Historical article note: This article was originally published on 2019-12-12. Rates, policies, home prices, statistics, product names and qualification standards reflect the environment at that time and may have changed. This archive is for historical record and general education only. It is not mortgage approval, investment, legal or tax advice.
Have you ever seen questions like, 'Houses in Toronto no longer have positive cash flow, how should one invest?'
Or have you seen advertisements like, 'Rare properties with positive cash flow'?
I think these are two poorly constructed sentences that make no sense. Whether there is positive cash flow only relates to the down payment, not the price, location, or how many bedrooms the house has. North York in Toronto is the most familiar area for most people. I have calculated a few different apartment buildings there: if the down payment is 35%, there is positive cash flow; if the down payment is 20%, there is negative cash flow. If a property with negative cash flow is defined as not suitable for investment, a property with loss, then how can the same property be profitable and worth investing if the down payment is 35%? From the cases I have seen, as well as my own investment experience, blindly pursuing positive cash flow is the most common mistake in real estate investment. I know 90% of readers won't agree with me; don't worry, we will discuss it slowly.
01 Who says real estate investment must have positive cash flow?
I often mention 'Rich Dad Poor Dad' in my articles. The author, Robert Kiyosaki, advocates that real estate investment should have positive cash flow. If you read his book 'Rich Dad's Guide to Real Estate Investing,' you will find that the author invests in entire apartment buildings and other types of commercial properties, not individual residential homes. The difference is that he applies for commercial loans, while purchasing individual residential homes requires residential mortgages. Banks have different requirements for these two types of loans. For a commercial loan application, they look at whether the property has positive cash flow; for a residential mortgage, they look at whether the applicant's debt-to-income ratio is below 44%. These are two completely different loan approval standards. Kiyosaki is correct, and readers have not misunderstood him. However, Kiyosaki’s investment approach is completely different from the way most readers apply for mortgages to invest in real estate.
TD Bank and CIBC Bank use the commercial loan approval standards when approving investment property mortgages. Therefore, when the loan managers from these two banks give presentations, they advise applicants to invest in properties with positive cash flow; in other words, they suggest applicants increase their down payment. Listening to what these two bank managers say can lead one to mistakenly believe that all banks have the same requirement, resulting in preparing an excessively high down payment and being unable to invest in real estate. Other banks look at whether the total household debt ratio is below 44% and do not require positive cash flow; the minimum down payment for an investment property is 20%. Borrowers who take loans from these two banks to buy investment properties either need a high down payment or choose properties in remote areas, resulting in relatively lower investment returns.
Besides Kiyosaki and the two banks mentioned above, there are a group of investors who live on rental income and constantly talk about cash flow from investment properties. For investors who live on net rental income, once they lose positive cash flow, it affects their lives. If the down payment is too low and there's no cash flow, or if tenants default on rent and there's no cash flow, it will impact these investors' lives. Therefore, they need to find investment properties with cash flow.
The last category is people who nag all day about investment properties needing positive cash flow, and they are the ones who don't own a single investment property. They have never invested in real estate, do not understand the bank's loan approval requirements, are virgins in real estate investment, and suffer from fear of marriage. Among these people are real estate agents who advertise that a certain property has positive cash flow.
Who says real estate investment requires positive cash flow? Commercial real estate investors; loan applicants at TD and CIBC and the loan managers at these two banks; investors who live off net rent; and people who have never invested in real estate. Are you one of them?
Wouldn't it be better to have positive cash flow?
Question: 'Why invest in real estate if it doesn't generate positive cash flow?' Answer: 'Do you need positive cash flow to invest in stocks? If there is no positive cash flow, why would you invest in stocks?'
Question: 'Isn't having a positive cash flow better?' Answer: 'That depends on who you are talking about.'
Compared to stock investment, many investors demand that real estate investments generate cash flow. I haven't found a source for this question: why don't people seek cash flow when investing in stocks, but insist on positive cash flow for real estate investment? Some people invest in growth stocks that don't pay any dividends, and the investors tolerate it themselves. I don't understand why they can't tolerate real estate investments without net cash flow. Even when investing in blue-chip stocks, dividends can't be paid monthly; as long as dividends are ensured annually, investors have no objections. When it comes to stock investment, I've never seen anyone choose stocks based on cash flow. Why be so strict with real estate investment? I really can't figure it out. If any reader has a good explanation, please leave a comment below.
Is positive cash flow good? Not necessarily.
In North York, an apartment costs 500,000 per unit. If you have 200,000 in cash, with a 20% down payment, you can buy two units, which not only spreads vacancy risk but also increases leverage. With 5 times leverage, if the property value rises by 10%, your return is 50%. With a 35% down payment to buy one unit, you'll have 25,000 cash left, which isn't enough to buy a second unit—you'll have to save more. Vacancy risk is double that of buying two units, leverage is 2.8 times, and if property value rises by 10%, your return is 28%. From the perspective of capital efficiency, the difference is significant. Buying one less property for positive cash flow, and having much less leverage, is not worth it.
