You Shouldn't Buy Real Estate For Cash Flow
This post was originally featured on my member blog on the Bigger Pockets real estate investing website.
Let’s start out with this: I am a real estate investor at heart. I love real estate and I am building my real estate portfolio just like many of you. However, I stopped buying real estate for cash flow. Let me tell you why.
The Problem With Real Estate Cash Flow
When I was introduced to the concept of real estate investing through the purple book, I got very excited about the idea of replacing my income through cash flow from real estate. I read all the blogs, listened to all the podcasts, read a bunch of books, and attended the real estate investor clubs in my area. I was very excited about the possibility of replacing my income with rental cash flow.
But, something never sat right with me. I would do the math on the cash-on-cash returns of a property and realized that at (a generous) $200/door per month, it was going to take a LOT of properties to get out of the rat race. I understood the other 4 ways real estate pays you (appreciation, tax breaks, loan paydown, and inflation profiting with financing), but the compounding of the real estate returns is a slow process. It’s a get rich slow scheme.
Find Financial Freedom With Laundromats
That discouraged me. Maybe you have had the same feelings of discouragement. It felt like I would be in the rat race for a couple of decades before the benefits began to kick in. I wanted to find some way to accelerate the process and find financial freedom faster!
What Real Estate Cash Flow Really Is
I have listened to a lot of real estate investors here on Bigger Pockets and other podcasts, blogs, books, and meetings say that they invest in real estate for cash flow and that appreciation is icing on the cake. I was sold on that concept. I’m not anymore.
Most of the time when investors encourage others to buy real estate for cash flow it is because it is a hedge against a drop in value of the property. Sure, the income from a single family rental each month is nice to have and may help you speed up the purchase of your next property by a couple of months, but most investors don’t feel the effects of this income in their life until they have acquired many doors.
Cash flow from real estate is, at least for the beginning investor, insurance. It’s main purpose is to ensure the investor will be able to keep the property long enough to allow the effects of time to work it’s magic on the appreciation, loan paydown, and inflation profiting. This is where real wealth is built.
Equity creates wealth. Cash flow is the insurance that allows an investor to hold onto properties while building equity.
What Does This Mean For The Real Estate Investor?
If cash flow from a real estate investment is primarily insurance, what does this mean for the real estate investor? Should we not be acquiring real estate investments? Of course we should be! Real estate does build wealth. It just usually builds it slowly or rapidly through forced appreciation.
If you’re trying to get out of the rat race by building up cash flow to replace your income, real estate investing is probably not the best place to do that. The cash flow is generally small, and compounding takes a long time. Even with leverage, real estate cash flow is not substantial enough for the average investor to exit the rat race as soon as many of us want to.
What’s an Investor to Do?
I have found that there are much better ways to find cash flow that will accelerate your exit from the rat race. I now utilize those investments to accumulate cash flow and acquire real estate to build long term wealth.
Let me tell you what criteria I use when looking for investments to find cash flow.
- Part time – I know the holy grail is “passive income,” but the reality of it is that most of us are going to have to put some effort in, at least in the beginning, to kick start that cash flow. So, I’m looking for a “side hustle,” if you will.
- Time independent – Even though my investments require some effort, the income is generally independent of the amount of time I put in. The investments I’m looking for must allow me to “make money while I sleep.”
- Simple – I want as few complexities as possible. This is a “side gig,” so I don’t want to have to invest a lot of time and effort chasing down people to pay me, managing a lot of people, holding a bunch of inventory, etc.
- Improvable – Similar to real estate, I want to have the ability to increase the value (and cash flow) of the investment through better management, effective advertising, physical improvements, etc. This would be the real estate equivalent of forced appreciation.
- Leverage-able – Leverage is one of the great wealth builders and is part of what makes real estate so lucrative. I don’t want to give that up in my investments.
- High cash flow – Obvious, but if i’m not going to invest in real estate for cash flow, the replacement investment must have a higher cash flow than I could get in real estate as an average investor.
- Equity potential – While I’m not making these investments primarily for equity, I would like there to be the ability to increase equity in the investments, truly as “icing on the cake.”
10 Reasons Laundromats Are the Best Investment You Can Make
What Are These Mystery Investments?
“Ok, spill it. If real estate isn’t the best investment to get out of the rat race, what is?” I hear some form of this question all the time. You might be wondering the same thing. Never fear, I aim to deliver! I will tell you what I invest in to build cash flow and then I will give you a few other similar options that meet the above criteria.
My cash flow journey started when I quit my career with a young family and no plans on what to do next. This was before I knew anything at all about investing, nor was it on my radar even. We had some money in the bank and were trying to figure out how to move forward in life. I had a genius idea!
We owned our house in Southern California. I thought we could rent out our house, take our money we had saved up and buy a condo on the beach in Hawaii and live there until our kids were school aged. Then, we could move back to So Cal and rent out our condo in Hawaii. Net gain: a condo in Hawaii! Pure genius!
My wife, genius that she is, had a different idea. She wanted to take our money and use it to purchase something that would bring us some income without requiring a lot of our time. It was a novel thought to me. Even more genius! So what did we end up doing?
You Bought a What?
We ended up buying a laundromat! A what? Yes, a laundromat. When we tell people we usually get one of two responses. 1. Why in the world did you buy a laundromat? That’s so random! Or, 2. That’s really smart, I’ve thought about doing something like that!
I will freely admit that it is a little random. But it is also pretty smart. Here’s the gist of why I think buying a business like a laundromat is a smart idea. Businesses, like, for example, laundromats, are valued a little bit differently from residential real estate. Whereas residential real estate is valued on comparable sales, businesses are valued more like commercial real estate.
