Want Real Estate Cash Flow? DON'T Buy Single-Family Rentals

Have you been told to go out there and buy a single family rental to go out there and achieve your cashflow goal? Well, guess what? Single family rentals are not the best vehicles to go out there and achieve cashflow in real estate. The Property Llama team and I broke down the data from 6,858 properties. And we uncovered some shocking truths when it comes to the dynamics of cashflow across different rental portfolios. After reviewing this data, you'll never look at your rental properties the same ever again. And you'll think about cashflow differently every time you go out there and analyze a rental property. Now, if you don't know me, my name is Chris Lopez, and I specialize in helping real estate investors understand their rental portfolios and then optimize it to go out there and achieve their cashflow goals. And can you guess what the number one reason people get into real estate investing is? It's for cashflow. They want to achieve a certain amount of cashflow by a certain time to go out there and retire. Cash on cash return is probably the most common metric real estate investors like to use. Now, if you currently own rental properties, you need to throw that metric out. Let me show you why. So now we're in the Property Llama software looking at a three bedroom, two bath, typical single family rental. Now, what you're seeing here at the top is a 19.5% cash on cash return. Amazing double digit numbers, right? Well, let's look under the hood. Now, this property was acquired in 2012 for about $125,000 purchase price between down payment, closing costs and repairs, the investor about $52,000 into the property. So when we look at cash on cash return, here's the issue for current landlords out there. We're taking the $10,000 a year we're making in cashflow in today's numbers, and we're dividing that over the $52,000 this investor put out 12 years ago. Do you see an issue with this? We're using today's dollars and dividing by a number over 12 years ago. There's a huge discrepancy in the time value of money. So a lot of people really get excited about that 19.5% say, but Chris, I'm making a 19.5% cash on cash return. Well, you know what? Percentages don't pay your bills. And there's a better way to evaluate the current cashflow performance of a rental property. It's not cash on cash return. It's cash on equity return. Now, before we dive into more numbers on here, I need to tell you about the tool that I'm using to analyze it. This video is sponsored by Property Llama software. Now this is software I helped co-create. Why? Because I needed a better way, a better tool to go out there and analyze rental properties. So beyond getting current numbers performance, the powerhouse that we can run scenarios of what if I did a cash out refi? What if I did a 1031 exchange? And the software can model it for you and give you side by side comparisons to help you understand, hey, if I did this, here's how the numbers look today. And we can forecast out for years to come. So go to propertyllama.com slash BP to go create your free account. So you can upload your own properties, get a free analysis and see what potential you have in your portfolio. So cash on cash looks at the money you put into the property to acquire it. Well, what's happened over the last 12 years? Well, we've seen market appreciation and also paid down the mortgage balance. So this property has about $430,000 in equity on here. So cash on equity says, let's take this $10,000 of cash flow divided over that $430,000. So over here, when we look at this, it's showing a 2.3% cash flow on equity. Now let's talk about this 2.3% versus 19.5%. They both are giving us about $10,000 here in cash flow, but which ones are the correct way to understand how your property is performing? It's the cash flow on equity, because that equity in your property represents real opportunity costs. You can pull the money out, you can sell the property, you can take the equity and go reinvest it elsewhere. So one of my goals, whenever I sit down and talk to an investor is to challenge their belief system. And we see this 2.3% cash flow on equity, I always ask investors, well, can you go out there and beat a 2.3% cash flow return? And they're like, yeah, I can go out there and do a high yield savings account paying four to 5% right now. You can go out there invest in T-bolts paying over 5% right now. So I want you to start looking at pure opportunity costs. Am I saying that's what you should do? No, I'm just trying to point out different ways to look at it and compare what you'd be doing with the money. Now, I don't know many real estate investors who will sell their rental properties and then go stick all their proceeds in a high yield savings account. So let's jump into the data and see different properties and their return on equity. So in this chart right here, this first column you're seeing is the single family home return on equity. And actually see here across all the properties we analyze, we're seeing about an average negative 0.2% cash flow on equity. So I have been amazed at how many investors I talk with who have a negative cash flowing property or multiple