How to Handle Cash Flow After Reserves Are Met

Question

Hello Everyone!My question is pretty start forward. I am currently getting our former primary residence ready to become our first rental and am working through some strategies. I also subscribe to the 50% rule for expense and cash flow planning and am building up the emergency reserves (6-9 months, still deciding) as we move forward.Here’s the question. Once my reserve coffers are filled, what should I do with the cash flow? Every month I will set aside 10% each for maintenance, CAPEX, vacancy, property management, and taxes/insurance (50% total). I realize those figures may be high for some but I like to be conservative. However, once I have a large enough cushion for emergencies, it seems foolish to continue to build an emergency fund due to opportunity cost of not utilizing that positive cash flow elsewhere. How does everyone like to handle this situation? I’m thinking of setting up a separate bank account for “future investments” and allowing the money to pile up in there until I redeploy it into another property. Then, rinse and repeat moving forward.Thank you in advance for any thoughts on the situation! Happy to answer any questions as well.- Steve

Jaysen Medhurst · Answer

There are a few different ways to come at this, @Steven Lewis. Before I get to that, are you darn sure that your house will make a good rental? You make me very nervous when you write, "I subscribe tot he 50% rule for expense and cash flow planning." That is a terrible, terrible way to come at investing. You must do a complete rental analysis based on actual numbers, not simple "rules." If you post your numbers here, I'd be happy to take a look. Or PM me, if you're more comfortable.As far as reserves, the key is to have access to cash should you need it. Some investors just keep a growing account of reserves. Basically, sitting on the cash.Some open a Line of Credit that they can draw on, if necessary, and then pay that off with future cash flow. Another approach is to keep a relatively small amount of cash on hand. Investing the balance in a mix of liquid securities that can be tapped if needed and offset bonds/CoDs to mitigate risk. Municipal bonds can be a great option here, since they're tax advantaged.

Jaysen Medhurst · Answer

@Steven Lewis, as far as your reserve fund: Sitting on the cash is the least risky and obviously provides no return. Even in a "high-yield" savings account, inflation is siphoning your money away each year. Just keep that in mind.Regarding the property, I'm going to challenge you regarding whether holding it as a rental makes good financial sense. My estimate is that you might cash flow ~$110/month after all expenses (see my breakdown below). Based on an estimated $100k of equity, your Return on Equity (ROE) is only 1.3%. That's pretty terrible. Your money isn't working nearly hard enough for you.$1800: GSR - giving you the benefit of the doubt($90): Vacancy - 5%($270): Repairs and CapEx - 15% combined($180): Management - 10%; always account for Management, even if self-managing at first($125): Insurance - My estimate($125): Property Taxes - My estimate($900): Debt Service - I figured $200k original mortgage, 30-year @ 3.5%=$110/month cash flow

Antonio Cucciniello · Answer

I couldn't agree more with what @Jaysen Medhurst said. The full analysis is needed if you are going to make something a rental, 50% rule is good for a quick check, but you need a deeper look to get accurate.

Son D. · Answer

@Steven Lewis what a good problem to have. I'd put the extra cashflow into paying off any debt that I have, which may or may not include the mortgage on that property (up to you). Otherwise you can save it up for the next property or whatever investment you're interested in.

Steven Lewis · Answer

Thanks for the reply! Our property will indeed make a good rental. If we were purchasing it today, then it would not but we’ve built some equity into it so it makes financial sense to hold for a few years at least. The numbers are as follows:Current estimated value: $240-250kCurrent mortgage amount: $160kCurrent rent estimate: $1700-1800 monthlyMy 50% rule of thumb was simply my way of easing concerns about allocating for expenses while bolstering our reserves. I have a very good handle on the costs associated with our prior home becoming a rental and the numbers work. We’re going to let the equity build then either sell, or do a cash-out refinance at an LTV ratio that makes sense for the gross rents.Our whole approach is to have a solid reserve first, then siphon off positive cash flow to continue building our down payment on future properties. I think we beat like your first option on simply sitting on a large, highly-liquid fund for emergencies.Does that sound like a logical approach?