Why Rental Cash Flow is More Important than Profitability
You can’t be profitable if your cash is flowing in the wrong direction.
We came across a study recently that pointed out a startling statistic: 82% of failed businesses fail for the same reason — poor cash flow management. What does that mean? Basically, it means that businesses fail because, despite having a good product and selling at a profit, they ran into a critical period where their cash-on-hand wasn’t sufficient to meet their must-pay expenses.
If you’re a landlord, you’d better believe you’re a business, and you’d better believe that your cash flow management skills are crucial for your long-term success. Many investors focus on how profitable a property is, but consider this: collecting eighteen month’s profit at $1,200/month and then having to sell at a loss because you got behind on your cashflow is a failure, but collecting twelve year’s profit at $200/month and then breaking even on the sale…that’s a win. Not necessarily the ‘best’ win, but it’s a good sight better than the first guy.
The Reinvestment Trap
It’s hard — almost impossible — to start investing with enough cash to fall back on if multiple urgent expenses line up. Even if you have more than enough money to buy your first few homes, the first couple of years almost always involve spending your time and effort growing your portfolio. It’s called “reinvesting,” and it’s extolled as a good idea by most every investment guru ever, real estate or no.
But there’s a hidden assumption in the concept of reinvesting: you’re supposed to reinvest your profits, and by definition your profits are what you’re left with after expenses. So if you reinvest too soon, you’re essentially reinvesting your cash-on-hand, not your profits — and that means you’re at risk.
The misleading part about all of this is that the difference between cash-on-hand and profit is a fiction — both are made up of a number of dollars in an account. You assign a dollar to the ‘used for paying expenses’ pile or the ‘profit’ pile based entirely on what you think you need to stay solvent, and if you’re wrong, you expose yourself to potential financial disaster.
The crucial tool for staying solvent is cash flow management. While that’s a subject worthy of a book or three, the basic process is at least conceptually simple:
- List all of your ongoing financial obligations. Include everything from taxes to gifts to bills to expenses — all of it. Break it down into how much you owe total per week. Consider the real world changes you expect to see over the next few weeks and take them into account in your list.
- Make a conservative estimate of your expected revenue, assuming things don’t go great, but aren’t disastrous. Keep upcoming real-world events like holidays, seasonal changes, and so on in mind and estimate using as much historical data as you have on hand.
- Calculate the amount by which your income will exceed your expenses each week. If there’s a week where income does not exceed expenses, take action immediately to (ideally) reduce expenses temporarily or (realistically) shift some expenses further into the future so you don’t end up with negative cash flow.
- Each week, check your estimates (for both revenue and expenses) against your predictions, figure out where you went wrong (if you did) and modify your future predictions to compensate, again taking real-world events into account.
- Determine the amount you owe, total, right now, in standing (not ongoing) debt.
- Determine how much you would need to recover from a significant disaster.
- Create a plan to divide your income-beyond-expenses into payments on standing debt, funding a disaster-recovery account, and actual
- Only reinvest actual
Is that process time-consuming, error-prone, and occasionally aggravating? Absolutely. Is it the only way to make sure that you’re actually on top of your cashflow and able to ensure you don’t become part of the 82%? Absolutely.