properties in their rental portfolio. So you can see that's common across single family homes, and also townhomes. They both on average are having a negative cash flow on equity. Now I want to contrast this with the two biggest graphs you see on here. The first is a large multifamily, which is five to 25 units. So that's commercial multifamily. On average, they're about a 5.6% cash flow on equity. And we're seeing small multifamilies, the duplexes, triplexes and fourplexes sitting at about a 3.5% cash flow on equity. So why do we see such a big difference between single family homes and multifamily? Well, let's look at your typical buyer out there. Why does someone go out there and buy a multifamily? Well, they're buying an investment property, they're buying an income stream. Now the vast majority of people out there buying a single family home, they're not buying an investment, they're trying to find a nice home to be close to their job in a good school district and to raise their family. So the reason we're seeing higher cash flow on equity for multifamily is because the price or the valuation of multifamily properties are based off the income it produces. For single family homes, when people go out there and buy or sell them, they're looking at sales comps, not the rental value on them. So as rents go up or rents go down, the prices of multifamilies adjust. So does that mean single family homes are a bad investment? No, I'm just putting out the performance in terms of cash flow. But now let's talk about a take the equity and turn that into cash flow. So let's look at the next graph, which is equity versus purchase year. Now you'll notice that the longer ago someone purchased a property, whether it's a single family home or multifamily, the more equity they have, which isn't surprising because that person's paid down the loan more and experienced more market appreciation. As we get closer and closer to present day, we see the equity start dropping off. Now the key here is how do we convert that equity into cash flow? So now I'm going to go through four scenarios on converting equity into cash flow. Well, since the graph shows that multifamily has the best cash flow and the cash on return on equity, we're going to focus on how do we move the equity into multifamily properties to achieve better cash flow. So the first option is just to simply pay off your rental property. I always encourage everyone to run that scenario to see if it's the right fit for your portfolio. So on the left here, you're seeing the current single family rental with about $50,000 left on the loan. On the right side is the same rental, but if I paid it off. Now the cash flow is going to be the biggest change right here. If I were to pay off this rental property, my cash will go from $10,000 to about $15,000 a year. Now in terms of cash flow on equity, that single family rental with the mortgage would be 2.3% and the paid off rental property would be about 3%. So that 3% is definitely better, but an extra 0.7% is nothing earth shattering. And let's be real, an extra $5,000, $6,000, $7,000 a year isn't going to retire anyone from their job. Now scenario number two is where we do a cash out refinance on the existing rental property. So we put a new loan on the property, replace the existing one, we pull out a bunch of equity to out there and buy a multifamily property. And I'm going to run a scenario where I do a refinance on the property. So I'm going to assume that we're going to have 7.5% interest rate, and I'm assuming go out there and buy a 6% cap rate property. Well, we all know interest rates are a lot higher, so putting down a 20 or 25% down payment's really tough. So we're going to leave 35% equity in the current property and put a 35% down payment in the new property. All right, well, let's see what this does to our cash flow. We go from a $10,000 a year positive cash flow to a negative $6,000 a year combined cash flow from the refinanced property and a new multifamily property. So this is not a good option. Let's look at scenario three, which is where we're going to sell the single family rental property, utilize a 1031 exchange to defer taxes, and then go out there and buy a multifamily property. So I'm going to come in here and run a 1031 exchange scenario. I'm going to assume a 7.5% interest rate and a 6% cap rate on the new multifamily with that 35% down payment because we already have a higher interest rate environment. So let's look at the cash flow on our new multifamily property. So we're at about $6,600 in the first year. Now that's less than the $10,000 we're currently making on our single family rental. But hey, at least it's positive when we compare it to the cash out refinance. We all know real estate is a get rich over the long-term type investing strategy. So let's fast forward into 5, 10 and 20 year timeframe. So this blue line represents the cash flow with our existing single family. And the yellow line represents the cash flow with our multifamily property. So while in year one, our multifamily property has less cash flow by year five, our multifamily cash was about $21,000 a year compared to about $13,000 a year. Fast forward to year 10, well, the multifamily