In a recent column I explained in detail the theory of real estate leverage that a customer had recently asked about. In the same conversation that customer asked for a definition of "the greater fool theory." I thought that would be a good, light topic to discuss after the somewhat mathematical and dry leverage subject that I previously discussed.

During "hot" real estate cycles, it is quite common, especially in strong areas like Glendale, Burbank, La Crescenta and La Canada, for investors to purchase residential income property, small commercial properties or even single family residences (for rental purposes) which, when rented, will have a NEGATIVE CASH FLOW. A typical down payment on a house would be 20%, whereas the typical purchase down payment on units might be 25% down and the typical down payment on commercial property 30% down. During the hot real estate markets of the mid to late 1970’s and mid to late 1980’s, it was extremely common, especially in this area, for investors to have a negative cash flow.

Negative cash flow is most easily defined as the monthly gross rents minus the monthly mortgage payments and all other expenses, such as real estate taxes, insurance, gardening, utilities, repairs, etc., etc. Negative cash flow merely means that at the end of the month one has to dig into their pocket to make up a shortfall, i.e. negative cash flow. It was quite common during hot times for smaller units, rental houses or rental condos to have a NEGATIVE cash flow of $200-300 a month. The question you now ask is, "Why in the world would anybody put good money down for the privilege of losing money every month?" That brings us back to "the greater fool theory."

During the hot markets that I referred to, it was quite common for your neighbor, your postman or your sister-in-law to buy a house for $100,000, add paint and carpet and sell it within 60 days for $130,000. It was also common (unfortunately) for some apartment buyers to buy a 4-6 unit building for, perhaps, $200,000-$300,000, immediately raise the low rents, and then resell the building for a $50,000 profit based on the hot market and the increase in cash flow. In this case, the new buyer purchased a property with a negative cash flow but was fairly confident that within a year they could resell the property to a new buyer for a profit, even though the new buyer would also experience NEGATIVE cash flow. That buyer was, theoretically, a "greater fool." The reason all these people were foolish in the first place was because they were buying a property with negative monthly cash flow on the assumption that they could sell it at some point in the near future for a substantial profit, thereby making the temporary negative cash flow a mere bother rather than an actual loss. For instance, if somebody loses $200 a month on negative cash flow believing they can sell the property in six months for a $30,000 profit, the $1,200 (6 months X $200) negative cash flow would be easily offset by the anticipated profit.

The only problem with the greater fool theory is that real estate runs in cycles. In the 1980-1983 period, real estate didn’t really go down in value, it just became extremely difficult to sell. Therefore, instead of making $30,000 profit in six months, it was necessary for the seller to pay negative cash flow for a year to three years. All of a sudden, that became a "no fun" situation and some owners were unable to weather the storm. Owners not able to weather that storm were forced to sell their property at a loss. Even if they were fortunate enough to sell their $100,000 property for the same $100,000 price, the broker, escrow, title and transfer costs would still cost them somewhere in the range of $7,000.

Trust me, the loss in real estate values during the 1990’s made firm, firm believers for the POSITIVE cash flow school. As values fell in the real estate market, many people did not have the "holding power" to suffer the monthly negative cash flow. After all, the only reason negative cash flow was palatable in the first place was that they expected to sell the house at a big profit in a short period of time. Unsophisticated real estate investors either ran out of savings or were scared and dumped these properties. As we now have been in an "up" real estate cycle for the past few years, the gutsy real estate investors who purchased property a couple of years ago have profited greatly. It is not uncommon in the income property market to see 20%, 30% and 40% increases in value in a short period of time. This brings a lot of "gravy" to the original sound investment, which was predicated on monthly positive cash flow.

If the market stays hot for the next year or two, try to remember this article before you buy a piece of property counting on "the greater fool theory."

Peter Rosenthal
VIP Trust Deed Company