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What Cash Flow Really Means When Investing in Rental Homes

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By Adiel Gorel

Understanding the value of cash flow in rental home investments cannot only optimize your investment, but also secure financial growth over time. This article seeks to demystify the multifaceted nature of cash flow in rental properties, particularly with the use of a 30-year fixed rate loan.

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For starters, it’s crucial to understand the basic premise of buying a rental home using a small down payment and a 30-year fixed-rate loan. This financing strategy entails constant principal and interest payments throughout the term of the loan. The total of principal and interest (PI) payment does not fluctuate regardless of inflation. That means inflation becomes a “friend” to the owner, as it constantly makes all prices rise EXCEPT the fixed mortgage PI payment, as well as the fixed mortgage’s balance. As a result, with the passage of time, and thanks to inflation, the REAL value of the fixed loan becomes ever-smaller since the price of everything rises constantly with inflation, while the mortgage payment and balance never do.

Historical data shows that rental rates usually trend upward with inflation, on average. While inflation may seem daunting for many economic sectors, it is a boon to the rental housing market. Property owners stand to gain increased revenue over time, as rents rise but the mortgage PI payment remains the same, which positively impacts their overall cash flow. As the home value also rises with inflation, the owner’s equity rises as well, building the owner’s net worth.

Often, investors and real estate novices interpret ‘cash flow’ as the initial cash flow that occurs at the time of purchase. This perspective, however, is limited, and does not give a comprehensive picture of the lifetime behavior of the property. While the initial cash flow is undoubtedly an essential factor to consider, it should not be the sole determinant of a rental property’s value.

The owner of the rental home enjoys constant cash flow improvement as rents escalate due to inflation. While rental income grows, the principal and interest (PI) mortgage payment remains static due to the fixed-rate loan. This discrepancy creates a widening gap between income and expense over time, increasing the rental home’s profitability. Hence, an investor’s cash flow does not stagnate at the initial point of property purchase but continues to rise in a beneficial cascade over time.

Given this evolving nature of cash flow, it’s more realistic to consider it over the years rather than focusing solely on the initial cash flow at the moment of purchase. Viewing cash flow as a long-term component can guide strategic decision-making, enhancing the likelihood of generating substantial financial gain over time.

At the risk of repeating myself (and this is so important for our future I think it bears repeating), the owner also benefits from an ever-decreasing real dollar value of the loan balance due to inflation. The principal of a 30-year fixed-rate loan does not increase with inflation. Over time, the principal balance decreases in real dollar value, making the debt easier to handle as years go by. This phenomenon becomes even more pronounced when an investor owns several rental homes. Once the loan balances reach a low point, say 25% of the home value, an investor can opt to sell several properties. After accounting for taxes (even if no tax deferred exchange is used), the proceeds can be used to pay off the remaining loans. With the remaining properties free and clear, they can provide a significant boost to the owner’s cash flow, creating a more secure financial footing. That is also an important facet of “cash flow”. Many people retire powerfully at that stage. Even though the loan is called “30 years fixed”, we don’t have to wait for 30 years, a scenario like the one described above typically happen in 12-14 years.

Rental homes, especially those financed via 30-year fixed-rate loans, are long-term investments typically spanning a decade or more. In the initial years, the rental income may merely cover the mortgage payments and operational costs, with little left as profit. If interest rates are high and the down payment is low, it is quite possible to begin the journey with some negative cash flow. However, as the years pass, the benefits of rising rents and the decreasing real value of the loan balance and PI payments, begin to manifest. Over time, these properties can result in a substantial income stream, possibly to the point of substituting regular employment income.

The primary “cash flow” most people rely on at the beginning of their real estate investing journey, is their job-based salary or income. But venturing into rental homes investment can create an additional, and in time, a primary cash flow source that can revolutionize your financial narrative. Thus, understanding and effectively managing cash flow in rental homes can set you on a path to long-term financial stability and growth, turning the dream of financial independence into a tangible reality.

