Don’t be scared. The real estate business is built on negative cash flow.
But what about Buffett’s first rule? Never lose money!
In my last post, we talked about the difference between cash flow and profit. This post expands on that difference. In fact, to make a profit, you have to be able to manage a business where negative cash flow is pretty much a given. I’ve even discussed situations where you may want to embrace negative cash flow on a rental to reap the benefits of long-term profitability.
So long as you are actively renovating properties, you will experience months of negative cash flow interrupted by brief floods of profits taken. Renovating properties requires you to spend money over time. Even if you have a few rentals, the positive cash flow they generate will not offset the money you spend on renovations.
You see the same thing with rentals, even if you do have more positive months. When you buy a new property, you can expect for it to generate negative cash flow—possibly enough to overcome the positive numbers from your other units—for at least the month of purchase. And if you buy it right, you’ll have to put something into getting it ready to rent. Then there’s ongoing maintenance and capital replacement (think water heaters and ACs). And finally, there’s periodic vacancy.
I only know of two ways around the inevitability of negative cash flow:
- Grow your renovation business to where you can close on the sale of at least one property every month.
- Grow your rental portfolio to generate enough income to overcome the deficit renovating properties creates.
Even if you succeed in one of these awesome accomplishments, you will still have to deal with periods of negative cash flow until you reach the pinnacle. That leaves just one course of action: pay attention and manage your money.
Most renovation projects take a few months to complete an realize your profits—sometimes six months or longer. That means you may have five months or more of negative cash flow before you bring in a chuck of cash that, hopefully, makes it all worth while. Here’s what a typical project looks like.
Some lenders cover some of the renovation costs, but you still have to pay for everything up front. In that case, your negative cash flow will be offset somewhat by the debt. We try to cover the renovation costs up front either with our own money or through additional debt. Even so, there is more cash going out than coming in most months. We still have to plan for at least four months of negative cash flow for every month in which we have a sale.
So where does this money come from, and what do we do with it? Much of it comes from the proceeds of previous sales. We make up the rest with additional debt, often from the members of the company. (I’d rather owe money to myself than someone else.) Regardless of the source, we keep it in a money market account separate from our normal operational checking account.
Before any of the partners takes a distribution from a project, we make sure we have enough reserves to cover all the renovation expenses, marketing expenses, personnel expenses, and office expenses for the next six months or the next planned sale, whichever is longer. It’s tough to leave that money sitting there earning five or six dollars a year, but operating reserves are a necessary evil.
Most financial pundits recommend keeping a cash reserve big enough to cover all of your expenses for six months. That’s not a bad idea for a real estate business, either. But it’s hard. The entrepreneurial imperative, after all, is to put that money to work. As the Second Rule of Acquisition states, “The best deal is the one that makes the most profit.”
And the most profit comes from putting your money to work as quickly as possible, doesn’t it. Kiyosaki recommends paying yourself first—that is putting your money to work at just about any cost. His rationale is that doing so puts pressure on you to make even more money to cover whatever the invested money was supposed to cover. And it does. It really does.
Last month, Carol found us one of those deals that you just can’t pass up. Unfortunately, it required us to use almost our entire cash reserve to get into it. That made getting through December and the first part of January painful. We were counting on the sale of one of our properties to come in. But as always happens when you need something, the closings kept getting delayed for one reason or another. That left me scrambling to find the money we needed to meet payroll, pay our mortgages, and cover the utility bills. I found it, but it meant robbing Peter to pay Paul.
Now we’ve closed on two sales, and that replenished our operating reserves. I feel a lot more comfortable going forward with money in the bank, but I don’t regret the purchase of the new property.
Would we have bought that house if we knew we would have to scramble for more than a few weeks? I honestly don’t know. Probably.Hermann says please like and share!