Why flipping is not investing in real estate

Posted on 10. Jun, 2010 by in General

Think of each property as a small business in its own right and manage it until it is throwing off cash, author says

Susan Smith

Globe and Mail Update Published on Friday, May. 21, 2010 6:00AM EDT

Building a real estate portfolio can mean working toward financial freedom – or it can mean taking risks that will give you more sleepless nights than days on the golf course.

The difference, according to Don Campbell, is cash flow.

“I would never buy a property that didn’t have positive cash flow,” says Mr. Campbell, president of the Real Estate Investment Network. “A lot of people, unsophisticated investors, buy properties as if they were stocks – the only way they’re going to make money is if they rise in value.”

Of course, it’s great if your properties do rise in value. But this is the “buy and pray” strategy, not the best for real estate investing, says Mr. Campbell, author of 81 Financial and Tax Tips for the Canadian Real Estate Investor, released in February.

Mr. Campbell’s advice is to look for properties in areas that have a future, not a past. And don’t make the mistake of thinking they have to be close to home. Look for places where the average income is increasing, where the population is growing faster than the provincial average, areas that are in transition and where there is spending on transportation infrastructure.

Then as you add properties, think of each as a small business in its own right and manage it until it is throwing off cash. Get your expenses where you want them to be, get your rents where you want them to be, develop a good relationship with clients, i.e. your tenants, and build loyalty.

When each property reaches that “normalized state,” you can think about adding another one. Adding properties too soon, Mr. Campbell says, is a recipe for chaos and frustration.

This is where cash flow becomes most important – because if yours isn’t positive, the bank isn’t going to lend you more money.

“If you have a positive-cash-flowing portfolio, the bank adores you,” Mr. Campbell says. “It shows that you know what you’re doing, that you have the ability to manage your investments, and that you have some business acumen.”

In fact, he adds, banks are insisting on positive cash flow now for investment properties. “You know you can expand when the bank says you can expand.”

Continually manage your portfolio with this in mind, and don’t be afraid to get rid of a property if it isn’t performing. Beginning investors often make the mistake of holding on for dear life to that one money-losing investment in an otherwise healthy portfolio because they don’t want to admit they’ve made a mistake. Mr. Campbell’s advice: Sell it, even if you take a loss, use the loss wisely from a tax perspective and move on.

Another reason cash flow is king is the show of intention when it does come time to sell. Showing that you intended to hold a property as a money-making instrument may qualify for a capital gains exemption, which means you would pay capital gains on only 50 per cent of your proceeds, instead of 100 per cent.

So-called flippers and blatant speculation do not qualify, as far as the tax man is concerned.

“If you’re lining up around the block for a box in the sky that doesn’t exist – and you hope to flip it – it’s not cash flow and it’s not a capital-gain-exempt investment,” Mr. Campbell says. “Therefore you’re going to be paying a lot more tax.”

You also may be left under water when the market goes south, a lesson some people learned during this last economic downturn.

While positive cash flow may mean paying taxes in the short term, Mr. Campbell says that’s a good thing. “I’m a big proponent in paying lots of tax,” he says. “It means you’re making lots of money.”

Offshore accounting schemes or other tax-avoidance measures are something to be avoided. The Canada Revenue Agency has been in this business a lot longer than any of us, he points out, and they’ve seen all the schemes come and go.

Remember, too, that cash flow does not necessarily mean net profit. If you have a good accountant – one who understands the ins and outs of real estate investing – you won’t be paying more taxes than you should be.

But since you will be paying taxes, it’s best to plan.

One pitfall Mr. Campbell says he sees, especially with new real estate investors, is that a positive cash flow can get spent rather quickly, leaving the well dry when tax time comes around.

“Estimate your profit,” he says. “If 80 per cent of your net cash flow is going to be taxable, put 40 per cent aside.” Checking profit-and-loss statements monthly is a must, he says. And another bit of important, if rather prosaic advice – hire a good bookkeeper.

Above all, he counsels, try not to get emotional.

“It’s all about the numbers,” he says. “We all do it – fall in love with a property – but you really can’t afford to get emotionally involved.”

It may not be romantic, and it may not be exciting, but “you have to fall in love with cash flow.”

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