The Myth of Cashflow – and understanding how to reserve properly and model.

[David Lutz]

Let me start by saying I am all in on RE. I have an MBA, spent years learning about RE before I pulled the trigger. And when I did, I bought 5 houses worth over $1M in 18 months with only $100K of my own money. So I feel pretty good about saying I am financially literate, know how to model, and to find deals purchasing out of state.

I’m also embarrassed to admit I was so focused on getting going that I just assumed I could track if I was doing well by watching my bank balance. That was dumb. To be fair, in addition to buying all those houses over the last 3 years I also dealt with an eviction, $47.4K in capital expenses, insurance claims, building teams in my local markets, and all the other nonsense involved in this lovely industry.

Anyway, I finally got around to putting together a complete general ledger and had the horrible realization that over the last two years (bank and credit card record limitation make it harder to go back farther)…

….. between 2022 and 2023 I have been $17.5K cash flow negative on $171K expected rent !!!!!

How the **** did that happen? I budgeted 21.2% of the expected rent toward vacancy, maintenance, and CapX, and in reality I ran at around 27% in the last two years. Also,.. why am I telling you? I figure that I’ve gotten so much from everyone at Bigger Pockets, and there is so little information on the hard numbers of how non-professional investors do, that I should give something back. Because most of the tools you have access to are a figment of imagination pushed by self-aggrandizing gurus and the Real Estate industry … because they only make money when you’re buying.

Again, let me stress I've made a lot of money over the last 3 years. I think you should buy real estate, I just want you to be smart. One of the major dangers is caused by the bizarre reality distortion field people have regarding the term cashflow. It seems like a lot of people use the term cashflow to refer to how much net income they average per month with no (or minimal) reserving or debt servicing. And the per door numbers sound huge, which is great but also meaningless. Because, reality check, if you think you're clearing $500 per month over 3 years ($18K) but you end up with one $5K Cap Ex cost, $4K in vacancy, and $3K in random maintenance then you're really only averaging $166 per month ($6K). And if you borrowed money for your downpayment from a HELOC, personal loan, cash out refi, 401K etc., then your hidden debt servicing can take your cashflow negative in a heartbeat. Rosy assumptions about how much free cash your real estate investment is going to throw off make it really easy to be unrealistic about what it's going to take to make owning rentals actually work.

So, 3 years into my Real Estate journey (5 with planning) I have some learnings I want to share:

• The default assumptions in every calculator you look at are rosy at best and complete lies at worst. Unless you buy a brand new house there is probably deferred maintenance. Your costs are going to be higher than you expect in the first few years. Plus, you’re not a professional. There is a high likelihood that you’re going to end up paying slightly more than you should for repairs, and turning houses when tenants leave is going to take longer than it should.
  • -- I’m sorry. I know you think you’re awesome. You’re not. Bleeding money that a pro wouldn’t is just going to happen. It’s better to anticipate it.
  • -- My recommendation is 25% of rent to cover vacancy, maintenance, and Cap X for older homes (+20 year), 20% for middle age (5 to 20), and 15% for new homes (you’ll need it eventually). I’m running hotter than that, but I honestly believe that I’ve caught up on deferred maintenance and these numbers are good for the long run.

• Have a plan for dealing with getting it wrong. I started with a $20K reserve. In addition to a strong W2, I have a HELOC to lean on. I stopped fed tax withholdings because the penalty is cheaper than borrowing cash, which buys a year (I still pay my taxes in full). In a pinch I can borrow against my 401K. And if things ever went truly sideways I could sell a house.

• Leverage is awesome. I borrowed 90% of the money for the homes I purchased at an average of ~4% interest. But the higher your leverage, the more likely you’re going to be cashflow negative. You’re going to make more money with more leverage, but only if you can handle the debt service. Don’t overextend yourself.

• As insane as it sounds, going all in actually helped. The rent from 4 houses covered the mortgage for 5 over the last 18 months I’ve been dealing with an appealed eviction and the court collecting and holding the rent.

• Everything I bought rented for 1% to 0.65% of the initial purchase price (more now). And the 1% has been the biggest headache. So if you go for cashflow you better be on premises, because there are going to be issue to deal with. And if you go for appreciation/quality houses you need to have a plan for dealing with weak cashflow.

• For pity sake don’t turn on water service on a Friday. My buddy and I have both ended up with minorly flooded houses despite the property managers telling us that all the taps had been turned off.

• If you’re buying out of state, ask potential property managers if they have local staff on site or if they outsource their inspections to a vendor (common for larger PM companies).

• When I model returns, I assume appreciation on B-/C+ properties at 1% above inflation. I did a lot of research, long term that’s a safe assumption. Rent I assume tracks with inflation (which is still great because a lot of your costs are fixed). This is probably a bit conservative, but I think it’s generally accurate, and I only like good surprises.

• You have to be able to get +$1000 per door to use a property manager, less than that and the minimums they charge start screwing up your returns.

• Water heaters, etc. cost roughly the same everywhere - it’s closer to a fixed cost. Buy where taxes are low on rental properties, populations are growing, economies are growing, and there are at least two of the following: Gov spend, Major healthcare, transportation hubs, universities, sports teams, industry concentration, tourism, manufacturing. These drive jobs, the more there are where you buy the better and more stable your investment.
  • -- If you’re as nuts as I am read the local area development plans and research planned corporate and other investments. Building an amazon hub and a zoo to the east of the city along with a new planned transit rail line? Awesome.

• Offer what you have and ask for help (preferably in that order). I did some financial modeling for an RE Agent I wanted to build a relationship with, and a year later he gave me some great recommendations on local tradespeople. During a friendly conversation I asked one of my property managers for recommendations on areas with the most growth potential and ended up buying two homes there.

