Three Strikes and You’re Out - The Real Estate Investment Version
Negative Cash Flow (NCF)
Negative cash flow is exactly what it says: operationally (after expenses and debt service), the real estate is losing money. Operationally means that depreciation and nonrecurring legal, accounting, acquisition, and organization costs are not included. Some causes of NCF can be over leverage, high debt service costs, under occupancy, high expenses, concessions, and below market rents.
When looked at correctly, real estate is a business. It is the business of selling and/or leasing square feet. As with all businesses in a capitalistic system, there is a report card that tells how you are doing. When you are making money, you are passing or succeeding. How well you are succeeding is determined by other measurements.
Conversely, when you are losing money, your business (real estate) is failing. Determining to what degree it is failing, and what the possibilities are for converting it to a successful business, require a different set of evaluations. Some important characteristics to be aware of in a failing business are:
1. Businesses with a negative cash flow are in a weaker competitive position.
2. Investing in a business with a negative cash flow is a speculation.
3. Success in a business with a negative cash flow requires above average performance and above average management ability.
Summary
The seriousness and potential danger of each real estate strike is clear: (1) borrowing money at a cost that is higher than the real estate’s yield, (2) not having enough operating funds to pay your debt service, and (3) losing money. These are all characteristics that have far greater risks than the upside might merit.
Some investors may want to take a chance on a real estate purchase that has one of these strikes. The correct word to describe such an investment is chance. Some investors believe it’s worth the risk for the upside potential.
There are three reasons why lenders should NOT lend money when one of these strikes is present. They are: (1) lenders assume the largest amount of monetary risk, (2) there is no upside potential for lenders, and (3) the people who provide lenders with their funds do so to invest with minimal risk.
The purpose of the “three strikes and you’re out” legislation is to stop crime. The motivation behind this legislation is to stop the tragedies that crime creates. The same motivation applies to real estate. Real estate’s three strikes should prevent lenders from lending and investors from investing. The result: an end to unnecessary failed real estate investments.