Business Valuation vs. Residential Real Estate Valuation
Businesses and commercial real estate are valued based on net operating income, or income minus expenses (not including loan payments). Commercial real estate values are determined by a cap rate. The cap rate is essentially the return on your investment that you could expect if you were to buy the property with cash. For example, if the net operating income of a commercial property is $100,000, and cap rates are at 5%, the value of the property can be found by the equation:
$100,000 / .05 = $2,000,000
So, the value of the commercial property would be $2,000,000. Put another way to make for an easier comparison with laundromat valuations, at a 5% cap rate a commercial property is valued at 20 times the net operating income.
A laundromat, however, is typically valued at 3.5-4.5 times the net operating income. This means that you can expect a much higher cash flow for an equal investment in laundromats. Let’s do a quick example with two all-cash purchases for simplicity. Let’s assume you want to invest $200,000 of cash to maximize cashflow and help you get out of the rat race as soon as possible.
When purchasing a residential property that yields a 10% cash on cash return, you can expect to put an extra $20,000 toward your freedom! Not too bad.
When purchasing a commercial property at a 5% cap rate (common for my area right now), you can expect to put an extra $10,000 toward your freedom! Better than nothing.
When purchasing a laundromat at the top end at a 4.5x multiple of the net operating income, you can expect to put an extra $44,500 toward your freedom! That’s more than twice as much as the residential property.
Obviously this is a simplistic example, but it demonstrates the principle and the power of a small business like laundromats to free you from the rat race rapidly.
How to Buy a Laundromat
Real Estate Investors Are Perfect For This
If you’re mostly familiar with real estate investing, you’re in luck! There is so much overlap between property ownership and owning a business like a laundromat that the transition can be very smooth. There are nuances to the business, but many principles transfer.
Notably, many of the creative financing options that are touted around the Bigger Pockets community apply to laundromats and similar businesses, as well. In fact, I would say creative financing is far more common in a business like a laundromat than in real estate, and sellers are typically much more open to seller financing and other creative financing options.
There are other similarities, as well. The business purchase process is very similar to property purchases that you may be used to. Terminology is very similar, as well. Laundromats and similar businesses often serve the renters that we are investing in housing for, so the demographics tend to be similar. And, laundromats and similar businesses can be managed much the same as rental real estate, making them even more low-maintenance than they already are. This makes them an excellent, nearly passive income source.
Also similar to the sage principles of real estate investing, leveraging an experienced mentor can accelerate the learning curve and collapse time frames to freedom with laundromats and similar businesses (I name a few more below).
Fix Your Cash Flow Short Term Then Build Your Long Term Wealth
If your goal is to accumulate passive income to replace your income and escape the 9-5, consider a business like a laundromat, vending machine provider, ATM provider, a car wash, or, like my 8 year old son, a bubble gum and toy vending business. Each of these can provide cash-on-cash returns far higher than the typical rental real estate while meeting the 7 criteria outlined above.
So, when you buy rental real estate, buy real state that cash flows. It’s savvy and safe investing. But, when you’re looking primarily for cash flow, don’t buy rental real estate (yet). Instead, opt for a low effort business that provides higher cash-on-cash returns and then utilize that cash to acquire cash flowing real estate.
Have Your Cake and Eat It, Too
But hey, this is a real estate investing site. We’re real estate investors. Allow me to get a tiny bit technical for a minute to give you an overview of how you can leverage a business like a laundromat to have your cake and eat it,too. You can build rapid wealth AND get high cash flow with a business like a laundromat. Here’s how:
By accumulating the real estate that your new laundromat is located on, you can turbo charge your wealth. Let me show you how.
As review, commercial real estate, similar to small businesses such as laundromats, are valued based on the NOI (net operating income). In order to find the value of a commercial property, the NOI is divided by the capitalization rate, or cap rate.
The cap rate is the percentage return one can expect if they buy a property all cash. An 8% cap rate means that if you buy a property all cash, you can expect to get an 8% return on your money. Cap rates vary depending on the market location, where in the market cycle the market is, the property type, the property size, and a variety of other factors.
Wealth Building Power of This Strategy
Let me give you an example. We’ll assume the cap rate for the property in this example is 7%. If the NOI of the property is $35,000 (rent – any expenses), then we can calculate what the property is worth.
$35,000 / .07 = $500,000
You can use this simple formula to dramatically increase your wealth by merely moving around the money you already have coming in. Here’s how the magic works.
Let’s say you bought a property at a 7% cap rate for $500,000. That means your property is charging your laundromat rent of $35,000 per year, or $2,917 per month.
For our example, let’s assume business is good in your laundromat, or maybe you were able to increase the business coming in. Your property can now charge your laundromat $300 per month more, making the new rent $3,217 per month. Let’s calculate the new value of our property.
$3,217 * 12 months = $38,604
This is an increase of $3,600 per year to your property. Assuming the same 7% cap rate, the new value of our property is
$38,604 / .07 = $551,485
The Result of the Magic
This is an increase of $51,485 in equity in your property, just for moving $300/month from your laundromat to your real estate. No money was gained or lost, it was just moved from one entity you control to another.
This is how you can use your laundromat, combined with the real estate that it is on, to supercharge your wealth!
You benefit from the high cash flow of the laundromat and the power of forced appreciation of the real estate. And to top it all off, both offer amazing tax advantages!
I have personally used this technique to dramatically increase my networth while maintaining high cash flows. It has proven to be a very powerful tool to help propel me forward financially, and I think that it can be for you, too!
How Laundromats Make You Wealthy
What Do You Think?
So, what do you think? Are you convinced that there are better options than real estate for cash flow or are you still skeptical? I’m curious to hear what you think. Let me hear your opinion (or questions) below!