• LLC get expensive if you're thinking of opening one for every property, plus it's a lot of work to make sure they can't be pierced. Consider just getting an umbrella insurance policy.

• Interest only HELOC are only just interest until you hit the repayment period, so make sure you're ready for the increase when you start paying back principal. Also, some lenders have limits on how many mortgages you can have and qualify for a HELOC. So if you think you might want one, set it up early.

• Current taxes on the property you buy generally lag current market value, and in some cases taxes on rental properties are higher than owner occupied. That’s all going to get corrected when your purchase triggers a reappraisal. So put together some realistic tax estimates before you buy.
  • -- All the info you need is available online from the local assessor, and pay attention to what the local community has tacked on to the mill rate. Taxes for two houses twenty minutes apart can be wildly different.

Major costs over last 3 years on 5 homes:

• $10K in missed rent leading to and waiting for eviction
• $3K Eviction costs (lawyers, travel, writ, etc.)
• $2.5K additional lost rent due to 4 month instead of 2 month property turn
• $3.8K for a new furnace
• $7.4K for a new HVAC
• $700 for a bathroom re-pipe
• $12K turn on large home, included new high quality carpet and full repaint
• $5.5K in unnecessary plumbing issues caused by tenant in eviction (no way to recover costs)
• $1.5K in utility bills during vacancy or owner responsibilities
• $900 for a refrigerator
• $4.8K for concrete piers to shore up a foundation
• $5.6K for a roof (insurance claim)
• $5.2K for another roof
• $1.3K for new AC line set (punctured in second roof replacement)
• $1.6 for a water heater
• $1.3 for a water heater
• $2K for a water heater
• $1.7K for new water line from meter to house
• … this actually isn’t everything but I’m getting depressed.

That’s $70.8K which was money that never made it to me, I didn’t expect to spend, or thought I had more time. And this is separate from regular maintenance my property management companies took care of and deducted from the rental income.

So the moral here is that RE is great but you can’t depend on cashflow. If you buy class C or D properties you are going to have way more issues than you can ever anticipate on paper. And if you buy class A or B you’re banking on appreciation. Either way, buy and hold is a long term play and it’s not going to throw off lots of cash in the short term. I’m guessing my year 4 is going to be pretty good, but it’s taken that long to get everything stabilized.

And If I decide to pull equity out to buy more houses, it extends this issue. I would end up with cash to buy more houses, but my monthly debt load goes up and cashflow goes down. So dream of equity and forget about cashflow,... its just a myth.

* These are just my personal beliefs based on my experience. If you hadn’t guessed I am not a RE professional (you probably aren’t either), and that’s kind of my point. I think it’s way too easy to over estimate investment performance based on how well the pro’s do. So don’t take any of my opinions as anything more than that. Make sure you do your own due diligence on your own deals.

**and if you find this info useful vote the post up. I'd like for folks to be able to find this kind of detailed info more easily.

[V.G Jason]

A lot of what you said here is what a lot of (experienced and/or intelligent) investors have driven home. With that said, I'd still say your sample size is just too small. Let's see how it fairs Year 8 and ideally closer to year 12-14. 

The description of prices & events that took place for what areas you bought neighborhood wise are par for the course. It's just a lot of volatility in cash flow for the first years; that's expected. That's why you don't invest on a short-term horizon though.

The right move isn't necessarily to cash-out refi and grow, technically. The move would be to cash out re-fi, then sell and deleverage. You scale originally. I wouldn't scale nowadays with cash out re-fis-- in the low rate era sure. Right now just less houses and better houses. Get up to 6-7 quality houses, sell 1 and re-fi one after 10 years. Sell the re-fi one year 12-15. Take that cash and pay capex/debt downs on the other 5, live debt free.

[Chris Seveney]

@David Lutz

This is a great post and thanks for sharing. We cringe when we see people who model assets through rose colored glasses especially when they have little money.

As you mention leverage can be your friend but you also need to make sure you have considerable amount of cash to cover the types of expenses etc you mention.

[David Lutz]

Quote from @V.G Jason:

A lot of what you said here is what a lot of (experienced and/or intelligent) investors have driven home. With that said, I'd still say your sample size is just too small. Let's see how it fairs Year 8 and ideally closer to year 12-14. 

The description of prices & events that took place for what areas you bought neighborhood wise are par for the course. It's just a lot of volatility in cash flow for the first years; that's expected. That's why you don't invest on a short-term horizon though.

The right move isn't necessarily to cash-out refi and grow, technically. The move would be to cash out re-fi, then sell and deleverage. You scale originally. I wouldn't scale nowadays with cash out re-fis-- in the low rate era sure. Right now just less houses and better houses. Get up to 6-7 quality houses, sell 1 and re-fi one after 10 years. Sell the re-fi one year 12-15. Take that cash and pay capex/debt downs on the other 5, live debt free.

 @V.G Jason  Appreciate you taking the time to comment. If I follow your second statement, are you saying that instead of continuously pulling equity out of the existing portfolio to fund expansion that you would grow to 6-7 houses and then consciously shrink the portfolio down to 5 with much higher equity levels (potential upscaling the quality of the houses in the process)?

I think what you're saying makes sense when you hit the point you're shifting toward retirement and looking to stabilize and increase your cashflow. But I'm still in growth mode. In order for me to hit my RE goals I need to keep growing my portfolio.

My current challenge is figuring out how to keep growing my portfolio as quickly as possible in a sustainable way. (any suggestions welcome). You said you wouldn't scale using cash-out refi nowadays, given the end of the low rate era. I agree with you.


