Gord Lemon reveals practical strategies to consider when your cash flow falls into the red.
Every real estate investor who is looking to own rental property has dreams of amassing a portfolio of consistently appreciating properties that spit out cash on a weekly basis from dedicated, happy tenants who pay their rent on time and never leave.
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Although this does exist, for many this is a real estate fantasy land. The reality is, property does not always appreciate, repairs and ongoing regular maintenance is necessary and tenants do move out which creates vacancies, sometimes leading to negative cash flow.
Negative cash flow results when the expenses on a property exceed the amount of revenue the property is generating. This sounds obvious but when initially calculating the numbers for a property purchase, some new investors miss the primary expense which is not documented in the online listings or other reports – the debt service… or the mortgage payment.
Some investors seem less concerned with negative cash flow, being satisfied that covering a monthly shortfall of a few hundred dollars will ultimately pay off in future appreciation. This has certainly worked well for some people; however, this is a risky game to play, especially in the current climate.
If property values do not go up in accordance with expectations and the only gain is a small equity pay down, it may take much longer than expected for an ultimate pay off. This kind of speculation makes me nervous which is why I personally recommend when purchasing property for the purpose of a long-term hold, make sure it is cash flow positive from the get go.
Realistically speaking, landlords who have one or more family homes or even duplexes, triplexes or four-plexes experience negative cash flow problems at one time or another.
How to cope with a negative cash flow
Below are a few potential solutions to remedy negative cash flow to varying degrees. Depending on your property or situation, some may work while others may not be possible due to the building structure, building size, lot size, location, zoning, equity amount, etc.
Please do proper diligence and check with your lawyer before embarking on a new strategy.
1. Create a short-term rent to own
A short-term rent to buy could be a solution for both the owner and the tenants. A rent-to-own strategy is designed for buyers who don’t have the capability to qualify for a mortgage.
Typically they don’t have good credit, confirmable income or the deposit required for conventional mortgage qualification. In a standard rent-to-own, the tenant ultimately purchases the property from the owner.
Briefly explained, the tenant is required to pay a small deposit upfront which is credited back to the tenant at the time of purchase, usually between one and five years down the road.
Throughout the term, the tenant pays the owner market value rent as well as an agreed upon amount above the rent. This amount above the rent is also credited back to the tenant at the time of purchase.
This strategy is beneficial for both parties. The tenant is given the right to purchase the house in the future at an agreed upon fixed price or an appraised price minus the amount of accumulated credits from the initial deposit and amount above the monthly payments.
The benefit to the owner is threefold. They receive an initial cash injection from the deposit, enjoy uninterrupted rent plus an amount above the rent and, have significantly decreased management and maintenance obligations as the tenant is treating the house as their future home. The result is higher cash flow and virtually no maintenance costs which should remedy the negative cash flow problem.
Screening your tenants is critical. Beyond the usual tenant screening of reference checks, employment verification and credit review, you must make sure the tenants have income levels that will allow them to qualify for financing in the future. You must review their debt load to make sure a bank is likely to work with them in the future.
You also need to review their plan to correct whatever issue they have, to make sure they know what steps they have to take to qualify for financing in the future. Honesty from a prospective rent-to-own tenant is imperative.
2. Short-term rental
Short-term rental is a niche opportunity very few landlords pursue although the returns can be extremely lucrative. If your property is located near a business area, a hospital or healthcare facility, a university or college, an airport, a resort area or in one of the many areas of Australia dedicated to the production of oil or natural gas, there may be an opportunity to get higher than market value rents on a regular short-term basis.
Many companies hire consultants on a short-term basis or transfer their employees from different areas of the country. People often prefer staying in a ‘homey’ environment rather than a hotel.
You can charge a higher rental amount for these furnished units which will still be less expensive to the company than putting their employee up in a hotel. If you choose this strategy, try to secure a long-term contract with the company.
