What are you doing with rental income?

[Account Closed]

Hi Readers,

Question for anyone who is currently receiving rental income - what are you doing with that money?

I have a multi-family property in NYC where I am cash flowing anywhere from $300-900 a month depending on the season (heating bill during New York winters are no joke!). I’ve been putting away all income thus far in a high yield savings account to cover any repairs, etc. I have a ~$10k cushion and now thinking about how I can use that cash flow in a more meaningful way.

Know some people use the money to pay off the mortgage quicker. While it would be great to be debt free in under 30 years, I don’t think there is an absolute need to do this. My tenants are paying off my mortgage and think there are other higher returning opportunities.

Should I be reinvesting my cash flow into my taxable investment portfolio to help support my goal of early retirement? Are others using that money to save for more rental properties? Should I continue to build up a larger cushion for any surprise house expenses? Welcome any and all thoughts!

[Costin I.]

@Account Closed - first I would make sure the cash flow is calculated correctly and taking in consideration all the associated expenses. I'll post at the end the list of expenses you should consider in that calculation.

Second, build your reserves. I try to save 10% of the rent each month until I have at least one month rent of the property saved. 

One property is a rental. 10 properties is a business. When you go from one property to many, you need to start thinking of this as a business, not a rental. Now you need to think about reserves for your business, your is operating capital. When your business gets larger and you have more properties, you might need one month rent per property. The reason is that you don’t need one month rent for 10 of the 20 properties saved since you will not pay all that at one time. Save 10% of rents until you have enough money to handle most major repairs. You are not going to have to replace all 20 furnaces at once so you don’t need to have all that money saved.

If you want to be precise, maintain a spreadsheet with all the mechanicals, appliances and big items in the properties, with the associated costs and lifetime expectancy. That way you'll know you how much you should save monthly/annually and what reserves you should have for the current year per property and total.

1. You have to accumulate enough for taxes every year
2. You need enough to cover expected regular "surprises"
3. You need enough to cover infrequent major items, like roofs and windows
4. You should keep a vacancy fund (I set aside 5%) even if you had none for years - You should have enough reserves to cover at least one month of vacancy. Vacancy will depend on the location, tenant mix and market but a safe factor for a smaller property would be 8%. Larger properties 5-7%.
The first one is easy, the third one is accumulated over many years, and the second one is learned by watching your expenses over a few years.

There's much more to consider. The reserve is your safety net. If you have a strong financial foundation, you need less of a safety net than someone with a shaky foundation. Things to consider:
- Income. Are you living paycheck to paycheck or do you have a lot of discretionary income? A 55-year-old heart surgeon can probably absorb a $20,000 roof without much trouble while a school teacher may have to borrow the funds at high interest.
- Number of units. Someone with 50 cash-flowing rentals can absorb a $20,000 roof repair more readily than someone with one rental cash-flowing $100.
- Condition of the investment. Cash Reserves really depends on the age and condition of the building and systems. If the property was renovated top-to-bottom four years ago, you would be safe with a small reserve whereas an old home may need a new roof and boiler and water heater and windows in the next 5 years.
That's just a few considerations. 

Run a "multi-level stress test" on your portfolio - what happens if one or more properties get vacant at the same, you get hit with an HVAC repair at the same time with a roof replacement, the property tax increase without the ability to increase the rent, a combination of the above. See how and for how long your reserves will float during different levels of stress, according with your risk tolerance threshold.

Then, once you have the reserves, you can look into what to do with the overflow. You can accelerate the loans or look for other investments. OR do both. OR pay down the mortgages and get a portfolio based line of credit, secured by the equity in the rentals - that way you can reduce the risk, lower the loans and at the same time be able to pull that money out repeatedly and put it to work for you with BRRRR.

To figure out what is better to do (pay down (which) loan or invest) look into Garrett Gunderson's “Cash Flow Index” (CFI) of a loan. When you take the loan balance remaining and you divide it by the monthly payment, you come up with a CFI number. If that number is less than 50, it’s a less than efficient loan and one you should think about paying off quickly to improve cash flow. If the number is between 50-100, it’s an okay loan, but probably next on the list to consider paying off if you don’t have any loans below 50 CFI. Any loan over 100 CFI is well structured, and there isn’t much rush to pay it off.
So, for example here, a car loan for $15,000 divided by the monthly payment of $650 gives us a CFI number around 23. This is not an efficient loan (from a cash flow perspective) and should be paid off sooner than later. For a mortgage of $75,000 divided by the monthly payment of $800, we get a CFI number around 94. This is an efficient loan, and of the two, the last one that should be considered for payoff. After focusing to pay off the car, the extra $650/month cash flow can then be applied that towards the mortgage.

Good luck!

Capital Expenses: Just make sure you don't confuse Net Operating Income (which is Gross Rent minus Operating Expenses) with Net Annual Income (which is the annual cash flow and is the NOI minus mortgage expenses and vacancy). And make sure to account for the following expenses:

1) Mortgage
2) Mortgage insurance (PMI or MIP) or FHA Risk base
3) Property Taxes
4) City Taxes
5) HOA (Home Owner's Association) Dues and Fees and Assessments
6) Insurance
a) Property Hazard Insurance (0.3-0.45%)
b) Flood Insurance
c) Earthquake Insurance
d) Umbrella Insurance
7) Vacancy Rate (usually 8% - the equivalent to one month a year, or 5-6% if multifamily and/or if experienced, if not use 8%)
8) Utilities (you’ll have these if your tenant is not covering them and/or during vacancy)
a) Water § Sewer § Garbage
b) Electricity
c) Natural Gas
d) Propane
9) General Maintenance (usually 5%)
a) Upkeep § Landscaping
b) Snow removal
c) Repairs
d) New Appliances
e) Make ready
10) Capital Expenditures (usually 5%, higher is the property is old and obsolete, less if fully rehabbed and all mechanicals and roof are new)
11) Property Management (8%, even if you self manage, your time still has value and there might be a time when you'll want to be completely hands off or you'll not be able to do it, vacation, retirement, etc.), including...
a) Office Supplies (e.g. stamps, envelopes)
b) Software
c) Gas/Mileage
d) Advertising + Payroll
e) Concessions
f) Lease loss
g) Lease renewal fees
12) Lawyer/Law office/Legal fees
13) Accounting/Bookkeeping/CPA/Tax preparer/Tax advisor