1) I don't want to do a cash out refi unless I'm getting enough capital to make giving up my current interest rates worthwhile. Because my current rates are so low, it will be 3-4 years before there's enough equity to make that really compelling.

1a) Am I correct that you're suggesting pulling out equity, but doing it through sale and reinvestment instead of cash out refi? As long as you can shift into a property that's better enough to justify the transactional costs (your bigger better houses comment) I think you're spot on. But that still requires having enough capital to make that possible, which puts me on a longer timeline than I would like.

2) I can't find lenders willing to take a second position at even marginally sane rates. (any recommendations?)

3) In long term SFR buy and hold I haven't been able to figure out how to structure a deal that works for both parties in a partnership. (ie. If I borrow a down payment from a friend at 7%, there's no way the deal isn't doing to be cashflow negative, and that puts a ton of pressure on appreciation to make the deal worth doing, and every deal makes me less able to do another in the near term)... Money partners make a lot more sense in forced appreciation deals where there's enough money to go around.

4) Seller financing feels like trying to find a unicorn. I'm not working in RE day-to-day, and I haven't seen these opportunities. I am keeping my eyes open for them, but it doesn't seem like a realistic growth strategy.

Out of everything, if I understand your suggestion 1a properly, I think that might be the most realistic option for growth in the current higher rate environment. As you pointed out. It's slower than I'd like (can't I have a lot of money with no work right now?), but it's practical. 

--- I'm not trying to be negative on any of the options btw, just realistic. I'm going to keep pounding my head on these issues until I find a solution to moving forward. If you have any additional suggestions I'd appreciate it.

Did I understand your original comment correctly?

[V.G Jason]

Quote from @David Lutz:

Quote from @V.G Jason:

A lot of what you said here is what a lot of (experienced and/or intelligent) investors have driven home. With that said, I'd still say your sample size is just too small. Let's see how it fairs Year 8 and ideally closer to year 12-14. 

The description of prices & events that took place for what areas you bought neighborhood wise are par for the course. It's just a lot of volatility in cash flow for the first years; that's expected. That's why you don't invest on a short-term horizon though.

The right move isn't necessarily to cash-out refi and grow, technically. The move would be to cash out re-fi, then sell and deleverage. You scale originally. I wouldn't scale nowadays with cash out re-fis-- in the low rate era sure. Right now just less houses and better houses. Get up to 6-7 quality houses, sell 1 and re-fi one after 10 years. Sell the re-fi one year 12-15. Take that cash and pay capex/debt downs on the other 5, live debt free.

 @V.G Jason  Appreciate you taking the time to comment. If I follow your second statement, are you saying that instead of continuously pulling equity out of the existing portfolio to fund expansion that you would grow to 6-7 houses and then consciously shrink the portfolio down to 5 with much higher equity levels (potential upscaling the quality of the houses in the process)?

I think what you're saying makes sense when you hit the point you're shifting toward retirement and looking to stabilize and increase your cashflow. But I'm still in growth mode. In order for me to hit my RE goals I need to keep growing my portfolio.

My current challenge is figuring out how to keep growing my portfolio as quickly as possible in a sustainable way. (any suggestions welcome). You said you wouldn't scale using cash-out refi nowadays, given the end of the low rate era. I agree with you.


1) I don't want to do a cash out refi unless I'm getting enough capital to make giving up my current interest rates worthwhile. Because my current rates are so low, it will be 3-4 years before there's enough equity to make that really compelling.

1a) Am I correct that you're suggesting pulling out equity, but doing it through sale and reinvestment instead of cash out refi? As long as you can shift into a property that's better enough to justify the transactional costs (your bigger better houses comment) I think you're spot on. But that still requires having enough capital to make that possible, which puts me on a longer timeline than I would like.

2) I can't find lenders willing to take a second position at even marginally sane rates. (any recommendations?)

3) In long term SFR buy and hold I haven't been able to figure out how to structure a deal that works for both parties in a partnership. (ie. If I borrow a down payment from a friend at 7%, there's no way the deal isn't doing to be cashflow negative, and that puts a ton of pressure on appreciation to make the deal worth doing, and every deal makes me less able to do another in the near term)... Money partners make a lot more sense in forced appreciation deals where there's enough money to go around.

4) Seller financing feels like trying to find a unicorn. I'm not working in RE day-to-day, and I haven't seen these opportunities. I am keeping my eyes open for them, but it doesn't seem like a realistic growth strategy.

Out of everything, if I understand your suggestion 1a properly, I think that might be the most realistic option for growth in the current higher rate environment. As you pointed out. It's slower than I'd like (can't I have a lot of money with no work right now?), but it's practical. 

--- I'm not trying to be negative on any of the options btw, just realistic. I'm going to keep pounding my head on these issues until I find a solution to moving forward. If you have any additional suggestions I'd appreciate it.

Did I understand your original comment correctly?

 In bold-- you're not understanding growth mode in this new era. Old era, growth mode= as many properties as possible. New era, growth mode= as many quality houses as possible. If you have $1million in cash, and you have $1million in loans at 8%. Are you better off paying down those loans or "scaling more"? 

The answer is likely a bit of both. I'm not talking about a retirement shift, I'm talking about understanding how growing your portfolio with the (new) inherent risks in a rate sensitive, supply shortage, location premium real estate market. You're thinking this is 2014, this is 2024. Your question of timeline makes me question what it is? I'm hoping it's north of 10 years.

