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97
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310
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David Lutz
  • Granada Hills, CA
310
Votes |
97
Posts

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

David Lutz
  • Granada Hills, CA
Posted

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.

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