Another opportunity can be found with families that are new to your area. Recently transferred people looking to purchase a home in a new city or town may prefer a short-term rental in a home rather than a hotel as they get acquainted with their new surroundings prior to committing to a house purchase. These can be short-term to mid-term rentals, often commanding up to three times market rent.
3. Find a joint venture partner
There are many professionals who make excellent incomes and are ‘married’ to their careers. Many are interested in real estate as an investment vehicle but don’t have the time or knowledge to participate in the day-today business. This person would become a joint venture partner and be used for a capital injection to eliminate the negative cash flow in exchange for a percentage of capital gain from appreciation.
If the reason for the negative cash flow is a difficulty in keeping tenants as a result of lack of maintenance (the number one reason for tenants moving), this capital can be used to make necessary improvements or adjustments in creating a more desirable property, thus attracting better tenants. Rents can then be adjusted upwardly.
Another reason for negative cash flow can be based on local economics or timing of the real estate cycle. Vacancy rates can become high in an area for many reasons.
Consequently, tenants enjoy many more inexpensive choices, often coupled with landlord incentives. The joint venture partner’s capital can be used to keep the property expenses at ‘break even’ until the real estate cycle moves to its next phase where appreciation and rental increases begin again.
4. Rent more space
Depending on where the property is located, it may be possible to rent out rooms as opposed to whole units. If the property is near a university, college or health facility, you may be able to convert the rooms into somewhat more ‘self-contained’ units. To do this, you will need to furnish each unit with a bed, dresser, desk and perhaps a bar fridge. The tenants would share the common living area, kitchen, bathroom
In the case of student housing, have the parents sign the leases as well as the student. This keeps the parents equally liable for any damages incurred, etc.
This arrangement can work for tenants other than just students. It can be ideal for graduate students, flight attendants, nurses, teachers, employees on temporary placement, volunteers on assignment, people on missions, or any other scenario where people need housing for a number of months at a time. You can obviously receive a higher aggregate rental amount, which can solve the negative cash flow issue.
In any of the above cases it is recommended to include a set of ‘house rules’ which each tenant must agree to and sign. This can address such things as parking, storage, kitchen duties, clothes washing, common area cleaning duties, gardening, noise levels, etc.
5. Renting separate amenities
A property may have a number of amenities included in the rent which may be charged to the tenant or people off the premises. To increase revenue from the existing tenant(s) you could charge for the use of the garage or basement/attic storage.
It is possible to rent space in the garage or driveway to non-tenants to store 4WDs, boats, jet skis, trucks or cars. The garage could be rented to a person who does
car repairs, or as a storage unit for any number of items. If the property is located in an inner-city area, you can potentially rent out the driveway for daily or weekly parking to corporate employees. Depending on the size of the backyard, you could even rent out an area to gardening enthusiasts.
6. Convert unused space into another room
You may have a large house with the potential to convert to a two- or three-unit building. This obviously requires a cash injection but can pay off handsomely in the long run. It is best to begin any conversion using unused or underused space such as a basement, attic, an out building, a room over a garage or even the garage itself.
Adding a small kitchen, bathroom and perhaps bedroom to any of the above scenarios can result in significantly increasing revenue.
Converting a lounge or dining room into another bedroom can also bring in extra cash. Make sure you check with your local council and get a DA approval before commencing.
7. Holiday rental or B&B
If your property is located in a nice area and is conducive in its physical layout, you could convert it to a bed & breakfast. Of course you must have the inclination for such a business and a proper licence to carry on such a business, but this can result in an
excellent cash flow.
8. Change the financing
Any landlord usually has a list of expenses with the debt service or mortgage payment usually being the largest. A refinance could reduce the mortgage payment by perhaps lengthening the loan term or decreasing the interest rate. A reduced loan payment will increase the cash flow.
The above ideas are to enable a landlord to hold on to their property and ultimately be rescued from the perils of negative cash flow. In some cases, however, it may be best to sell the property, cut the losses, stop the bleeding and take your lumps. Solving situations such as negative cash flow is part of any investor’s growth and success.
Gord Lemon is a mortgage and property investment professional with more than 25
years of experience.