There’s an old adage: Cash is King! But is it really?
As a bank loan officer, I’m going to show you the benefits of not using cash and why it’s not the “King” you might think it is.
Why is Cash Favorable?
Before we get to that, let’s examine why people think that “Cash is King”
You can opportunistically buy property. Because you can act fast and close on the property within 24 hours, you can often get it at a discount.
By having a nice nest egg of cash you can live comfortably without stressing-out about debt payments.
These facts are true. However, they come with some significant fallacies that many investors make.
1. You’ll Be Able to Buy Anything
Though you can buy properties at a discount, you are probably making low-ball offers and you will not be able to buy many (or any) of these properties. Think about the situation in reverse. If I am a seller, I will gladly wait 30-days and make more on my property from a buyer that is closing with a mortgage.
Let’s look at an actual example:
John and Sue are selling their house for $250,000. They receive an all-cash offer after 7 days on the market for $220,000. The all-cash buyer can close in 10 days. At the same, time they receive an offer with a pre-approval letter from a bank and can close in 30-days.
The couple that needs financing can close in 30-days and made an offer of $245,000. John and Sue are literally making over $1,000 a day by going with the buyer that also needs financing. I’m sure 99% of sellers would gladly wait 20 days to make an extra $25,000. Wouldn’t you?
2. You’ll Take More Risks
Yes, it is nice from a balance sheet perspective to not have any debt and not have the stress of debt payments. However, this also lets you stay in your comfort zone. I’m not sure about you, but when my back is against the wall, I fight!
To make both of these matters worse is the fact that you don’t earn any kind of economic return on your cash. The interest rates on savings accounts is about 0.25%. After inflation of approximately 3%, you are losing 2.75% a year.
Cash cannot be King when it offers a negative rate of return!
If Cash Isn’t King, What Is?
The short-answer: Cash Flow
Having positive cash flow let’s you source unsecured lines of credit that you can tap when you need to buy a property opportunistically.
Cash flow can also let you live comfortably as the cash flow from the property should be paying off your debt.
Cash Flow = Freedom
Why are you really interested in real estate investing?
It’s probably got something to do with freedom. Right? This is what cash flow provides.
Too many times, we base our success and failure on how much cash we have in the bank. Worse, we start evaluating deals with how much (or how little) cash we can put down on a deal.
Cash flow is the reason we are investing in real estate in the first place.
Calculating Cash Flow
Now, I want to show you how to properly calculate cash flow…two ways:
Cash Flow: Traditional Method
This formula is used by almost every investor.
Rent – PITI – Est. Annual Repairs = Cash Flow
Cash Flow: Jimmy Moncrief Method
My method turns the traditional formula around, and works it completely backwards. Before you even evaluate a property you should ask yourself: “How much do I want to make on this property?”
In my opinion, you should make at least $300 per unit or door.
Therefore, start with that and work backwards:
Cash Flow: $300 + Est. Annual Repairs + PITI = Ideal Rent Amount
Of course you need to have a very realistic view of how much you can get for rent after you do this calculation. Trust me, I have made a lot of mistakes and this is one of them.
There are two principal problems with my method:
- It’s easy to overestimate how much you can get for rent.
- It’s easy to underestimate how much annual spending will be to maintain the property.
To reiterate how important cash flow is, this is how a bank will underwrite your deal. They aren’t going to calculate how much money you are going to make in appreciation they are going to evaluate how much cash flow the property provides to service the debt.
Debt Service Coverage Ratio (DSC)
The calculation the bank uses is called a Debt Service Coverage ratio (DSC).
Most banks have a minimum DSC for real estate investments at 1.20. This means that for every $1 of debt you should have a minimum $1.20 in cash flow to service that debt.
Let’s go through an actual example of a property I recently bought:
- Duplex that is rented for $1,400
- Monthly payment: $988
- Insurance: $25
- Taxes: $38
- Estimated repairs: $50
- Cash flow (before debt service): $1,287
- Cash flow (after debt service): $299
This property has a monthly DSC = 1.30
Note, this property easily beat the bank’s requirement of a debt service coverage ratio of 1.20. However, it failed my test of making at least $300. I went ahead and bought the property because $1 is essentially a rounding error.
The point of this entire article is to look at your real estate company dynamically. What do I mean by that?
Well, I’m a banker and when I’m looking at financial statements, I’m acutely aware of that financial statement is a snapshot of what that 1 company looked like at that particular day.
In reality, companies are dynamic and cash flows are wildly erratic. I know plenty of staffing companies that are wildly profitable but on the verge of bankruptcy every other week!
Why? Well, staffing companies pay their labor every Friday (traditionally). However, the staffing company that I know of doesn’t get paid until after 90 days. THIS IS A HUGE CASH FLOW PROBLEM!
Hopefully this article has challenged you to think about your real estate investing in a dynamic way and focus on a dynamic metric like cash flow rather than a static metric like how much cash you have in the bank.
p.s. By the time you read this I will be building an orphanage in Zimbabwe. Did that fit into my budget? No, but just like my real estate company, I don’t evaluate my success (or failure) by the size of my bank account!