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Rental property cash flow went away in 1971

Posted by John T. Reed on

Income stock versus growth stock

Rental property was the equivalent of an income stock—one that pays dividends like utility stock—until 1971. Then rental property turned into the equivalent of a growth stock—no dividends, just stock price increasing, like Apple.

Double-digit cap rates

To put it another way, before 1971, cap rates were double digits. My first rental property in 1969 had net operating income of $1,711/year and cost $14,000 for a cap rate of $1,711/$14,000 = 12%. It had been on the market for a couple of months for $16,000 when I offered $14,000 and got it. Average deal then.

The first book that said an average person can make money buying rental properties was by William Nickerson. His book was titled How I Turned $1,000 Into A Million in Real Estate in my Spare Time. I became a friend of his in the 1970s. I did his eulogy at the San Francisco real estate investors club when he died in 1999. His book came out in 1959.

The first example in it was a $8,750 duplex. NOI $930 /$8,750 = 10.6% cap rate.

Back then, if you asked a real estate person why the high cap rate, they would have said, “No one would buy a rental and have to do the work of a landlord unless it is going to make a monthly profit for them.”

No appreciation then

What about appreciation? There was none. The median home price in 1954 was $18,206. In 1969 it was $22,322, an average annual increase of .4%, but part of that difference was new construction which was bigger and better than previous homes and thereby raised the average.

But the median home price in 2019 was $259,168, an average annual increase from 1969 of about 5.5%.

The median home price is now $300,000 (Zillow) and the median rent is now $1,800 (Zillow). With a 62% of rent NOI, you get a cap rate on the current rental house of (62% x $1,800 x 12)/$300,000 = $13,392/$300,000 = 4.4%.

Mortgage payments consume all cash flow

With an 80%-of-value mortgage at 3.279%, annual mortgage payments are $12,576, thereby reducing your cash flow to near zero when you count replacements like the roof.

Those who have a mortgage greater than about 50% of value and claim positive cash flow are lying

The problem is that millions of investors who have mortgages are claiming to have positive cash flow. Many new guys like you cannot figure out how. Simple. The people claiming positive cash flow are lying—to themselves and to you.

Specifically, they are using operating expense ratios in the 20% range and not counting replacements because they are “one-time” expenditures. The 20% operating expense ratios are a joke and one time does not mean never.

Today’s buyers are relying entirely on appreciation

Prices in relation to rent are now so high that the market is betting on marketwide appreciation and tolerating breakeven or negative cash flow. I recommend that you also use an active profit strategy of either buying for at least 20% below market value, e.g., a foreclosure or adding value like getting zoning changed from one house per acre to two houses per acre.

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