Additionally, positive cash flow can result in significant tax losses, because positive cash flow means that gross rental income minus all expenses including loan principal is a 'positive number.' 'Positive number' + loan principal = net rental income = taxable income. Higher taxable income means higher taxes, and paid taxes cannot be recovered, and they have to be paid every year urgently, which is not in line with the 3D principle of tax reporting (defer, divide, deduct).
The benefits of positive cash flow apply to two types of people: first, those who need rental income to support their family; without current rental income, they cannot get by, so they pay taxes when due. Second, if your loan has been rejected by banks other than TD and CIBC, you need positive cash flow. If you don't belong to these two categories, find your own reason: why do you insist that investment properties must have positive cash flow? I really cannot find one.
03 Cash is More Precious Than Gold
One of the foundations for the existence of capitalism is the interest rate differential between the returns of different risk assets. Stocks are riskier than bonds, so stock returns should be higher than bond returns and maintain a certain spread, which is why people are willing to take greater risks to buy stocks; similarly, bonds are riskier than cash, so bond returns should be higher than cash and maintain a certain spread, which is why people are willing to take greater risks to buy bonds. The interest rate differential between stocks, bonds, and cash supports the continued risk-taking and progress of capitalism. If an unexpected event occurs and disrupts this order of spreads, it could shake the entire capitalist system. In the past decade, people have vaguely felt something was off, a lingering sense of unease, but when asked why, the reason is that this balance has been broken, and most people are completely unaware.
If we replace "cash" in "stocks, bonds, cash" with "mortgages," everyone can more clearly see what concerns lie in our minds. Cash can be borrowed, right? If borrowed cash is used for investment, and the return rate minus the loan cost is higher than the bond yield, does this not create an inverse flow in the spread between bonds and cash/mortgages? Because bond yields become the lowest, the new order becomes "stocks, mortgage/cash, bonds." The necessary condition for this new order is sufficiently low loan interest rates. If investors are afraid to enter the stock market but have sufficient borrowing capacity, they will tend to invest using borrowed money, and the cheapest borrowing cost is a mortgage, making real estate investment the first choice for many families.
Our previous stereotype of real estate investors was that of landlords, but over the past decade, there has been a dramatic shift. Most of the families entering the real estate investment field recently maintain good credit records, have professional jobs, stable and relatively high income, and are skilled immigrants. These investors leverage their strong borrowing capacity, ultra-low loan interest rates, and the unstoppable rise in rents and housing prices to maximize the leverage on the cash they hold.
"How long can this new interest spread order of 'stocks, mortgage/cash, bonds' last? From 2009 to 2017, it remained like this, so many investors, including myself, rushed to maximize leverage, putting as much property as possible under our own names, fearing that interest rates would rise. The fear finally materialized in 2017 when the Bank of Canada raised rates five times from July 2017 to October 2018, and bond yields continued to rise. The most frightening part was that during this period, the Federal Reserve also announced rate hikes and balance sheet reduction. It looked like this new world order would end, returning to the old era with the traditional interest spread order of 'stocks, bonds, cash.' At that moment, Emperor Trump suddenly appeared, repeatedly criticizing the Fed for raising rates and harming stock market prosperity, strongly demanding 'preemptive rate cuts' to prevent a great depression. What is hard to understand is that the Fed actually yielded, and starting in 2019, completely reversed course by cutting rates and stopping balance sheet reduction. Such a dramatic situation could not have been the result of the president alone; we need to refer to Japan to understand how this happened. In 2001, Japan invented 'Quantitative Easing' (QE), where the central bank buys large amounts of bonds, reducing the number of bonds in the market, raising their face value, while bond yields fall. The long-term lending costs for banks are based on bond yields, so the long-term loan and mortgage rates fall. From 2001 to 2019, for these 18 years, the Bank of Japan was unable to raise rates due to excessive borrowing by individuals, corporations, and the government during the low-interest period. The U.S. borrowed from Japan and used QE as a large-scale weapon to lower rates in 2009. The financial storm at the time was alleviated, but surprisingly, 10 years later we find that after using QE to cut rates, raising them again becomes difficult. After the Fed consecutively cut rates, the Bank of Canada still did not lower rates artificially because there was no reason to prevent a great depression. No matter how the Bank of Canada decides, Canadian mortgage rates remain around 3%. If real estate investment returns minus 3% funding costs are higher than bond yields, real estate investment remains the preferred choice for many households.
It is said that confidence is more valuable than gold, but for real, tangible investment, in the current 'stocks, mortgage/cash, bonds' interest spread order, smart investors see that cash is more valuable than gold.
