Sometimes success requires making a few mistakes first.
That’s something Tom Karadza of Burlington-based Rock Star Real Estate Inc. can attest to.
Before they were “Rock Stars,” doling out real estate investment advice and guidance in Ontario, Tom Karadza, his brother Nick and their family were struggling through a real estate crash in Toronto in the early 1990s.
Their property portfolio had turned from positive cash flow into negative, as income was quickly surpassed by expenses.
“We almost turned into the motivated seller that we were looking for as investors,” recalls Tom Karadza.
The problem was they had invested too much into luxury homes and, during a downturn, they were hit hard.
“When the market collapses, it’s those luxury homes where the prices collapse the most, where income collapses the most, and demand collapses most,” Karadza says.
Rather than get out of the business, the family changed their investment philosophy. Instead of three-car garage high-end homes, they switched to smaller, more affordable starter homes. It’s been a successful move that, as a family, they’ve stuck to ever since because it’s proven always to have demand.
“Now we buy properties that are in the starter-home category,” says Karadza. “In a good economic climate or a poor economic climate, there’s always demand for starter homes. Shelter is a need, not a want.”
If the national economy goes badly and the real estate market tumbles, or if your personal economy goes badly and you lose your job or lose your income, you have to factor that all into your purchase. A good strategy of solid cash flow can help you through such situations.
But the lesson from the family’s past also drove home a very simple point, says Karadza – the primary goal of an investor should always be that the income covers the expenses. It’s simple, and seems obvious, but it’s not always calculated by investors into their overall strategy.
“A lot of investors get caught in the excitement of the deal and opportunity to make big money, and they forget the basics,” he says.
To keep those expenses below costs, it’s critical for your investments to have positive cash flow. Essentially you need to be taking in enough income from rent to cover the costs associated with holding the property. Thus you need to have the right strategy early on before you even make a purchase.
Don R. Campbell, president of the Real Estate Investment Network (REIN), says he wouldn’t even think of buying a property that didn’t have positive cash flow.
“Buying without cash flow turns a low-risk high-return investor into a pure high-risk speculator,” he says. “It is absolutely critical that investors budget for inevitable operating expenses above and beyond mortgage and property taxes.”
Cash flow allows an investor not to fret during the inevitable property price downturns that cycle through the market, says Campbell, as they are not fully relying on solely property price increases to profit.
Thomas Beyer, a REIN member and president of Prestigious Properties Group, sums it up by comparing it to a three-course meal.
Cash flow is the appetizer, which sets up the meal to be great. The monthly mortgage payment is the main course, adding more and more equity. And then the value appreciation to the property over time is the dessert – nice to have but not necessary for a great meal.
But first and foremost on that menu, you need to ensure you’re getting that positive cash flow.
“Why else are you investing in real estate? To lose money?” says Karadza.
It is one thing to say you’re going for a cash flow-positive property, but quite another to accomplish it consistently.
You need to be sure you’re buying the right type of property in the right location, and for the right price.
Veteran investors like Karadza and Campbell have the advantage of time and experience to temper their views, and commonly come up with similar hot spots to invest.
One area they both agree on is the triangle of Kitchener, Waterloo and Cambridge.
“There’s manufacturing out there, there’s universities out there, and there’s high tech out there,” says Karadza. “Plus it has good population growth, the population is growing and there’s a good average family income.”
Those attributes are going to attract most successful investors: population growth, universities and a strong local economy.
Downtown Toronto is not such an area, as its prices are often too high to be cash flow-positive.
“Every business needs a starving crowd, and with investment real estate, it is easy to put your business where there is a crowd starving for your product (which is rental property),” says Campbell.
To dramatically reduce your risk, buying only where there’s this ‘starving crowd’ (and will be for years to come) can ensure success in cash flow. Do your research. Find out where in Canada there is job growth, transportation changes and increasing population.
“The biggest mistake beginners often make is buying in an area because it is cheap, then quickly discovering there is no starving crowd to drive demand,” says Campbell.
The second biggest mistake, he says, is taking investment advice from someone who will profit by selling you a piece of property. Since it’s their job to sell that property, their priorities won’t always be in your favour. Always look for unbiased research and keep asking tough questions, says Campbell.
As prices have increased in many parts of the country this year, finding cash flow-positive properties has become more challenging in some ways. But a national point of view is not the one you want to take in real estate investment.
A true investor will ignore the national real estate numbers because they know investing is tied more to regional trends, says Campbell.
“Where one region is overpriced, other regions with just as strong or even stronger forward-looking economic fundamentals could be undervalued,” he says.
As an example, he cites Toronto and Vancouver as currently overheated versus their underlying economics, whereas Calgary has been underperforming and could be poised for a strong run by 2014.
The common refrain of real estate investors is “time in, not timing” the market.