If interest rates are high at the time of purchase, the investor needs to consider that, in the future, interest rates can only do one of three things: they can stay the same, they can go up, or they can go down.

If interest rates stay the same, all the benefits of the financial gift called “A 30-year fixed mortgage in the face of constant inflation”, accrue to the owner. The PI payments get lower and lower in real dollars, as the rents increase. The principal owed constantly gets eroded by inflation, and well as by the principal payments made monthly. In time (usually 12 to 14 years), the loan balance is a relatively small fraction of the home value, and the owner has good equity built up, which can be translated into significant cash flow.

If interest rates go up, the same benefits accrue to the owner as when the rates stay the same, with the additional psychological benefit of feeling good to be locked into a rate that is lower than the market rate.

If interest rates go down, the owner can refinance the loan to a new low rate. Yes, refinancing is not free. However, many lenders build the loan expenses into the balance of the new loan, making it easier as far as cash expenditures. It’s a simple calculation as to how many months of holding the property it will take to cover the expense of refinancing. For the long-term holders (and I recommend that everyone be a long-term holder), the refinance expense will be covered in a fraction of the future holding time of the property, and will usually justify itself many times over.

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When I talk to new investors, it is not uncommon for them to be engineers or managers in Silicon Valley. Such an investor is well paid. In many cases, they are married, and the spouse also works. I consider the initial overall cash flow in their life to be the cash flow from their salaries or business income. As the years go by, the property gives off higher and higher cash flow, as rents rise with inflation, while the mortgage PI payments remain fixed. After 12-14 years, in most cases, the investor may find themselves with several homes (some investors end up buying dozens or more, using 1031 tax deferred exchanges, as well as other methods, on route to building a large portfolio), with loan balances as little as 25% of the value of the home. They can then sell, say, a quarter of the homes, pay taxes, and pay off the remaining small loans with the proceeds. Now, with several (or many) free-and-clear properties, the houses provide so much cash flow, that in many cases the owner can retire well.

ADIEL GOREL

Adiel Gorel has more than three decades of successful real estate investing experience. As the CEO of ICG (International Capital Group) Real Estate, a world-renowned real estate investment firm founded in the San Francisco Bay Area in 1987, Gorel has helped investors utilize one of the most powerful investment tools—single family rental homes. He teaches people how to have fun with a process most find complex and speaks about the importance of securing a strong financial future for retirement, business investing, and college education.

Through ICG, he has assisted thousands of investors, from novice to expert, in purchasing over 10,000 properties to date. He is also the author of Remote Control Retirement Riches, and Invest Then Rest: How to Buy Single-Family Rental Properties, which includes numerous investor reports describing their real-life investing experiences. He has also authored Remote Controlled Real Estate Riches, Discovering Real Estate in the U.S. and Life 201.

Gorel has been featured on NBC, ABC, in Fortune Magazine, the San Francisco Examiner, and numerous radio shows showcasing his no-nonsense, insightful approach to rental single family home investing. He speaks worldwide and throughout the U.S., sharing his knowledge on a variety of topics including securing a powerful financial future, investing in single-family homes, the 30-year fixed-rate mortgage, and related subjects.

ICG has established an infrastructure to support investors in many metropolitan areas in the U.S. Gorel owns many properties himself.

To this day, Gorel supports individual investors via planning, assistance in remote home buying, and property management issues resolution.

He holds a master’s degree from Stanford University. His professional experience includes being a Hewlett-Packard research engineer, as well as management and director positions at Excel Telecommunications, and several biotechnology firms. He lives in the San Francisco Bay Area.

Is It Worthwhile Investing When Interest Rates Are Higher?

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By Adiel Gorel

Many investors are asking, now that interest rates have gone up by 2% relatively quickly, and home prices are up significantly from a couple of years ago, whether buying single-family rental investments is still something to consider.

The main point, at the heart of the matter, is that we can get a 30-year FIXED rate loan when buying single-family homes (technically 1-4 residential units) in the United States. This point is so dominant, it supersedes any other consideration. Surprisingly few investors seriously take this dominant factor into consideration.

