I had an fun and informative phone conversation the other day with Jeff Brown of Brown & Brown  in San Diego that made me think about cashflow – and the way that different investors think about what it means.

I talk a lot about cashflow in this column, but cashflow isn't really my game when it comes to investing in real estate.  The cashflow question, to me, really isn't about "how much cash is this property going to put into my pocket on a month to month basis."  The cashflow question, to me, is really about "are the fundamentals of this property strong enough that it will support itself?"

In other words: will it reliably generate enough income to cover principal, interest, expenses and taxes, with a little left over to cover vacancies and incidental expenses. When I run the numbers this is the primary thing that I’m looking for.

This is a strategy for long term wealth building; it’s not one that will finance a short term increase in your quality of life.

Compared with other investing opportunities – the stock market in particular – there is a compelling case for real estate. Consider the following two opportunities to invest $20,000:

• Put $20,000 in the stock market (assume a return of 8% - around the historical average)
• Put a $20,000 down payment on a $100,000 single family house (assume a rate of appreciation of 4.5% - also around the historical average)

The stock market’s 8% trumps the real estate market’s 4.5% rate of appreciation, but take into consideration leveraged backed by casfhlow an it paints a new picture entirely.

Instead of making an 8% return on a $20,000 asset, you’re making a 4.5% return on a $100,000 asset. That’s a great trade-off. And if you’ve done your homework on estimating the property’s cashflow potential then you’ve increased your confidence that the rent the property generates covers all of the associated expenses.

So that property isn’t going to finance your new Porsche anytime in the next 12 months, but when you cash out in ten years you can expect to put almost $80,000 in your pocket. And that beats the pants off the $43,000 that the same investment would have generated in the stock market.

Want a bit more risk? Take that $20,000 and put 10% down on two $100,000 properties - in ten years your investment will have grown to almost $140,000.

There is a catch, however. It’s going to be tougher to make your cashflow proposition work on that 10% down case. Assuming an 8% interest rate your annual payments (principal plus interest) will go from around $7,000 per year to over $15,000. Taxes and expenses will also be higher - so you’re going to have to search more diligently and negotiate harder to make the numbers work.

And here’s the ironic part; eventually an investment will turn into a really “good” one – one that starts churning out cash. Your rents should go up over time and your mortgage payments should remain relatively flat (assuming you’re not in some toxic waste exotic, which is harder to get these days). And when the investment starts getting lucrative on a month-to-month basis, that’s exactly the time to sell…your leverage is running out on steam. More on that in a future post….