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Many years ago, I bought a rental property that passed the “2% Rule,” where the rent was over 2% of the purchase price.
I lost money on that property.
Even when properties cash flow decently, they can still underperform other options on the table. As you ratchet up your game as a real estate investor—active or passive—keep an eye on the following as you evaluate cash flow and more.
Tax Benefits
Some investments offer outstanding cash flow but no tax benefits.
That’s not a deal-breaker, of course. It’s just a trade-off to be aware of.
For example, one of my favorite funds pays quarterly distributions at 16%. Our co-investing club has invested in it several times now, and it’s paid us like clockwork for years. But we pay taxes on those distributions at our regular income tax rate.
Fortunately, we also vet and invest together in plenty of equity deals, such as syndications that come with enormous tax write-offs. That helps offset the taxes on the other investments we go in on together.
Hidden Cash Flow Killers
Not every expense is easy to predict on paper.
That’s precisely why that “2% Rule” property I mentioned didn’t actually cash flow, and I lost money on it. In that case, it was high crime rates, vandalism, high turnover rates, and a generally horrible tenant base.
“I want to know what the neighborhood is doing, what the exit options are, and how much hidden risk is sitting inside the deal,” explains professional investor Austin Glanzer of 717HomeBuyers.com in a conversation with BiggerPockets. “A property can show positive cash flow on paper, but if its condition, taxes, insurance, or tenant base are working against you, that cash flow can disappear quickly.”
It’s a rookie income-investing mistake: missing the “invisible” but very real expenses that can derail a deal.
Unpredictable Expenses
I once bought a property only to discover that much of the wooden framing behind the walls had rotted. I didn’t come out of that unscathed, as you can imagine.
Noah Glatfelter sees this every day as he inspects houses through York Home Performance. “A rental may look good financially, but if the home is drafty, poorly insulated, or has old mechanicals, those issues can turn into tenant complaints, higher bills, and future repair costs. Smart investors look at the long-term condition of the property before buying,” he tells BiggerPockets.
Long-Term Commitment
As Glatfelter alluded to, cash flow investments are long-term commitments. You lose tens of thousands to closing costs, which hit you both on the front and back ends when you sell.
To overcome those losses, you need to hold the property for many years of cash flow. And even then, you’re likely counting on appreciation to cover those two rounds of closing costs.
I don’t mind long-term investments in my portfolio. Many investments I make as a member of my co-investing club are around five-year commitments. But liquidity and time commitment are still factors in the investing decision, and some growth-oriented investments require shorter holds.
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For example, we’re considering a preferred equity investment that will last no longer than three years. It won’t pay any distributions but will likely pay out over 20% annualized returns due to the extremely low cost basis alone.
Some deals are shorter than that. I’ve invested in a six-month note before. But investing along different timelines is one of the many ways I diversify my portfolio, as I invest $2,500-$5,000 at a time alongside other members of my co-investing club.
Multiple Exit Options
Often, cash flow investments have only one exit option: selling to another cash flow investor.
That “2% Rule” property I mentioned? I couldn’t sell that property to a homebuyer. No one in that neighborhood qualified for a mortgage.
Safer investments allow for multiple exit strategies. For example, in my club, we’re looking at partnering with a niche investor who buys properties for tenant-buyers who put down a huge down payment up front, then sign lease-purchase agreements. The properties cash flow decently, but even more importantly, the operator comes out ahead no matter what.
If the tenant buys, the operator earns a margin. If they default, the operator evicts them and sells the property retail, and still comes ahead because the tenant forfeited their big down payment.
Market Fundamentals Matter
If you buy properties in markets with weak population growth, employment, and community pride and values, you’ll end up with weak returns—no matter how the pro forma looks on paper.
“Sometimes the best deal is not the one with the highest cash flow on Day 1, but the one in an area where buyers and renters both want to be long term,” explains Dane Ohlen, a professional investor with Sell My Dallas House Fast, when speaking to BiggerPockets. “Investors need to think about long-term demand, appreciation, repair risk, taxes, insurance, and how easy it will be to sell if their plan changes. More demand offers more than one way to win.”
This brings us right back to multiple exit strategies.
Cash Flow Lives or Dies on Property Management
Income investments, whether active or passive, rely on property management for their performance.
I’ve seen good property management rescue deals that had otherwise gone awry. I’ve seen bad property management ruin perfectly good deals.
When our co-investing club vets a deal together, one of the first questions we ask is, “Who’s going to manage this property, and how many properties do they already manage for you?” I don’t care whether the management is in-house or outsourced—I care that the operator has worked with this same property management team for many years, on many deals.
It’s also why I like investing with land flippers. They generate strong profits with no property management required: “No tenants, toilets, or termites,” as they like to say.
Our club lent a note at 15% interest a year or two back to a land flipper, who put up his primary residence as collateral at a 55% LTV. He’s never missed a payment, as he enjoys enormous margins with minimal headaches.
The Crucial Role of Financing
Deals typically fall apart for one of two reasons: the operator either runs out of money or time.
You don’t need me to remind you of all the operators who lost money and properties after 2022 because they’d financed them with floating interest loans. Their cash flow turned negative, and they ran out of money.
But others got into trouble because they ran out of time. Even if their property cash flowed, their short-term bridge loans came due, and they found themselves unable to sell or refinance because of lingering high interest rates and cap rates.
It’s worth reiterating: The deals still lost money even though they were cash flowing.
Have Your Cake and Eat It Too?
Some deals cash flow well while you hold them and then produce great profits on the back end when they sell.
A few years ago, our co-investing club invested in an industrial seller-leaseback deal that paid solid 6% distributions while we held it. It closed out after two and a half years for a great profit, paying a total annualized internal rate of return (IRR) of 27.6%. Oh, and we got great tax benefits on that one, too.
On the multifamily side, we invested in a portfolio of properties that were geographically spread out, and the operator scored an outstanding price on them. Within six months, they were paying over 9% in distributions, and we’ll likely earn over 20% annualized returns on those, too, when they sell in a couple of years.
Cash flow matters, of course. I love high-yield investments and seeing those passive income deposits in my bank account. I once took my daughter to the Amazon rainforest and funded it solely with my passive investment income from that month.
But cash flow isn’t everything. Look holistically at every deal, whether you invest actively or passively. Go beyond the pro forma to look at long-term property expenses, market demand, and exit options, and your investments should find a profitable path forward even when life throws curveballs at them.