What's the fundamental purpose of growing your portfolio? To make more money right? Okay, then grow by scaling into high(er) quality homes and deleveraging, not stacking properties on properties with high(er) leverage amounts. This isn't just a risk tolerance notion, this is how you make more money. You kill your costs in a high rate environment and buy debt, in a low rate environment you take on more cheap debt. This isn't some rocket science I am spewing, this is just a 180 from what most BPers grew up listening to. 

If you're view of "scaling" is simply property count, be careful. You'll get tripped up. The non-linear rate increases in HOIs, capex, etc., your "scale number" will force you out if you move too tight. The only way around is keeping a ton of cash against your highly leveraged properties, but then we go back to the original question.

[David Lutz]

@V.G Jason

First, I appreciate you taking the time to reply. I know we're all busy.

Second, I think this is an issue where it's just hard to have detailed/accurate conversations via forum chats.

I promise you, I do understand the difference between a high and a low interest rate environment. To your point about "if you have a $1M do you pay down debt at 8%, or investing it",.. the answer depends on if you have access to a tax adjusted real return which produces more than 8%, and enough more to be worth whatever risk comes with it.

Honestly, the only place I’m not sure I’m on board with your thinking is the deleveraging. I can only see three reasons to deleverage, if:

• 1) You are retiring and prioritizing the establishment of a stable income stream. (which you said is not your thought)
• 2) If you’re already overextended and need to put yourself in a more secure cash position. (I’m not, per my original post I’m pretty conservative in my modeling and safety nets, I don’t get the feeling you’re swimming naked either)
• 3) You can get a better return investing the money somewhere else, even accounting for the transactional costs

The last is the most interesting. You’re implying that you can get a better return paying down your debt rather than leaving it where it is or increase leverage buying something new/bigger. I think that’s where I’m having trouble.

What’s the scenario where you sell home “A” that’s generating strong returns (I.E. the leverage is working for you) in order to pay down the leverage on home “B” (that’s also working for you)?

In Europe where you only have 5 year loans, or in the US with commercial property I could see this happening because your levered costs can change on you. But with a 30 year fixed you’d just leave the money where it is, and continue to get the benefits of a locked in leveraged return …….

To your questions:

• My timeline is generational wealth. I’ll probably switch from pure growth to a mix of growth and yearly returns in 10-20 years.
• I really don’t care how many doors I have, I just want to increase my portfolio market value and run it efficiently.
• You’re spot on regarding defraying fixed operating costs with better properties. But I think that’s an always thing, not just the current market. There is a limit to how much benefit you get pushing for nicer homes, at some point the spread between rents and home value starts to accelerate.

Final note, I do really appreciate the discussion. Always a good opportunity to learn something new 😊

[V.G Jason]

If your debt is 8%, and you are paying it down that's your guaranteed rate of return. Using the question of if you have $1million in cash with $1million in loans at 8%, if you hedge 20% of your loan volume and that guaranteed rate is subpar from the other $800k invested. That's a great problem, right? That's why you deleverage some, basic portfolio management. However, I'd argue truly yielding over 8% isn't as common as people think going forward. 

The argument of the benefits of a locked in leveraged return is fine, but it is only as material as you are able to capture the appreciation-- sell or refinance-- so with that said, the better quality houses will likely prevail in a high(er) rate environment than in years past. And assuming everyone has a budget, the quality houses will likely dip into the quantity of houses you can pursue.  I would argue the route to increase portfolio value in 2024 is quality houses + buying asset-backed debt versus scaling in property count.  An example, I'd buy 7 higher quality houses at varying downpayments 25-40%, with 2 downpayments worth in debt funds versus 16-18 lower quality, 20% downpayment houses. In 2014, I'd argue the inverse, I'd take the latter. 

[Becca F.]

@David Lutz

This is a great post, should be required reading for all investors especially new investors. I made the mistake of chasing doors and rushing into buying Class C properties for "cash flow". Almost listened to some misguided advice to sell my Bay Area SFH rental with lots of equity and reasonable property taxes (thanks to Prop. 13) and 1031 to multi-unit OOS or lots of SFHs/duplexes for more cash flow... hard pass. I can check on my Bay Area property 3 times a week if I wanted to. Buying an apartment building OOS sounds risky to me.

The property tax issue is important. I have unlimited property tax increases on my Class A Indianapolis home, 17% with the recent assessment. I didn't see how I could appeal it since the assessed value is lower than market value and didn't have the comps to appeal it. I don't hear a lot of people bring property taxes up. I'm paying more in property than a Phoenix investor and his house is worth twice mine but half the property tax and Arizona has had better appreciation than Indiana. 

Stolen AC unit, repairs with Class C so I'm -$300 to -$500 a month, with -$700 most recently on what was supposed to cash flow positive. I've spent so much in inspection fees and sewer line scopes with offers OOS, could have taken my kids on a nice vacation with that money. I would add have an unbiased party (maybe another experienced local investor, someone not involved with the sale of the property) do a detail video walk-through and pay them $100 or $120 before submitting an offer.

With overextending yourself and leveraging too much, I've decided not to buy anymore and take out more mortgages at 7% rates for now. It scares me what some investors do but it's not my money and I hope they have a lot of cash reserves. 

I thought I did my due diligence but needed to do more due diligence - learned a huge lesson. 

[Glen Wiley]

One thing you might notice is the cost of some repairs. I replace water heaters for about $700. One great way to scale a portfolio is gaining skills with plumbing and other repairs and taking the time to do the work yourself.

If you enjoy working with your hands you can save a fortune by learning to do as much of the maintenance on your properties as you can.

I get it that some folks would rather hire someone - I like to look at it as though I am getting paid the difference between what it cost me to do the work vs. hiring a tradesman. On the water heater that is about $700-800 for a few hours of work, plus I enjoy it.

