What if I don't account for expenses?

Question

Hello BP, I just love asking questions and getting people's insight. So I have a friend who I try to explain some real estate things and he had a question. Being on Bigger Pockets, I've learned that you put money away for vacancies, capital, expenses and things like that. I try to tell my friend that after I've put all the cash away for expenses and mortgage, and try to get a property that cash flows $100 a unit which I think is a good number. Also, aside from the main question, does $100 a unit sound like a good number to shoot for when analyzing a deal? But his mind set is he wants to just keep all the rent and put it away in his pocket WITHOUT putting any money away for expenses and just to pay for them when they arise. He doesn't think there is a difference. Can someone help me explain the necessity to put away money every month instead of pocketing the entire rent minus the mortgage if there is one? To me, I think it's important to account for these things. He jus thinks it's better to put away $400 let's say for arguments sake, instead of $100 cashflow. He said he will have a large enough nest egg to pay for anything that arises such as cap ex and utilities during a vacancies and such things but otherwise, keeping all the money.

Bill Gulley · Answer

(A friend, LOL)

How you use your income has nothing to do with "accounting" for future expenses, except you better have cash when you need it. Lenders will "account" for expected expenses to determine your cash flow, but that has no bearing on where or how you save your money......or spend it.

In reality it's about the risk you are willing to take, spend it or save it. On a newer home, one in very good condition you can slack off the maintenance, but you better have the insurance deductible and mortgage payments in hand and setting aside your tax obligation. The risks of your hot water heater going out aren't that great, an newer home should be in good condition; an older home carries a much higher risk of unknown emergency expenses.

Mom and pop landlords fix things when they break, professionals use a maintenance schedule taking care of items before they break. Annual inspections will clue you in as to the expected expenses that are on your way in the future, then you can have a better idea of how to budget.

Initially, expect the unexpected, you might use a credit card to cover an expense or dip into savings, you need to be in a position to cover expenses, how you "account" for them is a "budget" and "use of funds" matter. :)

Marcia Maynard · Answer

Our income and expenses from our residential real estate portfolio are accounted for in the financial books of our business. We maintain significant reserves to be able to handle the unexpected. We maintain good business practices to mitigate risk and maintain sufficient insurance, both to cover the property and our liability. We budget for capital expenses and operating costs.

How you take cash out of your real estate investment business depends on the type of business entity you have and your goals.

Here are some examples from our experience:

Sole Proprietor: The only money that goes into our personal pocket is the money we take out as an owner's draw. When we take an owner's draw, it reduces our equity in the business. If the business needs more cash, we can put more money into the business and that increases our equity.

Partnerships and multi-member LLCs: The only money that goes into our personal pocket is the money we receive as a guaranteed payment for services rendered (deductible business expense) or as equity out (return of a member's capital) or as an owner's share of the profit (passive income). An LLC's tax classification can be changed to accommodate payment of a salary or wages to an owner for their work in the business too. It's complicated... consult with a tax professional.

Hugh Ayles · Answer

It's a business.  You need to keep cash set aside for your business.  You will be able to sleep better if you are capitalized.

What if you misjudge your spending habits and a big expense comes up?  If you need to pocket the money rather than set it aside for future expenses, you are undercapitalized and should not have rental property until you can set aside cash.

Good businesses do not run by depleting the cash.

Corwin Hernandez · Answer

Lol, I promise, it's my friend and boss. Explaining real estate to him is almost impossible. He doesn't understand the concepts. I appreciate  your expertise on the subject

What if I don't account for expenses?

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