Many businesses fail in the first few year mainly due to poor cash flow management. According to a recent survey, the number-one thing small business owners say they wish they’d have done differently was have more start up money.
Even experienced companies file bankruptcy, not because they don’t have a good business model but because they run out of cash. Consumers, too, don’t often manage their cash flow effectively and this can lead to foreclosures. True, the catalyst may have been an unexpected layoff, a change in the economy, a divorce, or some other crisis, but with sufficient cash reserves, consumers can overcome virtually any problem.
The same principle applies to any business. Something can go wrong or business can become slow because of a down cycle, but as long as the business manages its cash flow, it will survive. Real estate investing is no exception. The reason most investors fail is because their plans and investment strategies don’t include effectively managing their cash flow.
For example, let’s say an investor (we’ll call him John) buys a house as a rental property investment with no money down. If John has no cash reserves, what happens if he experiences a 20 percent vacancy rate—that is, he doesn’t rent the house for several months? What happens when there are repairs and unforeseen problems that may result in the need for thousands of dollars in repairs or improvements? John will have real problems if any of these events occur if his cash flow is low or nonexistent.
Many novice investors make the mistake of putting more cash down to lessen the risk of negative cash flow. This may be wise, unless you are putting up your last dime into the property. Regardless of how much cash flow you have on paper, you can still end up negative. With no cash reserve in the bank (because it’s all tied up in the property), you will end up scrambling to come up with cash when the property goes negative.
Although I plan for repairs, vacancies, slow months, and a down market, I’ve had more than my share of unexpected cash crunch issues. For example, several times a local municipality made me re-pave a driveway, remove an abandoned car, or rebuild a fence. My insurance company made me re-concrete a long walkway because of what they considered safety issues. More than a dozen plumbing problems have caused major water damage to my properties—damage that was less than my insurance deductible. Every investor at some time gets blindsided by an unexpected repair cost, so be conservative when establishing your cash reserves. In short, it’s better to have a cash reserve to handle negative months than to put more money down to increase your cash flow.
In essence, real estate investors are no different from average Americans who struggle to get by and live paycheck to paycheck, then suddenly get hit with an unexpected medical bill or car repair expense. The bottom can fall out from underneath quickly, so you’d be wise to set up a financial safety net.
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Attorney William ("Bill") Bronchick, host of Legalwiz.com, has authored six best-selling books and is sought nationwide for his 25+ years of real estate and legal knowledge. He has been interviewed by numerous media outlets, such as CNBC, TIME Magazine, USA Today, Investor Business Daily, Forbes, and the LA Times, to name a few. William Bronchick is the co-founder and past President of the Colorado Association of Real Estate Investors and the Executive Director and founder of the College of American Real Estate Investors. Click on the "About" link above for more information on William Bronchick.