We put together a proforma for prospective deals to try to capture all of the projected costs to determine the real monthly cash flow. I do this many times a year to refine my ability to sketch it out. A key part of your message is that folks need to fully understand their expenses when modeling a deal before they execute on a purchase.

[Steve Smith]

David,

Wow, is all I can say. You got some bad training and headed down the wrong path. You don't need 5 houses, you need ONE good one, PERIOD. Buy local, manage it yourself and LEARN the house investing business. Get a GOOD quality house, and a GOOD quality tenant. Have the tenant do the basic maintenance as part of his lease. Let him pay you monthly ON TIME, or AHEAD OF TIME, without fail. If you give him a good deal on a great house and you get a qualified tenant, he will do this for you.

THEN, buy house number two next year. Repeat this over and over again. If you do it right, it will be easy and you should create about $1M in net worth in 10 years. As time goes on, sell your worst rental and replace it with a better one. NEVER ReFi anything! Every time you do that, you loose money. As time goes on, pay off your small loans and end up with free and clear houses.

Once you have 10 free and clear houses you can live off of them debt free for the rest of your life. If you want to live a bit higher on the hog and buy expensive stuff, get 15 or 20 or a few more, but do it with the same formula as above.

You don't need 100s of houses. I cringe when I hear about folks that bought 100 or 200 or 1000 houses. Makes NO sense. I keep reminding myself: KEEP IT SIMPLE, STUPID.

And, YES you can do subject too's and seller financing. 90% of mine are that way. And lease options to sell work great.
Just learn how to do it right. And you don't have to do repairs and remodels yourself (unless you like to work for low wages and sweat). My hammer is for cracking open nuts, not remodeling.

Just food for thought....

[David Lutz]

@Steve Smith Congrats that you’ve got a system that works for you and it’s finding success.

One of the challenges of living in California is that buying local doesn’t make sense. The properties are so expensive due to the land that if you need a mortgage you’re going to be cashflow negative, and the laws are so anti-landlord that I’m not sure it would be smart to buy here regardless.

How are you going about finding your seller financed and subject too opportunities?

[Steve Smith]

Quote from @David Lutz:

@Steve Smith Congrats that you’ve got a system that works for you and it’s finding success.

One of the challenges of living in California is that buying local doesn’t make sense. The properties are so expensive due to the land that if you need a mortgage you’re going to be cashflow negative, and the laws are so anti-landlord that I’m not sure it would be smart to buy here regardless.

How are you going about finding your seller financed and subject too opportunities?

David,

But we're not talking about California, but it still works. Have several friends that are doing well out there. Yes, it's pricey, but the basic concepts still work. I won't do California, nor will I live there with the crazy liberal politicians that want to tax and harass you  to death. Life is too precious to spend it there, but a beautiful state to visit, just not going back there for now.

As for seller financing, I have not issue finding it. Just ask for it and it it doesn't work, go on to the next deal. You just don't need that many deals to afford to wait for a good one. I'm finding it all the time.

[Nicholas L.]

@David Lutz

thanks for the honesty and transparency.  as you basically said, i think your experience is way more typical than people like to admit.  this is just the reality of the first few years stabilizing a property - and especially with interest rates higher.  "i'll budget $50-100 a month for capex" new investors say, and then the HVAC and the water heater go, and the roof comes a few years before planned.

my experience has been similar: i have a few properties , including a condo, that just haven't needed much yet, and so they've "cash flowed;" and I have others that have taken an "investment," or whatever you want to call it.  i just did a 6K turnover - some things i had been putting off, some things a tenant damaged.  but i view my properties as VERY long term investments and i take pride in improving them.

so that's what you went through - what are your plans?

[Sastry Srini]

@David Lutz
thanks for sharing and excellent post. Helping me to reflect on my real estate journey and strategize for next stage.

Thanks to others who contributed to this discussion.

My approach would be..

Just like any other investments, we need to reposition ourselves every few years .. so do 1031 with properties appreciated for couple of small SFH with positive cash flow ( either keeping the same leverage or deleveraging if possible).

That way, goal is getting right mix of appreciating properties and income producing properties - thus stabilizing the portfolio .

[Alfred Lee]

  Nn.

[David Lutz]

Hey @Nicholas L. 

I’ve been thinking a lot about your question, regarding my future plans, in context of some of the discussion here. Fundamentally I think I just have a very different approach to thinking about RE than some folks. My view is that I never want to outright own any RE.

Most annual returns look roughly like: Market Value x 2% equity gain (mortgage paydown) x 2% cash flow x 3% appreciation for a total annual return of ~7% vs market value. Those numbers shift depending on the property, but because you tend to trade cash flow for appreciation, but I think it tends to balance. If you own the property outright there’s no equity gain, but your cashflow would go up.

Anyway, on a $100K home that would give you a nominal return of 7%... but the S&P averages a nominal return of 11%. So you’re having to put in all the effort to deal with you “passive” RE to get a smaller return than just sitting back and sipping margaritas. I get that there are tax advantages, diversification benefits, reduced risk, etc., but still. Conversely, if I only have 25% equity and the performance of the house stays the same my nominal return is 4x on 7%, or 28%. Which blows the S&P out of the water,… and part of the increased return is for dealing with the extra complexity and risk of the financing.

I know I just explained the value of leverage, but the point I’m making is that without the leverage life would be a lot simpler and easier to just invest in the stock market, and probably more profitable. So if anyone out there wants a guaranteed return of 7% and wants to do seller financing let me know 😊 I’ll be happy to take care of all the headaches and set you up with a stable income.

