I recently worked with an investor who withdrew from buying a great one bedroom condo that he was going to use as a rental. He withdrew because he was going to have negative cash flow the first few years that he owned the property.
What really surprised me about the situation is that the investor was buying the condo with a no-money-down loan and despite putting none of his own cash in the property; he still expected to break even right from the start!
This is kind of like buying a cow for the milk, but not being willing to feed her!
The same goes with buying small rental properties, (the kind of properties that an average person could afford).
If you were to make a 30% down payment on a rental property, (the kind of down payment the banks might want on an investment property) you would likely get a small amount of positive cash flow right from the start.
However, if you buy an investment property with a small down payment or no down payment, you should expect to have to "feed" the property during the first few years of ownership. This is not necessarily a bad thing.
Consider the purchase of a 0,000, single family home with 4 bedrooms and 2 bathrooms that could be rented for 00/month.
Here is what could happen when you make a large down payment, and what might happen when making a small down payment or no down payment:
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Example #1: A large down payment & positive cash flow:
"Joe Investor" makes a 30% down payment (,000) when buying his 0,000 rental home. This leaves Joe with a mortgage of 0,000.
At a 6.5% interest rate, Joe's monthly payment with taxes and insurance would be about 10 (PITI). Let's assume maintenance and vacancy costs of 0/month. Joe's total monthly cost of owning the property would be 80/month.
The difference between the rental income of ,400 and the expenses of 80 gives Joe 0 in monthly positive cash flow.
If the home went up in value 2% the first year, Joe will have made ,000 in appreciation + ,440 in total positive cash flow. Total profit: ,440
Joe's total first year return on the ,000 he invested would be: ,440 ÷ ,000 = 9%
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Example #2: No down payment, and some negative cash flow:
"Jane Landlady" has great credit, but not a lot of cash, so she decides to buy her 0,000 rental home with no money out of pocket. Her mortgage payment is ,489 per month (PITI).
Like Joe, Jane also has vacancy and maintenance costs of 0/month.
Jane's total cost of owning the home is ,659 per month. Jane is receiving ,400 per month in rent.
Jane has to take 9/month out of her pocket to make up the difference between the cost of owning the property and the rental income she receives.
Jane's rental home also goes up in value 2% (,000) during the first year.
Jane's total investment into the home is 9 for 12 months, or 08.
Jane's first year return on her cash investment: 00 ÷ 08 = 128%.
Needless to say, Jane is very happy about this.
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Jane will probably have several years of negative cash flow before she can raise the rents high enough to cover her costs. The good news is that her return on invested dollars (the "negative" cash flow) will always be dramatically higher than Joes.
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P.S. What if Joe & Jane both stop making payments on their rentals due to not being able to get their homes rented? Who will be the first person the bank forecloses on?
Not Jane, she has very little equity. It would cost the bank money to take back ("foreclose on") and resell Jane's rental home.
Poor Joe though, the bank wants his rental house bad. There's lots of equity in Joe's rental home. The bank isn't going to lose a dime foreclosing on Joe's rental house
Joe loses his rental home to foreclosure and Joe kisses his good credit, goodbye.
Jane's no down payment strategy has bought her a little extra time and that might be just enough time to let her save her credit and save her rental home from foreclosure.
