Assets and Liabilities

[Bryan P.]

Had a thought/question about assets/liabilities...

[Jon Holdman]

First, the 50% rule includes vacancy. So, if you're taking out another 8% on top of that, you're double dipping on vacancy. OTOH, the 50% rule does not include any debt service. So, cash flow is:

cash flow = rent - (50% * rent) - P&I payment

Second, you mixing two concepts together in an unusual way. I think you're just using the terms incorrectly.

When analyzing a business you look at two key financial statements: income statement and balance sheet.

The income statement deals with income and expenses. How much are you taking in? How much is going ont. The difference is cash flow. The formula above is a very brief estimate of an income statement from a rental. To get to profit, you have to put in other factors such as taxes and changes in inventory.

The balance sheet deals with assets and liabilities. The bottom line is net worth. Assets increase your net worth, liabilities decrease it. If the bottom line is positive (assets larger than liabilities), you're in the black. Negative, more liabilities than assets, and you're in the red or underwater.

To get an overall picture, you combine the two. Over time, positive cash flow will improve your net worth. So, while being cash flow positive and having a positive net worth is the best, being cash flow positive can dig you out of a negative net worth, given time. Being cash flow negative will eventually lead you to bankruptcy. But having a positive net worth buffer can give you time to deal with a temporary negative cash flow situation.

Now, to go back to what you wrote. You say the payment on your residence is an expense of $475 and of that $60 goes to principal reduction. The $475 expense is relevant to your income statement. The $60 in principle is relevant to your balance sheet. On your balance sheet, you would show an asset (the house) and a liability (the loan on the house). The $60 in principle each month goes to reduce the amount of the loan and so improves your net worth. But as far as cash flow, that's irrelevant. The saying is "you can't eat equity". So, as far as your income statement, you have to put the entire $475 on the expenses side.

Then you say the rentals produce $380 in equity each month. You go on to talk about 50% rule, so I think you actually mean $380 in positive cash flow. Equity would be the principal paydown portion of your payments on the rentals, like the $60 you mention on your residence.

When paying of a mortgage, you can think of the principal part of the payment as a form of savings. You're taking money out of your cash flow stream and using it to improve your net worth.

So, assuming you mean $380 in positive cash flow (this should be after taxes, by the way, since the $475 is paid with after tax dollars) and you have a $475 expense, you have negative cash flow of $95 a month. If you bought another property that produced similar cash flow, your total cash flow from the three would be $570. So, vs. the $475 expense, you would be cash flow positive by $95 a month.

I'm missing how that translates into needing to buy one house a year. But, yes, if you can continue to buy one house a year, and they each produce $190 a month in true cash flow, then you will end up with a nice income. If you don't need that $190 a month in income for day to day expenses, you can snowball your property acquisition. After a while, the properties throw of quite a bit of cash you can us to buy more properties.

I'm assuming the $190 per house in positive cash flow is calculated as above (cash flow = rent - (50% * rent) - P&I payment) not some other way. And, keep in mind that any particular house in any particular year will vary quite a bit from this estimate. If you're in this for the long term, some year the house will need a roof or furnace or have serious tenant damage or some other big ticket expense. Those are in the 50%, but they come at irregular intervales. OTOH, if you have a portfolio of 20 houses, you can pretty much count on several of these big ticket items each year.

As far as assets, liabilities and your net worth (your balance sheet), each property you buy adds an asset. If you're getting a loan, that also adds a liability. Assuming you're putting in some cash for a down payment, buying a house probably doesn't change your bottom line net worth. That is, before you buy you have an asset of some cash worth $10,000. You buy a $50,000 house with the $10,000 as a down payment. Now you have a $50K asset and a $40K liability. So your bottom like remains the same. Over time, the loans are paid down and eventually off. As you do that, your net worth improves. But that doesn't directly affect your cash flow.

You can make it affect your cash flow. By taking a loan, for example. That does the reverse of buying a house. If, at some point, you've paid off a house, and you take out a $40K loan against it, you're created a $40K liability (the loan) and a $40K asset (the cash). Your net worth is unchanged. Now, if you turn around and spend the cash, though, you're decreasing your net worth. OTOH, if you have a tenant who can pay down that loan, then they're offsetting your spending.

You may think I'm being pedantic about how you're using "equity" and "liability". You're right. These terms have specific meanings. And are combined in specific ways to evaluate your financial position.