Is negative cash flow all bad? When might it be good? The answers to these questions will vary with your individual status.
Suppose it were possible to buy a $400,000 house for $295,000 because the seller had loaded it up with debt and was unable to make his payments. Appreciation in the area has historically been above average for many years at about 10% per year, but sales are now slow. Even when payments are current and the house can be bought simply by taking over the $3500 per month total payments, nobody is buying. The rental market for this priced house was stalled at $2,000 per month for well-qualified tenants and the current owner would lease it back for that amount; so buying it would cost $1500 per month.
Who would buy it, and why?
Start with the basics: The house has an honest $105,000 equity and a prospective former owner tenant who has kept the payments current. If you could afford paying $18,000 per year in negative cash flow, 70 months could go by before you’d have paid as much in negative cash flow as the equity you got when you bought the house.
During that time, the equity would have been growing at about $40,000 per year. That boils down to 222% per year return on your investment without counting any tax deductions. Where else could you invest $1500 per month and get $40,000 in equity each year?
Suppose you couldn’t afford the negative cash flow? There are a lot of people around who fancy themselves to be investors, but who really don’t have very much money to invest. Some of them do make a lot of money and could use some tax shelter.
Suppose, once you bought the house, you approached such a high-bracket person and showed him the foregoing figures; then offered to “cut him in” for half of the profits if he’d pay the $18,000 per year negative cash flow. In the 25% tax bracket, if he deducted this negative cash flow against his other earnings it would only cost him $13,500 out of pocket each year, so the yield on his half of the equity value would be $52,500 “going in” and 148% of the annual gain each year.
Of course, your own investment would be your time and talent to manage the property while your half equity also rose by $1,667 per month.