When I retire, instead of owning my homes outright I plan to cycle taking cash-out refi on them to re-leverage, live tax free on the loans, and let the tenants pay them down again.

Regarding debt, If it's at the same interest rate and terms (and ignoring different potential tax treatment) all debt is the same. So, except for the mortgage deduction, there's no difference between owing a $50K mortgage vs a personal loan, or a draw on a HELOC, or any other source of cash. If the interest rate and loan terms are the same, so is the monthly payment. Now obviously those don't tend to be the same, but it does mean that when I'm looking to optimize my returns I care about the overall cost of the financing, not the source.

I monitor my overall debt to equity ratio to make sure I don’t end up over leveraged. Most companies are considered in good shape if it’s less than 1.5. RE companies can operate over 2, but they’ve got scale to defray risk. This approach lets me look at all of my debt vs all of my equity across all my obligations. I combine that with my Debt to Income ratio, which tells me how healthy my cashflow is. Between the two I have a very good sense of how comfortably I can take on more debt.

My experience has been that my money works the hardest in $200K to $350K SFH, and I believe that would extend next to $450K to $700K duplex or triplex. In that range I think I get the best general mix of cashflow and some appreciation in C+ to B neighborhoods. That can probably be better expressed as RE that rents for 0.65% to 0.85% of the purchase price, where the lower range only works on newer homes that don't have delayed maintenance.

As you start looking at more expensive homes which rent for a smaller fraction of the purchase price you become dependent on appreciation. You can always cash-out refi to get access to that equity, but the real challenge it creates is to your debt to income ratio. The rent you can get for the property is not going to support pulling out as much equity since the property is skewed toward land/location (appreciation) not usage (cashflow). So some of the strategies others have expressed here have their advantages, but they do slow down your ability to grow. And on the flip side buying properties which cashflow really strongly might look good on paper for supporting a strong debt to income ratio, but you get all the headaches discussed previously around real life performance of houses that are too cheap.

So I don’t really care what interest rates are as a stand alone statement. I care about what kind of payment I would have to make, how that affects my debt to income ratio, and if I can generate enough of a return to make it more worthwhile than paying down debt or investing in the stock market. But given my prior statements,… even if the current interest rates mean that my cashflow is 0%, my leveraged return is still a 2% equity gain and 3% appreciation at x4 for a 15% return. That beats any of my alternatives and will improve if I’m able to refinance to a lower rate in the future.

So as long as my D/E and D/I ratios are healthy I think I should continue to expand my portfolio. When they get weaker I will look to consolidate and pay down debt. Even though some of my debt is variable and that’s weakened my D/I slightly, I’m still in a very good spot. So I want to buy another house, although that’s obviously dependent on finding the right deal. It’s a whole other conversation, but pretty clear that the axiom “you make most of your money when you purchase” is true. Getting a good deal is huge.

In terms of how to go about doing it, I want to keep my current RE at their current really low locked-in rates, since that protects my D/I. Also since my current homes are all in that 0.65 to 0.85 ~ish range, and I know them, I wouldn’t sell any of them to trade up unless it was for a very compelling multi-family opportunity.

Instead I’m starting to look for alternate sources of financing and using my very strong RE portfolio performance to support borrowing in other ways. Even though my current cashflow has been weak (per my original post) it’s pretty clear that I’ve been catching up on delayed maintenance and that the fundamentals are really good. (D/I looks at monthly obligations, it doesn’t care about my cap ex woes since those pass as you catch up on them).

Anyway, that’s what I’m thinking about next. What are all of your thoughts/plans?

[David Lutz]

@Sastry Srini

Per the post I just made, I would question if you need to reposition yourself every few years. If you can't find other sources of capital and the only way you can re-leverage is by selling and buying into something larger, than you're right.  But if you're able to find other sources of capital to make a down payment with, then having some properties with less leverage gives you the ability to buy new properties with more leverage and keep your overall portfolio balanced. And you can avoid the large transactional costs of having to sell your existing properties.

Since you can cashout refi up to ~80% LTV, you're not going to get that much more capital to upscale by selling and doing a 1031. It might still make more sense to do that based on what you're selling and what you're buying. I'm just not sure it's a necessity.

Agree with your comment on the importance of a stable portfolio.

[Becca F.]

@David Lutz

I appreciate the analysis. I'm considering repositioning my portfolio, selling my 3 Indianapolis properties and doing a 1031 exchange to one appreciating property in Nevada, Arizona or Northern California (Sacramento) in the near future. My thought was also fewer cap ex, repairs, etc. NV and AZ have lower property tax rates than Indiana.  The historic Indy appreciation has been 3% (2019 to 2022 being outliers). My property taxes on Indy #1 (Class A owned 10 years) increase with no limit, 17% with the recent assessment but I kept it since it's doubled in value and has an interest rate of 3.875%. Rent to Price Ratio 1.17%. Property tax rate is 2.77%. I've owned the other Indy Class C#1 for a year (RTP 0.88%) and Indy Class C#2 for 4 months (my buyer's remorse purchase, will either rent it out after repairs are done or possibly sell and cut my losses) so I haven't seen a property tax increase yet. 

 Every time I see the interest amounts I'm paying, I cringe even though I can write it off on my taxes. I started paying an extra principal payment on the properties with the highest interest rates (6.75% and 6.99%) but a couple of investors told me to stop doing that. So I'm putting that money into the S&P500 (retirement accounts and brokerage). So far my index funds return is higher than my returns on my real estate but I don't get tax write offs. I feel that I have a lot in net worth real estate and am trying to go more in the direction of liquid assets (HYSA, brokerage accounts).  