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For some who have read other materials I have written, the following is a bit of a repetition, but it’s well-worth understanding this point fully. The 30-year fixed rate loan does not usually get its due as an amazing financial tool that should be utilized by any savvy investor who can get it.

For many foreigners, it is incomprehensible that in the US we can get a loan that will never keep up with the cost of living for 30 years. During that period, essentially everything else DOES keep up with the cost of living, including rents. Only the mortgage payment and balance (which also gets chipped down by amortization) do not keep up with inflation.

You can talk to many borrowers who have taken 30-year fixed rate loans and after, say, 14 years, realized that although there are 16 years remaining to pay off the loan, the loan balance AND the payment seem very low relative to marketplace rents and prices. The remaining 16 years are almost meaningless, since in many cases (statistically and historically) the loan balance will be a small fraction of the home price and not very “meaningful.” Just to get some perspective, most other countries on Earth have loans that constantly adjust based on inflation. Both the payment and the balance track inflation all the time—usually with no yearly or lifetime caps as adjustable loans have in the US.

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The power and positive effect on one’s financial future gets magnified when you consider that in 2022, we are still in a period in which interest rates are very low. While investors cannot get the same favorable rates as homeowners, it is nevertheless quite common nowadays to see investors getting a rate of between 5.75% and 6.25% on single-family home investment properties. From a historical perspective, these are very low rates. Most experts think that, in the future, mortgage rates will rise further. From a historical perspective, even 7.5% is considered a relatively low rate. These days, you can “turbo boost” the great power of the never-changing 30-year fixed rate loan by locking in these still-low rates, which will never change. If in the following years interest rates indeed go up, you will feel quite good about having locked under-6% rates forever.

Once you have gotten your fixed rate loans, two inexorable forces start operating incessantly: inflation erodes your loan (both the payment and the remaining balance), and the tenant occupying your SFH pays rent, which goes in part towards paying down the loan principal every month. These two forces create a powerful financial future for you.

Many of us have been “spoiled” during the COVID Pandemic that started in 2020. The Fed lowered rates to the very lowest point in the history of the US. Homeowners could get loans at 2.75%, and even a bit less. Investors could get loans at 3.5%, 3.75% or 4%. Happy times.

Recently, rates rose quite quickly. Homeowners now get loans at 5% or slightly more. Investors get loans at about 6%, depending on credit. It feels like the sky is falling, but it’s important to retain the historical perspective. These rates are still historically very low. Recall also that currently, inflation is at 8.5%. Inflation is your “best friend” when you have a fixed-rate loan, since it constantly erodes the true value of your payment and remaining loan balance. Getting a 6% FIXED rate loan when inflation is over 8% is quite favorable.

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The 30-year fixed rate loan is so meaningful in changing your future that it works well over the long-term, almost regardless of the interest rate. Obviously, the lower the rate, the better. However, by way of an example, when I began investing in the 1980s, interest rates on mortgages were at 14%. Every single investment home I bought back then (and I always made the minimum possible down payment) started out with a negative cash flow. Nevertheless, it was clear to me that since the loan was FIXED, the payment would remain the same, but everything else would keep up with inflation. That meant, to me, that within a couple of years, the negative cash flow would turn into break-even, and a couple of years after that, it was likely to turn into a positive cash flow. A couple of years after that, the cash flow was likely to be a stronger positive, etc.

Those notions came to fruition exactly as I had seen them. I started celebrating every time one of my homes got to “break-even.” I knew that from then on, the cash flow would be evermore positive, on average, as the years would go by. Even with 14% interest rate, the system worked. Those homes changed my financial life enormously.

Of course, when rates went down, I refinanced. First, I refinanced down to 12%, then came the magic “single digit” time, when I refinanced to 9.95% and was ecstatic about it.

