Image courtesy of renjith krishnan / FreeDigitalPhotos.net
Ever heard the term “forcing cashflow” before?
If you’ve done any real estate investing at all, sooner or later you’ll run into the concept but it’s a topic with implications well beyond real estate. It’s a tricky subject and one that I still struggle with today.
I faced the classic “forcing cashflow” situation a few years after I purchased my infamous fourplex. Regular readers might recall I actually bought two fourplexes at the same time from the same seller. After a few years of thin cashflow and pouring too much free cash in to feed the mortgages, I dumped the more problematic of the two and walked away with some decent appreciation profit.
I examined my situation. My personal monthly bills (outside of mortgage) totaled about $1,500 at the time. I was pretty obsessed with cashflow in those days so the math was simple based on my objective — specifically raising the monthly income from the property up above the amount I’d need to cover my bills. I talked to my friendly neighborhood mortgage broker and asked how much cash I’d need to bring in if I wanted to bring my payment down to $1,000/month (including escrow). Rents in the four units were around $650. So on paper I’d have $2,600 in revenue and after paying the mortgage my cashflow would be a sweet $1,600 (not counting maintenance, vacancies, etc.). Not bad, right? Who wouldn’t want a free $1,000+ coming in every month?
Well, there are a few ways to look at forcing cashflow that complicate the matter. First we have to break out of the mindset that forcing cashflow is either “good” or “bad.” Rather there are various types of forcing cashflow that may or may not make it a good idea for your particular situation.
Old school real estate investors usually talk about forcing cashflow in the context of something amateurs do to make their numbers “work,” while they, the savvy investors, boast about their “cap rate” and similar methodologies to evaluate their purchases. And they’re quite right to do so because strictly forcing cashflow ignores the opportunity cost of putting the extra money elsewhere. For example, in my case, I would have been MUCH better off investing the money in stocks. That is to say the return I got on the additional funds was less than I could have gotten elsewhere. Thus my overall income situation would have been better by paying more attention to return and less to cashflow.
However! While all of that is true, there are other important ways to think about this. Let’s reverse things to help see this clearly. Imagine for a moment, I pulled some cash out of my property instead of putting cash in, say via a simple home equity line of credit loan (forcing a negative cashflow, if you follow me). Suddenly instead of the $1,000/month coming in, perhaps I have to feed it by $500. This could put an investor in an untenable situation, unable to keep up with payments and vulnerable in a crisis. Or to put this another way, if you were buying a rental property, how much should you put down? How could you know what the right amount is?
Cap Rate (along with GRM and GSI for you real estate investing nerds) is cashflow neutral — it only helps you determine whether the purchase (or sale) price is fair (based on revenue). Cashflow is profit-neutral, it just tells you how you’re structured. For example, you could have a 10 percent Cap Rate building (unheard of around here, we’re usually around 6 percent if we’re lucky), but if you bought it with 20 percent down and had some vacancy issues and repairs, you may have gotten a good “deal”, but the building could still be draining you every month. If you decided to force the cashflow, though, and put 50 percent down, you got the same good deal on your property and are enjoying some tasty cashflow. However, you’d have to examine your overall investment posture because you might have come out ahead by putting that additional cash into other investments.
Real estate makes a good example, but we face decisions on forcing cashflow every day, often without realizing it. Every time we’re faced with a decision on whether to pay for something up-front in order to save more over the long haul we’re making this kind of decision. Older car beginning to cost more and more in repairs — would a newer car put you ahead or behind? Worn-out refrigerator burning way too much electricity? Better to keep limping along or upgrade?
So how does one know how much to force cashflow? I have three ways I evaluate this kind of situation:
- Payback time – Identifying the time until you reach break-even can be a smart way to look at things. All else being equal, it can be a good idea to achieve the shortest possible break-even time with all invested money. Say you’re considering dropping $5,000 on new windows in your home to replace the drafty single-pane pieces of glass in your house. And let’s say your heating and cooling bill is $200/month and you estimate it’ll drop in half with new windows. So, “savings” of $100/month. Worth it? At a savings of $100/month, it’d take just over four years to break even. So it obviously comes down to how long you’d be staying in the house. If it’s your forever home, the sooner you get started the better. If you’re planning to move in two years, tape plastic over your windows and tough it out.