My Bay Area properties have significant equity (acquired pre-2013). The SFH is rented out to family members so I'm not getting market rate rent - a couple of people suggested selling to buy a multi-unit which would cash flow more but my property taxes and I would imagine the insurance would be a lot higher.

Like a lot of CA homeowners and investors, I have stagnant equity (just sitting there). I've heard different arguments for paying down mortgages as you get older and retire. Isn't there more risk with continuing to leverage with when someone doesn't have a W2 income when they retire?

[David Lutz]

@Becca F.     First things first, you’re awesome 😊

Also, I’m happy to give you the “guy on the internet who you don’t know and now has advice about your financial future opinion”, but just remember that’s what you’re getting.

It sounds like you’re going through the right mental arithmetic. When you say the rent to price ratio on Indy#1 is 1.17, is that to purchase or current market price? I tie all of my analysis to current market because that’s what determines how it’s performing vs other possible investments. (i.e. a house purchased for $150K, now worth $200K and renting for $1,400 is at 0.7%, which means it’s well positioned to support D/I ratio in the future if I want to do a cash out refi. The fact it was purchased for $150K just effects how quickly I’ll have enough equity to make a cash out refi worth doing.

Your index funds are pre-capital gains (assuming they aren’t tax advantaged) which mean’s you’ll probably owe 15% on returns. That means you only need a return greater than 8.24% to make investing a better option (assuming its post tax money being used to invest or pay down debt). That’s all complicated by investment returns being active and the debt write-off being passive and how that effects your tax picture, etc. But it does make a compelling case for investing, plus that keeps your cash more liquid and gives you more options. So completely agree with the other advice you were given on that.

I had the same issue with stagnant equity in my primary, but you have the regular options of doing a cashout refi or a HELOC to get at it. BTW, if you have 5 or less mortgages you can get a HELOC with Third Fed for 1% below prime, no origination fee, and a $65 annual fee.

Regarding consolidating properties. It all comes down to how the numbers work out and what your goals are. If you’re still trying to grow your portfolio then the rent to market price of the property you buy in 1031 exchange maters a lot, if you’re just looking for stable income and less headache it doesn’t. Regardless, I am a big proponent of buying where property taxes are low, since that’s a variable cost you can control. I have a lot of concerns about CA due to the growing problems with insurance costs (those aren’t going away), tenant rights, rent control, etc. NV and AZ could be good, I know the AZ market has been running pretty hot. But honestly, I don’t know those markets as well. I guess whether you should sell comes down to how well the three properties are performing as a whole and if you could find one or two properties which would better meet your goals and are worth the transactional costs. Maybe just the two class c? Sounds like the first property is treating you pretty well.

Not sure the normal advice of paying down mortgages applies to folks like us that are building RE portfolios. What you're getting at is that when you lose your W2 it significantly worsens your debt to income ratio – which would make getting traditional loans harder. But that doesn't impact DSCR loans if you still want to grow. Anyway, as long as you have enough rent coming in monthly to cover the costs of owning the rental properties I don't think that creates a lot of risk, you would just want to increase the size of your reserves since you won't have the W2 to depend on. Regarding the amount of leverage itself I see that as a function of Debt to Equity. If you have 3 million in property, and are carrying 2 million in debt, plus have 1 million in 401K you'd have 2 million in combined equity and be at a ratio of 1. In that scenario you have enough assets that you could sell part of your portfolio or liquidate 401K to easily have no debt and be left with 2 mill in assets. That wouldn't make me lose any sleep. So the only concern about losing your w2 would be if that was going to make your D/I ratio so bad that you were burning through your 401K faster than you feel comfortable with. With that in mind you probably want to be more conservative as you get toward retirement, but I don't think that means you need to actively pay down your mortgages faster, you could just take your foot off the gas on re-leveraging as quickly.

Love your post though. And congrats on your RE success. Please let me know what you decide to do and how it goes. Hope it works out really well !!!

[Allan C.]

@Becca F. Keep in mind the grass isn’t always greener on the other side. You missed the large AZ and NV run-up, so jumping in now likely won’t give you the same appreciation you think. I know you’ve been figuring out your long-term strategy, but I suggest you do more analysis and thinking before you reposition.

You’ve made good steps to value quality over quantity, but you don’t have clarity on which market and which asset class. I also get the sense that you don’t have a solid team/system you can fully trust. That issue will resurface when you enter a new market, so take that into consideration.

From the posts I’ve read, I suspect your ideal strategy will be anchored on building equity through debt pay-down. Yes appreciation would be nice, and some cash flow too…but it seems you need to simply your investment approach to paying off high loan balances with the least amount of doors.

Are there solid A class properties (with good schools) in Indy you can buy at high price points? I’d give that notion one last thigh before you give up on that market entirely.

Problem with NV is lacking education system state-wide; also not a diverse enough economy IMO. AZ is better, but I would be less bullish on appreciation and focus more on good quality tenants that will make life easier on you - say like Scottsdale.

[Becca F.]

@David Lutz

Thanks! I think you have more confidence in me than I do.  The 1.17 rent to price ratio on Indy #1 is based on the purchase price to current rent. If I use a current market value of $285,000 the ratio is more like 0.57%. I did a cash out refi during the pandemic and used that money to pay for help pay for renovations to the Bay Area. 

