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.

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