should be about 37,000 versus about $16,000 a year in the single family. And every single year that Delta gets bigger and bigger. So as we get into scenario number four, I have a key question I want you to answer. Would you rather have $841 a month in cash flow or a one-time check of $396,000? Now keep in mind in the beginning, I talked why I don't like cash on cash return. And that's because it doesn't take into account the time value of money. So keep the time value money at the top of your mind while you answer this question. Now, most people say, Hey, I want that one-time check. That's almost $400,000. Now let me introduce you to scenario four, which is sell your property, get that big lump sum of cash, and then go out there and reinvest in more real estate or a different asset class. Now I know as we get into real estate investing, we're taught, Hey, get that monthly check, get that monthly rental income, which is great. But when you look at $840 a month versus $396,000 as a one-time check, which one has a bigger impact? The $400,000 check does. Now here's another way to look at that. If we take $396,000 and divide by $841 a month, that equates to 39 years. Let that sink in. Would you want the check now or the next 39 years get the equivalent amount? When you look at numbers like that, taking that lumpy cash for the day makes the most sense. But here's the next objection I get from people. But Chris, I will pay so much money in taxes when I sell the property and pay lumpy cashflow. Well, let's talk about the US tax code a little bit. How is your monthly rental income taxed? Well, that's taxed in the ordinary income tax rate. Now that tax rate will go anywhere from about 10 to 37% at the federal tax level. Plus, if you have state income tax on top of it, you'll owe more taxes. Now, if we sell a property, how are the gains on the sale of property tax? Well, if you've owned it for more than one year, you're going to pay long-term capital gains tax. And those are generating tax between zero and 20%. So I encourage you to go out there and talk to your CPA and research the current tax rates for the federal level and the state that you're in, and then go run the scenarios yourself. Because if we look at the taxes on an $841 a month, I may pay up to 40% taxes because I live here in Colorado. Now, if I sell the property, I may be paying around in the low 20% tax bracket. And so when I started thinking about this lumpy cashflow, I went through this paradigm shift of what is more tax efficient? No one thinks twice about paying taxes on that monthly rental income, but they hit the brakes when they talk about selling a property. But look at what the most tax efficient situation is. So the next question a lot of investors ask is, well, if I own the rental property, I keep taking that monthly cashflow check every single month. I have the depreciation of my rental property to offset my monthly income. Yes, you do. But I encourage you to go out there and talk to your CPA and your tax returns to understand how much depreciation benefit you're getting. The depreciation benefit is calculated on the purchase price you paid for. Now, while this property we've been using is currently with about $480,000, we purchased it for about $125,000. So it has a few thousand dollars a year in depreciation benefits. And when you compare that to today's cashflow, those benefits are often a marginal amount with no big impact. Someone change gears here and stop talking about numbers and taxes and cashflow and talk about the reason we invest in real estate. It's for some quality of life. It's to retire your spouse, spend more time with your kids, and eventually retire yourself from your job or business. Right after COVID happened, I met with this investor and he was 70 years old and he was just selling, cashing out, didn't care about taxes. He goes, look, Chris, I'm gonna walk away with over $10 million. And if I walk away with 12 or $13 million, it makes no difference. I only have a few years left of good health where I can go out there and visit my grandkids around the country, go spend two months a year cruising. And ultimately, he went out there and retired to Hawaii. And he said, I just want to go out there and simplify my life. You hit a point in your portfolio. You hit a point in your life where maximizing cashflow, saving a dollar in taxes, simply doesn't matter. He said, I'm out. I'm taking my giant lumpy cashflow. I'm going to go out there and enjoy life. So as we wrap up this video, I want to end on that story and think about the whole reason you're out there investing in real estate, because as you know your why, those taxes and the details become less important. And once you hit that tipping point where you can just escape the rat race or change your portfolio and simplify your life, maybe you should go out there and do it. So I encourage you to go evaluate your portfolio, calculate what your cashflow on equity is. And I encourage you to go through the what a scenario of selling every single property you have to take lumpy cashflow and reinvesting it elsewhere to simplify your life and achieve the lifestyle that you want. Let me know what you're going to do in the comments below.