Since rent impacts cash flow, my PM advised me that he doesn't raise rents on great tenants so I didn't raise the  rent after the first lease renewal. I've heard this with many self-managed investors, they haven't raised rents in years - I understand that you want keep good tenants but expenses go up.  With Year 2 I raised it 6% (which was $90) largely because of my property tax increases - the tenant was understanding of my increased expenses. I'm in the market rate range - house was built in 2005 so it's good condition, but I don't have upgraded granite countertops,  white cabinets or new LVP flooring.  It has upgraded maple cabinets from that 2005 to 2013 era. So I wouldn't get top rent and it would cost to renovate the kitchen, bathrooms and floors. We are coming up on Year 3 renewal, assuming they renew unless they decide to move out. What are people's thoughts about how much to raise rent on existing tenants? 

[David Lutz]

@Becca F.

*** there’s a math error in a prior post 5% x 4 = 20% return, not 15% :P I was going too fast while the kids were busy. No idea how I did that, or why the update function isn’t working so I can’t correct it.

You comment helped me clarify my thinking. I try to buy houses with an immediate rent to purchase ratio of 0.65%-0.85% range because I feel like that's where my money gets the best mix of appreciation and cashflow, and then I try and keep the current rent to market value in the 0.65%-0.85% range (obviously dependent on what rents are doing) because that supports being able to do cash out refi and still have the house cashflow. If market rent to market value falls below ~0.65% then I'd consider selling to get the equity out, since a cashout refi to a LTV of 80% would probably be cashflow negative. It would depend on what was going on with the rest of my portfolio. But my attitude is specific to wanting the highest possible growth I can get while still maintaining some positive cashflow. I could see people with different goals having radically different opinions.

In line with that statement, I tend to keep my properties slightly below market rent, but keeping pace with increases. I’m not sure that being even farther below market rent would increase my tenant longevity. And there’s a significant cost to falling behind.

Let’s say a hypothetical $200K home has a market rent of $1,500 (0.75% rent to price) and is actually being rented out for $1400 (0.7%). That’s a pretty good incentive for the tenants to stay.

And let’s say that the market home value and market rent both tend to go up at 3% a year. If you freeze the rent, then over 10 years the rent stays at $1,400 instead of going up to $1,881 [$1400 x (1.03^10)]. You’re giving up a 34.4% increase in rent. And at $1,881 you’d still be well below the ten year out market rent of $2,015 [$1500 x (1.03^10)].

Over ten years if the rent is frozen you collect $168K vs $192.5 if you stay below market rent but keep up with annual 3% increases. That’s $24.5K you’re giving up. If you bought the house with $50K down, that would be a missed return of 5% a year (24.5/10/50 = 5%) on your initial investment. And to your point, operating costs are going up that whole time.

I get it that there’s also a cost to tenant turn over. But how much more likely is it that a good tenant stays or leaves in year ten if Market rent is $2,015 and you’re charging $1,881 vs $1,400? Even if you averaged $6K in costs per turn you’d still need to turn over more than 4 times in 10 years to end up worse off.

Plus, with the frozen rent you are way below market and end up cashflow negative if you try an pull money out of the house. Connected to that, your debt to income is worse so borrowing is harder. Selling the house with the tenants in place is more difficult too, because you have leased tenants at well below market and have to discount your sales price slightly to get someone else to deal with it.

With all of that in mind I think you’re a lot better off pacing market rent and not falling too far behind. In your specific scenario I still think it sounds like Indy #1 is performing well, I would just push to increase the rent. If you want to be generous about it you could tell the tenants your operating costs are consistently going up (which is true), share the current comps with the tenant, and ask them what kind of increase they would be comfortable with.

What are peoples’ thoughts on where rent’s should be set or the best way to get them up if you fall behind?

[Jay Hinrichs]

nice post.. 

for me I always tell folks right off the bat its 40 to 50% of your rent on a 1400 and under monthly rent will go to  expenses PM etc etc.. if you do better fine.. but to think that 30% or less is going to work it could happen but probably wont.. and then you have disappointment.

Investors I know use those plug numbers every time.. it works. no need to go into the Tulles on numbers its not like your going to live on cash flow of a small portfolio of fully levered rentals.

the money is made in mortgage paydown and appreciation cash flow just allows that to happen.

[Yiyi Zhang]

As for seller financing, I have not issue finding it. Just ask for it and it it doesn't work, go on to the next deal. You just don't need that many deals to afford to wait for a good one. I'm finding it all the time.

 Steve, thanks for the insights and your strategy about GOOD quality house & seller financing, just want to make sure I understand your strategy correctly:

1. When you say "GOOD quality house ", what is your criteria exactly? 

2. For seller financing deals, when you ask for it, do you mean on market ones or through networking with other investors? 

Thanks in advance! 

[Becca F.]

@Allan C.

Thanks for your perspective. I don't plan to buy anymore property for now unless I do a 1031 exchange or sell off the Indy Class C homes (probably very little capital gains since I haven't owned them long) and definitely not in the Indy area even if it's Class A. I've been investing in more liquid types of investments: index funds, stocks and looking into Master Limited Partnerships and other strategies. I don't want to take on more mortgages at this point.

My thoughts were that if it's causing my stress level to go up, it's not a good ROI. It's amazing how much more relaxed I am now after spending a year constantly looking at Indy deals. I also think my kids wouldn't want to deal with those Indy properties in the future.

[Becca F.]

@David Lutz

For that Indy Class A house, I did do a $50,000 cash out refinance (to help pay for the Bay Area house renovations) in 2021 so my loan amount is bigger than the original loan amount resulting in the 0.57% rent to price ratio. I guess if I had just done a rate and term refinance then that ratio would be higher? It appreciated, I pulled out some equity which enabled me to add value to the Bay Area house to rent it out - it wasn't safe to rent out with code violations before the renovation. 

That's a great point about selling a house with tenants who have way below market rent or trying to pull money out of it and the debt to income ratios being off.  I'll start pulling rental comps