Real Estate Speculation vs. Investing – Does Cash Flow Matter?

by Steve Crossland, REALTOR in Austin TX on July 19, 2006 · 9 comments

There is debate among real estate investors regarding the difference between “Investing” and “Speculating” in real estate. Generally, the tone and context in which the word “speculation” is used tends to be negative. i.e. “That’s not investing in real estate, it’s {sneer – with furrowed eyebrow and spittle flying from lips} SPECULATING in real estate”. OK, I’m exaggerating a little bit.

The most common dividing line used in making the distinction between speculating vs. investing in real estate is whether or not a real estate investment property returns a positive cash flow. If the rental property does not provide cash flow sufficient to cover the monthly carrying costs of the investment property, and the investor is betting largely on future value appreciation to provide the eventual return on investment, many consider this to be speculating. And they consider speculating to be an inferior, less desirable and more risky form of real estate investment than “positive cash flow investing”.

Wealth can indeed be built owning negative cash flow rental homes. We would all prefer positive cash flow properties, but focusing too much on monthly cash flow ignores other important factors. Let’s take a closer look at this question of cash inflow/outflow and the labelling of positive or negative cash flow as ‘good’ or ‘bad’.

Here are some questions for those averse to negative cash flow to ponder.

Is the money one sends monthly to a Roth or SIMPLE IRA, 401K, etc. “speculation”?
There is certainly no disposable monthly cash proceeds immediately returned from those investment vehicles, yet there is a monthly cash outlay. Is the monthly cash outlay “negative cash flow”? Are not people who invest in retirement accounts “speculating” that those accounts will someday be worth substantially more than the sum total of cash outlay needed to feed the investment over time?

Is it unwise for an investor to believe, after prudent consideration of all options and using reasonable assumptions, that her initial investment plus monthly cash outlay will grow more in a piece of Austin real estate than it will in a mutual fund?

Does the Loan Product used to obtain a rental property determine whether it’s a good property to buy or not?
It seems that the people who are down on negative cash flow base their judgment about the soundness of a real estate investment solely on the monthly cash flow. That ignores a lot of other very important factors.

For example, let’s say I can purchase a home with a 30 year loan that would provide a small positive monthly cash flow, but instead I decide to obtain a 15 year loan with a better interest rate. Let’s say that the 15 year loan does not result in a positive cash flow. Have I gone from being a real estate investor to a real estate speculator? Has anything about the home or its potential for future appreciation changed with the loan product?

What if I make a 50% down payment on the 15 year loan, and now the rental property does provide positive cash flow? Has the deal now become an “investment” again, instead of “speculation”?

What if I pay all cash for a property and I pay 20% over market value, but since I paid cash, the property provides a positive monthly cash flow? Does the positive cash flow make it an acceptable investment, or would the future value of the property and return on initial cash invested also be important to consider?

What if I obtain a property for 20% below market value, but it produces a negative cash flow? Does the negative cash flow make me a speculator, and the property a more risky investment, or does the instant equity make it ok?

What if someone decides to start making additional equity payments each month on a rental home, such that they can aggressively pay off the note in 10 years instead of 30, and it causes negative cash flow? Is the investment now a poor investment because it doesn’t provide positive cash flow?

Why don’t we all just buy mobile homes?
If positive cash flow is the sole determining factor of what makes an investment property worthy of consideration, why not invest only in mobile homes? Mobile homes, in most parts of the country, can provide rental cash flow returns that are far superior to those available with suburban family homes. Or does the fact that mobile homes depreciate in value make them a poor investment choice? If so, is that to say appreciation really does matter more than cash flow?

These are just a few ways to look at the “cash in, cash out” questions that often come up when evaluating rental property as an investment choice, and to get you to start thinking with more of an open mind. I think it’s missing the big picture to use a single factor – cash flow – to decide if a real estate investment decision makes sense or not. I see a lot of real estate investors chasing cash flow instead of looking at cash flow simply as one of many factors to consider.

How do we think of money anyway?
I think many Americans have a limited and distorted view of money and how they choose to allocate, or “invest” it in their lives. At the core, we are either predominantly Investors, Spenders or Savers. To me, as an investor, I think of every dollar that comes through me as either a seed that is planted, with potential to grow (invested in appreciating assets), or simply a dollar spent. The choice is mine, though society and media advertising certainly try hard to sway me toward the less wise choices of consumer and lifestyle spending.

The monthly cash flow gap I might experience on a particular real estate investment property is money I view as seeds being planted.

Spending is not evil, and we all have expenditures that are required such as food, clothing, shelter, transportation, insurance, education, etc. But many people, I have observed, confuse their necessary life expenditures with consumer/lifestyle spending.
Essential expenses are necessary. All other expenses are discretionary, and one has to decide how those discretionary expenses will be allocated between lifestyle and investment or savings options.

