow. Indeed, in some markets—particularly on the coasts—it’s all but impossible to get a property to cash flow (with a loan on it, at least).

So, You Aren’t Cash Flow Positive—What Now?

The first thing to do in such a situation is to take the emotion out of it. Who cares if you feel ashamed of a bad purchase and think you should dump it no matter the cost? Or who cares if you really love the property and feel like you should keep it no matter what?

In business, we need to think calmly and rationally. So, we start with the dispassionate questions:

1. Does the property actually not cash flow?
2. Is it temporary?
3. Is it fixable?
4. Is it tolerable?

Let’s delve deeper into each.

1) Does the Property Actually Not Cash Flow?

This is a question that can be approached from two sides. If a property just barely cash flows while occupied, then it doesn’t actually cash flow. Eventually, the property will become vacant, and that loss needs to be accounted for on whatever cash flow analysis you put together.

The rule of thumb is 10%, but it depends on your market.

In addition, the property will require capital expenditures from time to time (like a new roof). These need to be accounted for as “recurring capital expenditures” or “replacement reserves” (as Wall Street calls it).

Furthermore, if a property just barely cash flows after taking vacancy and recurring capital expenditures into account, it should be viewed as highly suspect.

On the other hand, you may have a property that just had a bad year. For example, if you own a fourplex and had a wave of moveouts and capital expenses, it may just be an anomaly. Under normal circumstances, the property would cash flow just fine.

Figuring out what is actually going on will require digging into the numbers and working out why it isn’t (or is) cash flowing to determine whether this is a structural issue or not.

2) Is It Temporary?

As I write this, we are in the middle of the coronavirus outbreak and resulting economic turmoil. Black swan events are difficult to predict and can make normal business operations go completely haywire.

One estimate concluded that one-third of apartment renters didn’t pay their rent in April. While we haven’t seen anything even close to that, these are still obviously tough times.

The question you need to ask is whether the property can cash flow under normal circumstances. Also, consider how long you can accept the current losses you’re experiencing, given we don’t know how long this abnormal situation will last.

If the property was cash flowing prior to this crisis, it will likely continue after the crisis has abated (whenever that will be).

3) Is It Fixable?

A property that doesn’t cash flow might not be stuck in such a situation.

Some owners, unfortunately, like to cheap out on everything. Oftentimes, this leads to a bad tenant base that won’t pay rent and will trash the units. Simply upgrading the property could fix the situation.

Or perhaps there’s something more creative that can be done. Can the property be rented to students for a higher monthly rate? Or can it be used for military or corporate housing? Maybe try Section 8?

Can you add an accessory dwelling unit (ADU) or turn it into a duplex? Can you subdivide the back lot and sell that? Can you chargeback the utilities?

Could you make some alterations and increase the rent enough to offset the cost? For example, is there any potential for a garage conversion, attic conversion, adding a bedroom or bathroom, building a fence in the backyard, etc.?

These are possibilities you should consider before making a decision.

4) Is It Tolerable?

“Negative cash flow should never be tolerated!” I hear the critics yelling.

Well, true enough. But you already own the property. What’s done is done, and every decision has tradeoffs.

If you have a decent-sized portfolio, it might make more sense to hold than to sell. That decision is based on the market.

Determining the Best Course of Action

Ask these questions next:

1. Can you refinance your way to cash flow?
2. Is there big upside potential?
3. Should you sell?

Again, in each of these instances, dig deeper.

1) Can You Refinance Your Way to Cash Flow?

This isn’t common, but with rates at historic lows, refinancing might be a solution in some cases. This is especially true if you have a high interest private or hard money loan on the property.

We’ve had bank loans in the high-5s before; right now we can refinance in the low- to high-4s. Needless to say, that type of change in interest rate can have a major effect on cash flow.

2) Is There a Big Upside Potential?

It’s sometimes been said that the difference between investing and speculation is that investing brings in cash flow. Appreciation is a bonus, whereas speculation is simply relying on appreciation. This is, however, simplistic.

Speculation, in my opinion, is more like when you are blindly hoping for appreciation.

If you buy a property across the street from a site where a major mixed-use development is being built, you can be pretty sure it will soon appreciate considerably.

So, if you are in the “Path of Progress” and there is a very good reason to believe that your property will soon appreciate substantially, tolerating negative cash flow may be acceptable—although I wouldn’t consider this approach unless you have a sizeable portfolio and other cash-flowing properties to make up the gap.

Furthermore, be careful with this. Entrepreneurs are imbibed with a bias toward optimism. Merely hoping the property will appreciate is insufficient. There needs to be a really good reason to believe it will soon appreciate—and by a large margin.

3) Should You Sell?

Right now, the real estate market is in significant turmoil. It’s hard to tell if prices have dropped much, but sales certainly have.

Therefore, prices are likely to follow.

In this instance, it makes sense to hold off until the coronavirus lockdown is over to list a property. But that being said, don’t get too cute with trying to “time the market.” This is often just a euphemism for procrastination.

Furthermore, if you have a house that cash flows just barely while rented but won’t cash flow overall, I would usually wait until it becomes vacant before selling. That’s especially true if the property is nice enough it would attract homeowners and not just investors.

Conclusion

Negative cash flow sucks. I can’t tell you what to do in a broad sense—there are so many possible situations.

That being said, the key thing is to ignore your emotions and look at all of your options. Figure out the best path forward in a logical sense.

There are many things to consider, but do make sure you consider them all before jumping to a conclusion.