“You’re trying to be in the market for as long as possible,” says Karadza. “If you’re in for five, 10, 20 years, your property will appreciate, your cash flow will be there for years, and your mortgage will be paid down so your equity will build up.”
As a modern example of the difficulties of timing the market, he cites the recent turnaround in market sentiment in Toronto.
As the global economy sank and the U.S. property market fell off, surely that was a good time to buy in hindsight. But anyone who was in Toronto at the time of the collapse of Lehman Brothers certainly would have been fairly wary about making a real estate purchase.
“There’s never really a right time,” says Karadza. “Instead, you should look at the fundamentally strong communities. If you can buy properties in good areas and survive the ups and downs of the market, that’s the better strategy than timing the market.”
Karadza says he can show “war scars” from decades of investing experience to back that strategy. In the end, you need to have the right mindset as an investor to make sure you come out ahead.
“The more we do this, I realize it’s less about property and more about the mindset of the investor,” says Karadza. “We can have two investors with very similar homes and one will lose money on it while the other will make money in the same exact environment.”
One investor will boast how great it was, and another will have a negative experience. That’s because you have to be resilient and ready to stay in the real estate business for the long term if you plan to be successful. Flipping is a risky business, and few advocate it anymore.
“A lot of people think that through real estate, they’ll make a million dollars tomorrow,” says Karadza, laughing. But then his tone gets serious. “It’s a long-term thing, and it requires work. It’s not a hobby, it’s a business. Your customer is the tenant, and your product is the property.”
How long to stay negative
Going without positive cash flow is not sustainable for long, and unless you’ve got deep pockets, it’s to be entirely avoided.
“If your portfolio demands money from you every month, you will end up either stopping your investment (because) you can’t afford to feed it anymore, or you’ll have to get a second job to pay the negative cash flow,” says Campbell. “That sounds like the opposite of financial freedom.”
In addition, a negative cash flow significantly reduces your ability to get future mortgage financing, he says. That includes a mortgage to purchase your personal resident or investment properties.
Stick with a cash flow-negative property for too long and it will destroy your finances, destroy your enthusiasm for real estate and crush your ability to build long-term sustainable wealth, says Campbell. “Sell your dogs, keep your stars,” he says, summing it up.
But sometimes, it can’t be avoided. Either you bought a property that was cash flow-positive in the beginning that has since failed to be so, or you bought a cash flow-negative property with some optimism behind you.
Either scenario, while not ideal, can be managed.
Say, for example, you see a property for well below market value, it can still be a useful buy, says Karadza.
“Maybe you’ll accept that negative cash flow because you know you’ll add another unit or fix it up somehow to add to the revenue,” he says. After fixing it up, you can rent it for more, and then hopefully have built your way into cash flow-positive territory.
“Those first few months might be negative, but you’re willing to accept it because you bought the property below market value and you got a great deal,” says Karadza. “Then I can see accepting negative cash flow because you have a plan in place to increase that cash flow.”
Some big time investors with millions of dollars to spare can afford to sit on land purchases as well, an obvious cash flow-negative investment. After 10 years, they can profit mightily if they bought in a newly developing area such as parts of Brantford, Ont. But that’s not for a typical investor starting out.
“That’s a whole other level of investing,” says Karadza.
If you have a property that goes to negative cash flow and you don’t have a plan in place to fix it, however, then it’s time to get out. The only exception might be if you learn of a new transportation project recently approved so you know the rental demand will pick up soon, for example.
But even then, you have to accept some risk and live through some period of waiting with negative cash flow. That’s not ideal for any investor.
Keeping cash flow liquid
If you do have cash flow coming in, sometimes it’s hard to know what the best plan is to do with that money.
In the long term, investors should be looking to reinvest that cash flow into other properties. But until you build up enough savings, that’s not possible.
Karadza recommends you avoid putting that cash into stocks or equities because its value can change too sharply and unpredictably near the time that you’ll need it.
Instead, you can explore keeping it in something like an emergency fund.
Karadza says investors might want to keep about $5,000 for each single-family home, for example. That can be used for unexpected repairs, or cover temporary periods of vacancy. But hopefully it can soon add up to enough to purchase another investment property.
Either way, it’s key to keep the access to the money free and easy.
“We want easy access to it because a good deal might come up and want to jump on it,” says Karadza. “We keep it very liquid. The biggest thing is to get that money out of cash and back into real estate.”
If it’s just sitting there, he says, the money is doing very little other than offering a buffer to any emergency.
“We will hold it in something liquid, but we’re nervous at that point because our money isn’t working for us,” says Karadza. “It’s just sitting there, inflation is eating at it, and it’s getting less and less buying power over time.”
To read more, see Mark David's article on New investors guide to spotting positive cash-flow properties.
Are you looking to invest in property? If you like, we can get one of our mortgage experts to tell you exactly how much you can afford to borrow, which is the best mortgage for you or how much they could save you right now if you have an existing mortgage. Click here to get help choosing the best mortgage rate