If one chooses to scale back on lifestyle and consumer spending and reallocate more discretionary dollars toward assets that might grow in value over time, I think that person is thinking and acting like an investor, even if they purchase a negative cash flow rental property.

Some of the same people who choose to spend money maintaining a lifestyle that includes an overabundance depreciating/disposable assets (“stuff”) and consumer junk (more stuff), are the ones who judge negative cash flow investors to be dumb. I think folks who think in those terms are off base in both their spending habits and their judgments of others.

This is not to say that real estate investing, and especially negative cash flow investing, is the best investment vehicle for everyone. It’s not, and I talk a lot of potential investors out of buying. Some folks just don’t have the financial strength or the emotional temperament needed. Real Estate investing is risky regardless of what the cash flow looks like, but it can also a powerful vehicle toward wealth building.

Also, there are probably few of us who could honestly examine our family budgets and not find hundreds, maybe thousands, of discretionary dollars flowing out monthly toward things less deserving than a real estate investment. How many of the dollars that pass through your budget each month become seeds that are planted and how many dollars are merely passing through, never to be seen again? Could you cut back enough spending each month to reallocate funds toward an investment property (or even a Roth IRA) without sacrificing too much in lifestyle? How might that affect your balance sheet in 10 years from now? It’s just something to think about.

For a detailed overview of one possible cash flow scenario with Austin rental property, see this blog article.

{ 9 comments… read them below or add one }

1 Greg July 19, 2006 at 6:21 pm

A couple counter points:

* Even cash flow break-even properties result in a loss for tax purposes. The amount of these losses that may be deductable in a current year is capped for many investors at 25K or less. Buying negative cashflow property can cause an investor to have a reduced return from the tax savings avenue.
* The critera “property must cash flow under such-and-such financing assumption” can be useful as a *proxy* to criteria like “I must get a property for a below market price”.
* You can’t “eat” appreciation. You can only access it by selling or getting a loan. In order to continue investing (with your own money) you need to have cash available to invest.
* It is important as an investor to know how your investment will do under various likely scenarios – including under low or no appreciation scenarios. A property that does not cash flow will not fare as well under “worst case” scenarios as one that does.

PS: The paragraph begining with “Some of the same people who choose…” is not a rational argument. It’s like saying “Some people who disagree with me on this issue are also pedophiles. Would you listen to pedophiles?” On what do you base the claim that there is a correlation between the “cash flow is important” and “I like to buy lots of consumer junk” viewpoints?

2 Steve Crossland July 19, 2006 at 6:44 pm

Hi Greg,

The “some of the same people …” comment relates to personal conversations I’ve had over the years with different people regarding real estate investing, and money in general. It’s a paradox I’ve noticed. High consumption spenders with little or no investment tend to be more critical and skeptical of real estate investing, and have more excuses for not doing it, than those of us that do invest in real estate.

Thanks for your comments.
Steve

3 Norman Richards July 19, 2006 at 6:52 pm

http://en.wikipedia.org/wiki/Speculation – That’s a great summary of speculation. While it’s true that much of what we consider investing is speculation, there are certainly degrees of riskiness. The risk of speculating on a highly leveraged investment with a negative cashflow (-$500 in the example you gave) is very high. The Austin market has to do exceedingly well to be able to cover from such a losing starting position. The signs are good that it will, so maybe it isn’t super risky, but that’s a huge difference from being highly leveraged in an property that will likely generate a modest positive cashflow. If the market does well, you win just as big as the pure speculation. If it doesn’t, you’ve still got an solid base. Since it’s easy to find good investment properties in Austin now, there’s no reason to settle on a pure speculation.

Just to follow through with the analogy to stocks, stocks do generate investment income. Companies generate profits, which are returned to investors in the form of dividends. It happens to be that many companies decide to reinvest their profits rather than return them to investors, in the hopes of growing to generate even more profit later. (not to mention the tax inefficiencies of dividends) When you buy a stock, you are generally investing in the revenue of a company, even if that isn’t directly returned in immediate cashflow. Perhaps you can argue that even this is still partially speculation, but it’s different from speculation in commodities, options or even austin housing.

Anyway – it’s a nice discussion. In the end, no matter how you choose to make your money, think important thing is that you know what you are getting into.

4 Stuart Strum July 30, 2006 at 2:50 pm

I think that the idea of quick payoff to build equity or other strategies that may result in a negative cash flow could still be good investments, but one should consider not just the direction of cash flow (positive or negative) but its magnitude, both in absolute and percent of capital terms.