- Yield – Another way to look at forcing cashflow is to compare the income (or ongoing cost reduction) to what you could do in the market. In the above example we were considering investing $5,000 on new windows. What if we took that same amount and invested it in stocks? Using my 5 percent rule, we’ll assume we can make an annual 5 percent if we put our money to work in the market. Let’s compare that to our energy savings with our windows. Our energy bills drop by $100 in this example, so $1,200 per year. Making that on $5,000 isn’t too shabby. And if this is our forever house, we make that (24 percent!) into perpetuity (after year four). (Which is why it makes so much sense to make your house as energy efficient as possible. Although keep in mind saving $100 a month may not be realistic for quite a few of you.) But you do effectively make zero for four years so it’s a long term investment and that’s the way you have to look at it (although you’ll be warmer in the meantime, which is nice). And, of course, you’ll want to count the money you’re NOT making for four years in your math.
- Bar lowering – Traditional investors will scoff at me (rightfully maybe) for this one, but since my goal is pretirement, there is another way I look at things. I call it bar lowering and the idea is that even if your potential investment doesn’t make sense under the first two items, it may still be worth doing if it brings your pretirement closer. The idea is that it may be easier and simpler (and more guaranteed) to spend some money lowering your expenses to bring your needed income amount down. The most common example of this is paying off a mortgage. If your interest rate is only 3 percent, it may not make sense mathematically to pay off your mortgage when you could probably make more in the stock market. Let the stock market gains pay for your mortgage and keep the difference, right? Depending on your overall situation, especially your age, it might actually make more sense to take the guaranteed win of paying off your mortgage, which also lowers the amount of passive income you need each month. In effect, this is what we’re doing when we buy the new windows above as well. By dropping our bill by $100 a month, that’s $24,000 we don’t need to earn and invest (again based on 5 percent — $24,000 * 5% = $1,200/year). The basic idea here is that it’s easier and less risky to cut costs than to build up an investment portfolio. So it’s just another way of cutting “spending” even though it’s not the mindless consumerism we talk about so often here on Pretired.org.
So to me it’s not as simple as just comparing everything against what I could do in the market, although that’s become my main approach. And there are other things that complicate these decisions further. How do you really figure out what the savings could be on something like new windows? Basically it comes down to a guess. And then there are factors like resale value and your personal comfort to be considered.
For example, I constantly struggle with whether it makes sense to add solar panels to my house — something I really want. We currently budget $100/month for electricity (yes we have some of the lowest-cost power here in Seattle). I estimate it’d take $15,000 to solarize our house. That means the payback would be over 12 years! That’s hopelessly long — especially considering that we may not stay here forever. I really want them, but it just makes no financial sense. The only thing that tempts me is the bar lowering. With one up-front payment, I’d never have to pay for electricity as long as we stayed here. My share of the minimum monthly bills requirement would drop to a tiny $700!
Yet, the equivalent amount invested would only yield maybe $62/month (applying 5% to $15,000 again). And because I wouldn’t be paying a bill of $100/month, it’d be worth it, right? I don’t know! See? Confusing!
We make these choices every day without realizing it. Some are simpler than others. For example, we finally got smart and bought our own cable modem instead of leasing one from the cable company. It took nearly a year to break even but now we have the lower bill and every month is gravy. Not a big deal, but just another little hole to plug in our budget. We switched the gas furnace a few years ago at considerable expense. That was probably a 3-4 year payback timeframe, but we’re warmer and the ongoing bill is lower (lower monthly overhead).
Do I regret forcing cashflow on my old fourplex? I wouldn’t do it again. In retrospect, I think I would have been better off improving the building and increasing the rents versus trying to lower the financing overhead. But if I’m honest, if I could go back in time I’d sell that building much earlier and dive into the stock market head first. I became so obsessed with cashflow, I forgot to keep an eye on the big picture. Fortunately what I learned about cashflow and the positives and negatives of forcing cashflow help me greatly today as I put together the final elements of my pretirement.