04 Is negative cash flow a loss?
Everyone knows that profits are taxable. In real estate investment, the taxable amount should be the net profit. Friends who have done real estate investment will definitely know that real estate investors have to fill out the T776 form every year, listing gross income and "all expenses," and finally calculating a net rental income. If this income is positive, it must be counted as personal income for taxation; if it is negative, it is a loss, which can be deducted from the total taxable income before paying taxes. "All expenses" only include loan interest, not loan principal, while the monthly mortgage payment must include the principal. Let's compare the relationship between profit and cash flow:
Profit/Loss = Gross rental income - All expenses
(Positive/Negative) Cash flow = Gross rental income - All expenses - Loan principal
From comparing the two formulas above, it is clear that negative cash flow does not equal a loss. So what is the money added each month for negative cash flow? Remember the example we gave earlier: with a 35% down payment, there is positive cash flow; with a 20% down payment, there is negative cash flow. Therefore, negative cash flow equals the installment payment of the down payment, not a loss. If the bank allows you to pay the down payment in installments and lends you as much as possible, in this era where cash is king and cash is more precious than gold, would you still insist on positive cash flow and borrow less?
Negative cash flow requires the investor to have abundant off-site positive cash flow, meaning their personal income is not only enough to cover living expenses but also enough to add to the down payment each month. The term "off-site" is very important. Remember the example we introduced before about Buffett using leverage? Buffett never uses margin to buy stocks in the market; his leverage is off-site, using insurance float as leverage. In Li Xiaolai's new book "The Self-Cultivation of Chives," it is also mentioned that investors are market chives when entering any unfamiliar investment field; they must have sufficient assets or cash flow off-site and cannot go all-in waiting for in-market investments to achieve expected returns or positive cash flow.
05 There is an investment method called "dollar-cost averaging".
Graham was Buffett’s teacher, and his advice to investors in his later years was to buy index funds; Buffett’s advice to the general public is also to invest in index funds; the book "A Random Walk Down Wall Street" ultimately advises investors to invest in index funds; there is a popular long-term investment course in China that also recommends investing in index funds. How to buy index funds? The advice is quite consistent: "dollar-cost averaging." That is, setting aside 1,000 yuan each month to buy index funds. When the market rises, you buy fewer shares, and when the market falls, you buy more shares. The result of long-term dollar-cost averaging is an average purchase cost, and the return is the market’s average return. Dollar-cost averaging in index funds is the most conservative, passively defensive investment; it does not aim to beat the market, only to preserve and grow one’s savings through the capital market.
Negative cash flow real estate investment is the same as regularly investing in index funds: invest a fixed amount every month, rain or shine, achieve average returns, enforce savings, and prepare a gift for your future self.
06 Fear and Anger in Life
Some people are very angry at others for taking out large loans to invest in real estate, feeling that daily income is all used to pay off debt and not for consumption to stimulate economic development, and that high debt levels bring instability to society; some people are filled with fear of real estate investment and dare not borrow money, watching others take loans to invest while they themselves feel paralyzed as if nails were driven into their feet. Product manager Liang Ning gave an example to describe the difference between anger and fear: when a cat urinates around its territory and another cat intrudes, it feels angry; but when a tiger intrudes into its territory, it doesn’t feel angry, it feels fear. A person’s boundary of fear is the boundary of their career, wealth, relationships, and essentially their life. Everyone understands this principle, but the reason they still cannot live a good life is that emotions like fear and pleasure are a person’s operating system, while various knowledge is the application programs (apps) on the operating system. If the operating system version is low, no app can run properly. Without changing the boundaries of fear, learning anything is futile, and even inspirational teachings are useless. The fear of real estate investment is not because people are too ignorant to distinguish between negative cash flow and loss, but because they lack experience and courage in using OPM (other people’s money) due to their family upbringing. By setting an example for children on daring to borrow and invest, and showing them your investment results, children will never have any fear in this regard for their entire life. Many people worry that their children will fall behind at the starting line, making them work extremely hard while the parents only spend time and money accompanying them. Actually, the best education is to set the example for children. Families where parents make the down payment and let their children take out loans to buy investment properties do not need their children to win at the starting line when they are young. How to educate children to let go of fear? Only by personal demonstration.
Conclusion: I think many people don't realize that negative cash flow is not actually a loss, but they don't understand that negative cash flow is essentially installment payment of a down payment. It's the bank, in addition to giving you a loan, authorizing you to pay precious cash in installments, which is such an honor. Dollar-cost averaging is a method to diversify and average investment costs, and it is also a way to accumulate wealth by regularly saving small amounts. It not only smooths out market volatility but also helps investors develop long-term investing habits. Negative cash flow in real estate is like dollar-cost averaging in real estate. As first-generation immigrants in Canada, there is so much we need to learn and even more we need to prepare for the second generation. We must distinguish between 'borrowing for early consumption is debt' and 'borrowing for investment is leverage' in order not to be afraid ourselves and to ensure the next generation has no fear of borrowing. Living in a capitalist country, if you don't learn to make money using OPM (Other People's Money), you can only sell your labor. So what is the point of immigration? Criticizing others for having too much debt is a sign of ignorance. How do you know how much wealth they have earned using these loans? The sooner we free ourselves from ignorance and let go of fear, the sooner our anxiety about the future will disappear. Continuous learning, combined with the courage to take action, is what allows us to achieve financial independence.