Monday, June 17, 2013
Rental Finances 101
How does a Rental (or Income) Real Estate Investor manage the finances on his rental properties? However he wants to...Gosh! Well, while I jest a bit, that's essentially true. Everyone has his own style and comfort level as it pertains to finances, but I'll give you a peek into what I do and what has kept me out of financial worry throughout the real estate and financial crisis of 2008 onward.
Let me deal with three more common issues: 1) Cash Flow 2) Maintenance & Repairs 3) Vacancies
No free cash flow: Unfortunately, too many people buy rental properties that are not cash flowing. In other words, after receiving their rent monies from the tenant and paying the mortgage PITI (Principal, Interest, Taxes, Insurance), they either break even, or are left in the red and must "feed the alligator," as we call it in the business. This is a very risky way to run a rental business. An income property should be able to pay for its direct costs AND leave enough monies to cover ongoing expenses. However, many compound this financial short-sightedness with other problems...
Underestimating Maintenance & Repairs: If you are rolling the dice just hoping you will not spend major money on ongoing repairs and maintenance, you are walking a financial tightrope on a windy day! Contrary to what many want to believe, with few exceptions, you will spend 1% of the value of the home every year on maintenance & repairs. That's $1,000 a year on a $100,000 house. You may not spend that grand in year one, or even year two, but you WILL spend it. Carpets needs replacing, HVAC systems break down, roofs need replacing, walls need painting, etc, etc, etc. If you don't set those funds aside, their absense will come back to haunt you when you least expect it and can least afford it. I set aside 10% of the monthly rents.
Vacancies: The vacancy rate depends to a large degree on your rental market. In some areas, multi-year tenants are the norm, and a blessing. In my market, the average tenant stays approximately 18 months to 2 years. Everytime they move, you lose the rent proceeds for at least a month, often longer. That adds up, especially while you must continue to make the mortgage payments. I set aside 8% of the monthly rents.
You must also consider whether you want to manage your rental real estate yourself or hire a rental management company to do the heavy lifting. I started off managing my own, but decided that that was not as passive as I'd like. For the past 6 years or so, I've used a rental management company. This comes at a cost: While some charge on average 8-10% plus the first month's rent upon locating a new tenant, mine charges a floating scale percentage of the rent proceeds each month the house is occupied by a tenant. In my opinion (and given my semi-retired status), this option is well worth the cost. No phone calls at inconvenient times for repairs, no rent collections, interviews, walk-throughs, inspections, bookkeeping, etc. My rental real estate operations are as passive as I want and need them to be.
If you purchase a rental property at what you consider "break-even," but have not factored in the above three categories, you're very likely to fail in your rental property venture. At the very least, you will add as much stress as the person who brings an alligator into his house and lets him roam free. I can't imagine living that way, can you?
Is it possible to sleep well while owning rental properties? Of course! But you must purchase the property with sufficient cash flow to accommodate everything mentioned above. To accomplish this you must, 1) Purchase cash flowing properties. 2) Be realistic about expenses and make sure the cash flow is sufficient to pay for all those expenses month in, month out. You must budget for these on an ongoing basis and accumulate the funds until they are spent.
Here's the formula for a typical rental property (a single family dwelling):
(RENT PROCEEDS) - (PITI) - (8-10% RENTAL MANAGEMENT) - (10% VACANCIES) = FREE CASH FLOW
Let's look at some real-life figures using my Property #3 which we're attempting to pay off quickly:
+Current Monthly Rent: $850.00
-PITI: $548.11 (Principle & Interest: $424.57)
-Rental Management Fee: $75.00
-Maintenance & Repairs (10%): $85.00
-Vacancies (8%): $68.00
Total Free Cash Flow $73.89
Assuming no repairs or vacancy in a particular month, the proceeds roll over into accumulation mode until they are needed. Like any good budget, this one helps to eliminate the nasty budget-busting surprises and expenses along with the additional stress of now trying to make a mortgage payment while fixing a plumbing problem or whatever the maintenance du jour.
For me, this system works, and it has worked well for many years. It keeps me above water even during times of higher vacancies or unforeseen repairs. However, like many systems, you must be faithful to it. For example: Avoid the temptation to spend your accumulated reserves just because they become many. Been there, done that. Ouch!
Rental real estate is not without its problems, and the above scenario will not play out in all geographic areas around the country. Additionally, you will get the occasional bad tenant who disrespects your property or doesn't pay the rent and has to be evicted. That's par for the course. However, a rental management company coupled with a good financial plan takes the edge off and allows you to sleep at night while giving your tenants the privilege of buying you a house...or houses. Not a bad deal...when done right.
Any thoughts or questions? I welcome them.