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I have thousands of investors’ success stories that I hear all the time. One small example is the Silicon Valley engineer who bought 16 homes, then 13 years later saw his loan balances were under 30% of the home values, despite there being 17 years still remaining on the life of the 30-year loan. He sold 4 of the homes, paid his taxes, and used the proceeds to pay off the small remaining 12 loans, retiring on the strength of 12 free and clear homes. Many of these success stories, including his, are from people who started buying when rates for investors were between 7.75% and 8.25%.

Many investors are also taken aback by the price increases that took place during the Pandemic. They feel they are being hit by high prices AND higher interest rates.

One very important thing to remember is that while I am writing this (May 2022), inflation is at 8.5%.

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Some people are concerned about starting out with only a break-even, or a very slight positive cash flow, when making 20% down payments. They have gotten accustomed to starting out with a healthy positive cash flow, even with a mere 20% down payment, during the super-low rates era. However, the INITIAL cash flow is just that: initial!

As time goes by, the mortgage payments remain the same. However, rents rise, on average, with inflation. These days there is a huge demand to rent single-family homes in the suburbs, with a yard and room for a home office. There is more demand than supply in the rental space, and rents are going up quite furiously across the nation. Even if rents only rise with inflation, inflation these days is quite high. Either way, the cash flow gets better and keeps getting better as the years go by, while you build equity in the home, changing your future.

I look at these investments as long-term. They will very likely change your future, but they need 10, 12, 14 years to get to the desired result. At the beginning, the “cash flow” that has the most meaning is your own income: the income from your W-2 job, or your small business, in addition to what your spouse may earn as well. THAT is what pays for your food, transportation, utilities, and kids’ expenses at the present. In the future, when the rental homes can get you to retire powerfully, the equation flips and then the rental homes will provide the very meaningful “cash flow” you can retire on, as I describe in the example above.

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The mistake many new investors make is thinking that they MUST have immediate large positive cash flow at the outset, despite not really needing it, since they generate sufficient “cash flow” in their jobs. This thinking may create a situation whereby an investor never gets started. Possibly a book the investor had read might have put the idea in their head that initial cash flow is the primary thing to look for. Ten years later, I see people expressing great regret at never having started due to these notions. Some people resort to buying inferior properties in inferior locations, seeking a “better initial cash flow.” Buying bad properties usually doesn’t end up that well.

Today, as in any time I have seen, is an excellent time to acquire single-family rental homes, finance them with the astounding 30-year fixed rate loan, and then letting time pass while inflation does its thing.

We will talk about it in more detail at our upcoming quarterly event, complete with a Q&A.

ADIEL GOREL

Adiel Gorel has more than three decades of successful real estate investing experience. As the CEO of ICG (International Capital Group) Real Estate, a world-renowned real estate investment firm founded in the San Francisco Bay Area in 1987, Gorel has helped investors utilize one of the most powerful investment tools—single family rental homes. He teaches people how to have fun with a process most find complex and speaks about the importance of securing a strong financial future for retirement, business investing, and college education.

Through ICG, he has assisted thousands of investors, from novice to expert, in purchasing over 10,000 properties to date. He is also the author of Remote Control Retirement Riches, and Invest Then Rest: How to Buy Single-Family Rental Properties, which includes numerous investor reports describing their real-life investing experiences. He has also authored Remote Controlled Real Estate Riches, Discovering Real Estate in the U.S. and Life 201.

Gorel has been featured on NBC, ABC, in Fortune Magazine, the San Francisco Examiner, and numerous radio shows showcasing his no-nonsense, insightful approach to rental single family home investing. He speaks worldwide and throughout the U.S., sharing his knowledge on a variety of topics including securing a powerful financial future, investing in single-family homes, the 30-year fixed-rate mortgage, and related subjects.

ICG has established an infrastructure to support investors in many metropolitan areas in the U.S. Gorel owns many properties himself.

To this day, Gorel supports individual investors via planning, assistance in remote home buying, and property management issues resolution.

He holds a master’s degree from Stanford University. His professional experience includes being a Hewlett-Packard research engineer, as well as management and director positions at Excel Telecommunications, and several biotechnology firms. He lives in the San Francisco Bay Area.