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Cashflow is King (Sometimes)
September 29, 2007

A common mistake of many real estate investors is the way they evaluate a potential investment properties. Below is the process I have seen many first time investors use.

Step One : Look at Cashflow. Ok, what's step two? In the minds of many investors there is no step two. Basically if the property has good cashflow they move forward. There are many pitfalls if cashflow is the only element you evaluate.

What are some issues with this approach?

1) The property is over rented.

MLS Listings will frequently say that a property is under rented. They rarely if ever say a property is under rented. What would cause a property to be under rented? The previous owners could have offered one or two months free in an effort to get rents unnaturally high. They could also be renting to family members and other incentives could be known to only the owner and the renter. Lastly, and don't underestimate this, sometimes an owner just gets lucky. This is one of the benefits of using a realtor. Out of town investors are the most likely to unknowingly purchase over rented properties.

2) The property is going to be negatively affected by future developments in the near future.

The real estate landscape is always changing. And while future developments can have a positive impact on a property they can also have a negative impact. For instance a new halfway house next to a potential rental property is not exactly going to help the future appreciation of a property.

3) The property will be difficult to Rent Out

Additionally subdivisions that are built farther out away from jobs and conveniences of a town can have low purchase prices but can be very difficult to rent out and are unlikely to appreciate in the near future. I have heard of a subdivision in Dallas where 90% of the homes were purchased by out of town investors. As local investors called it "Stink Bait for California Investors". I am sure the numbers looked good for a out of town investor that didn't investigate to realize that while people in California accept spending an hour in a car to commute to work people in Texas are not currently willing to accept such commute times.

4) The property has low potential for future appreciation

This is similar to point 3. Developments in far flung areas have a difficult time appreciating. The problem is that in 5 years when you are trying to sell your house a new subdivision is being built down the road. People that are buying in the suburbs often place a premium on "new" houses. This makes it difficult to sell your investment property. Additionally appreciation is limited when there is a large amount of available land close to your property. The reason for this is that as demand increases the available vacant land next to your property is developed. When demand increases but supply increases proportionately appreciation is limited.

5) The property has serious structural or other defects

Houses with structural defects often have good price to rent ratios. The reason for this is that renters usually are not bothered by a foundation crack that will cost 30k to fix in a few years. As long as the house is currently livable they are going to be ok with the current living situation. But a structural problem can be expensive and time consuming for a property owner to deal with. In the worst case scenario a property can be unrepairable and will need to be demolished.