It’s one thing to buy a house in good condition, good neighborhood and favorable setting with respect to transportation and amenities where the monthly payment on a 20% down 30 year fixed note is negative by $50 or $100 per month, but those condos in Florida and San Diego where the equivalent payment is 3 to 6 times market rental rates can’t stay up there forever.

In Austin, there are pockets that are out of whack in such an analysis. Some of them are sustainable because of special properties and limited supply means demand can support the prices, regardless of rental rates. Basically, these are neighborhoods in close in areas where rich people want to live.

But $200/sqft for those dinky little crackerboxes near North Loop and Lamar? You could justify such prices for that location if one could consolidate lots and build dense housing or primo quality houses with at least 1700 sq ft (being this close in will be very desirable when gasoline is $8/gallon, and believe me, it’s coming, and it will get here even faster via W’s skilled hand at diplomacy). But with current zoning restrictions and square footage limitations, economically viable use of these properties is verboten. Maybe people paying these prices know somebody on city council or the planning commission, but I don’t.

5 Paul Skellenger August 20, 2006 at 3:48 pm

I am currently developing an investment strategy that includes rental income. If you consider total return on investment, even a modest 6 to 8% appreciation in the property plus a marginal rent can make this comparable to other investments. I am concentrating on Lakeway and was wondering whether the June figures of $.80+/sq ft are based on the total number or single family rental homes available for lease, or is the data somehow limited, and what is the expected percent of time the property is likely to be leased in Lakeway?

I also have partnerships with two builders in the area. So if I can compete with new homes out here, what is the best price range, square footage, etc.? I am looking at trying to stay between $400,000 to $500,000 to the home buyer. I feel that 3000 to 3500 sq ft with better finish out is plenty of house. Also, better warranties and better dirt with a decent view seem to me to be desirable. Maybe 2000 to 2200 sq ft is plenty and we should be looking to turn at $325,000. I have no desire to be stupid, but I have no fear either.

With all that is going on at hwy 71 and 620, it seems inevitable that rates of appreciation in the area will increase. The mall, the lake, golf courses…….. This is vacation land meets city. I have spent much effort getting to know this area. Maybe I am nuts, but I am asking my partners to jump on this with me. Any comments appreciated.

6 Steve Crossland August 23, 2006 at 12:09 am

Hi Paul,

The 620/71 area has terrible traffic problems and it’s also a very desireable area to live if you don’t mind the drive into Austin. Only 2 routes – north to 2222 or south to 620/71. If there is an accident or problems at either end and your trying to get home from Austin, to your kids game, to a meeting, etc., it’s too bad. Might as well pull into Starbuck and relax for an hour or two.

But it’s still a good area to be looking at, in my opinion.

Steve

7 Steve Stowers August 26, 2006 at 1:30 pm

We currently own several properties in what used to be called the NW part of Austin – Arboretum area (360 & 183 corner). One of our houses in the area is an average home – 2700 sq ft in Great Hills. We have rented the house out for the past 2 ½ years with absolutely no problems and in each case got full contract amount plus term (12 months). The average number of days on the market has been less than 2 weeks. I attribute our success to the location. As they say in Real Estate, it’s location, location and location.

Based on our experience with the Arboretum area, I’m really interested in investing in property downtown. Again, the primary reason for this is location. I noticed on one of your charts you show the average rental amount for central Austin as .80+/sq ft. Unfortunately, I believe the Central Austin area is pretty large and thus covers a number of different neighborhoods. Do you have any numbers (rent price per square foot) near Clarksville and Tarrytown areas? With the traffic on MOPAC only getting worse as more people move to Austin, I see those two areas as being very attractive.

Somewhat related, what do you think about the development of Townhomes and/or Garden Homes in the Tarrytown area? Do you think it’s an advisable investment in Tarrytown.

Steve

8 Paul July 13, 2009 at 4:30 pm

This year I had 2 positive cashflow properties and 1 negative, the negative cashlow showed my overall income to be fairly low and I got $8000 back in taxes. This will cover any negative cashflow for the year. Now i am refinancing the negative cashflow at low interest rate, and now it will be positive.

9 vlad zakashansky September 26, 2011 at 11:20 am

Hello Steve,
Thank you for writing a very good article. I was happy to read an article by a very knowledgeable real estate expert that ACTUALLY understood real estate, wealth building and personal financial management.
I also feel that there are many tax shelters involved in owning properties, whether they are cash flow positive or not. A lawnmower that is purchased to mow your rental properties yard is a business expense, yet it can also be used to mow the lawn at your own residence, giving yourself an economies of scale

Good luck with your journey of passing valuable information down to others who desperately need it.

Vlad Zakashansky

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