An Example Of Where There Is Negative Cash Flow Purchase Real Estate

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Purchase Real Estate

In real estate, when you wholesale or flip a property, you are engaging in a form of real estate arbitrage. However, that is not the type I am referring to here. The type of arbitrage I am referring to occurs in the rental market.

So how does a real estate arbitrage strategy work in the rental market?

With this policy, you buy a property for a fixed amount. However, instead of renting the entire property to one tenant, you rent different parts of the property to different tenants. This allows you to generate higher monthly cash flow due to economies of scale.

In any rental market, the smaller the unit size, the more money you’ll make per square foot compared to larger units of the same size. A tenant renting a 1-bedroom apartment typically pays more per square foot than a tenant renting a 2-bedroom apartment in the same market.

Here is an example of how this works.

Let’s say you are looking to buy property in Forest Hills, New York, a middle to upper middle class neighborhood in New York City. Here is the average rent for an apartment in this area:

1BR – $1300 to $1400 per month

2BR – $1400 to $1600 per month

3BR – $2000 to $2500 per month

3BR house $3000 to $3500 a month

The average 3 bedroom 2 bathroom home goes for $700,000. Based on just a 6.25% interest rate and a 20% down payment the mortgage is going to be over $3400 per month. If you rent this house out to a tenant, even if you can get $3500 per month, you will still have a negative cashflow property.

On the surface, this doesn’t look good for you as an investor. If the homeowner is unable to sell the home, you as an investor may have to pay off the lien before purchasing the property. Depending on the terms of the contract, this may not be feasible.

However, before you decide to walk away from the deal, there are a few things you should know about judgment liens that can have a big impact on your decision.

If you find a property that has a judgment lien against it, your first step should be to find out how much all the liens on the property are. Then consider the amount you are buying the property for as well as the full market value of the property. Depending on the real estate arbitrage you would instead rent the bedroom to three different tenants. Each tenant will have exclusive use of a bedroom and shared use of the rest of the house.

Suppose you charge each tenant $1300 per month? Multiply that by 3 tenants and the monthly income for this property now jumps to $3900 per month. So in the first scenario, this asset generates negative cash flow while in the second scenario, this asset generates positive cash flow.

Is a home out of your budget? No problem! You can buy an apartment and implement the same policy. You can buy a 3 bedroom condo for $500,000. With a 20% down payment and an interest rate of 6.25% your mortgage is a little over $2400 per month.

Similar to the housing situation where one person tries to get positive cash flow by renting out an entire apartment, this is the most difficult. Even if you charge $2500 per month, you will still experience negative cash flow when you factor in taxes and insurance.

Once again, the arbitration policy works in this situation as well. By using an arbitrage strategy and renting the apartment to 3 separate tenants, even if you only charge $1000 a month, you will have a positive cash flow from the unit as a whole.

There are some investors who take this strategy to extremes. For example, I have seen some investors put a maximum of 2 beds in each bedroom, plus 2 extra beds in the living room. An investor rents to 8 different tenants for $500 per bed per month. In the apartment scenario, even if your expenses are $3000 per month, the investor in this scenario will have a positive cash flow of $1000 per month.

I personally do not recommend that policy as it may be illegal in many parts of the country. You will need to check the laws in your area. Additionally, such a strategy will only work if you target specific communities that don’t mind such shared living quarters. Two examples are college students and immigrants who have recently moved to the country or are in the country temporarily on a student or work visa.

In addition to additional cashflow, another benefit of using a real estate arbitrage strategy is reduced vacancy costs. If you rent an apartment to a tenant and that tenant moves out, the apartment does not generate any cash flow for the period the property is vacant.

With an arbitrage strategy if one of your tenants moves out, instead of having an empty apartment that generates zero cashflow, you have an apartment that still has other tenants paying rent. While you may not get the entire cash flow during this period, the good thing is that you will at least get some cash flow.

This strategy also has some disadvantages. For example, if a property is damaged, there is no way to know who is responsible for the damage unless the damage is in one of the specific bedrooms. Trying to prove this in court or penalize all tenants can be difficult depending on the laws and regulations in the area you want to invest in.

Finally, you should note that the arbitrage strategy works in other ways as well. For example, if you own commercial space, you can rent out part of the space to another company. I have seen some owners even set up a single desk and telephone line and rent the desk to a business owner who wants an office but only needs one desk. Be creative and you will find many ways you can use this strategy to profit from your real estate investment.

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