Many years ago, I heard a phrase meaningful enough to remember:
“If your outgo exceeds your income, your upkeep will be your downfall.”
I really, really wish I could remember who said that.
I wish I had originally said it.
Growing up, the phrases “live within your means” and “don’t spend money you don’t have” were frequently uttered by my parents and grandparents, having lived through periods of economic uncertainty including many recessions. Even the Great Depression. I remember my Grandfather telling stories about childhood in northern Michigan in the early 1930s and how “nobody had two nickels to rub together”; yet, people survived tough times by helping each other.
In essence, this sage financial advice is telling us to live and operate within the constraints of our own economic reality. Neither an individual/family nor a business can survive (long) by outspending its income. Nor can government, theoretically, although it seems to find ways.
The word “profit” may evoke a negative connotation, as it sometimes seems contrary to societal expectations for a business to attempt to make a profit.
Reality #1: There isn’t a product or service in this country that is sold without making a profit.
Reality #2: There are groups of people who expect and absolutely depend on a profit being made – the first two groups that come to mind are employees and shareholders.
A business needs to have gross profit from selling services and products so that it is able to pay employees, pay fixed expenses, and sustain operations.
A business needs to have net profit to expand operations, pay down debt, or reinvest.
An individual or family needs to make a profit, or income, in order to defray the usual costs of living and be able to make an economic contribution to society (pay taxes).
Last week, our blog post on leveraged appreciation (read it here) discussed one way in which real estate offers better returns than other asset classes. Another way profit is made in real estate investing (way #2 of 5) is by simply having your monthly income larger than your monthly expenses.
This is called cash flow and it is analogous to profit.
If we purchase leasable residential or commercial real estate with no debt, it seems pretty logical that our monthly expenses would be less than your income. Consider the example of a $250,000 commercial office building that rents for $2,775 per month. If there is no mortgage on the property, our only expenses are those the tenant doesn’t pay. Say we negotiated a solid triple net lease with the tenant paying all expenses. Our yearly cash flow is ($2,775 x 12) = $33,300 compared to our $250,000 investment – a 13.3% cash-on-cash return. This is actually quite good and probably better than the average income and expense scenario.
Typically, the owner would pay some of the expenses. Assume for this example that the owner pays the hazard insurance on the building ($1,500), property taxes ($5,000), and the grass cutting and snow plowing ($2,500 each). This $11,500 in annual expenses comes as a direct headwind to the owner’s return from cash flow and the annual cash flow is now $21,800 for a return of only 8.7%.
Still not bad…especially since this is only ONE of FIVE ways real estate pays you!
Can we do better?
Absolutely.
Let’s partner with a commercial lender and purchase the building with 20% down. Our down payment is $50,000 and closing costs are estimated to be $5,000. So now we are collecting $21,800 net cash flow on only $55,000 out of pocket – much better, right?
Not so fast.
We now have a mortgage payment. As I write this in late 2020, even commercial mortgage rates are at historic lows. Assume we have been approved for a 5-yr balloon, 20-yr amortization commercial mortgage at 5%. We can probably do somewhat better, but the cash flow wouldn’t be duplicatable when rates increase. Our monthly payments are $1,320 including both principal and interest, and that is $15,840 per year. Our annual cash flow is now $5,960. This is 10.8% of our $55,000 cash out of pocket.
Not bad, considering it is only ONE of FIVE ways that real estate pays you!
Note that there are many dials to spin in adapting this possible situation to a probable situation for you. Your prevailing rates for commercial leases may be higher than quoted here; then again, your acquisition costs may also be higher. The expenses may be different – you may not have a snow plowing bill. Your market may prefer a modified gross lease, or you may be fortunate enough to command an absolute triple net lease.
Be sure not to confuse cash flow with net operating income – the latter is a term that is particularly important in commercial lending, but often misunderstood and often miscalculated. After we finish our deeper dive into each of the five ways that real estate pays you, we will explain net operating income by way of an interview with a prominent national commercial lender.
As you consider this, remember that profit is a desirable word in our economy and should be something we expect from any business or real estate venture.
Until next time,
Dr. Lee Newton
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Disclaimer: I give ideas, not advice
We invite your feedback, questions, and comments.
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