My thoughts (and confusion) on capital expenditures

[Lucas Mills]

I've posted about this before but I don't feel that a reasonable and sufficient conclusion was ever reached, at least not on my part.

I have not yet done any deals. I currently work 8-5, have about 30k in the bank, and want to transition from my w2 job to real estate.

Ultimately, I want to be a very passive investor wherein I have the choice to grow my investments, or take a couple months off to do... whatever. I can live comfortably on 3k/month which translates into 20 properties cash flowing at $150/month, or 15 properties cash flowing at $200/month.

The confusion for me lies here - in my mind, when I purchase a property, it should effectively be able to sustain itself. I don't want to have to worry about contributing a single cent to the property in order to cover an expense. Of course, this may be necessary in the short-term, due to the fact that the cap ex reserves for that property won't have accumulated significantly for a few years, but that's ok.

However, over time, I want the income of the property to be greater than the expenses. Otherwise, what's the point? If my properties are continually draining their own reserves over a long period of time, then, eventually, I will end up with no cash reserves and will have to think about working a w2 once again just to pay for expenses and keep the properties afloat.

At least, potentially, until the time comes when the properties are paid off (~25 years into the future) and I receive an instant boost in cash flow, around $200-$300 per property. But, I don't want to wait 25 years until the properties are paid off to feel like I can work as little or as much as I like. I also don't want to operate under the assumption that I will be able to increase rent over the coming years to accommodate lack of cash flow in the here and now.

To that end, I have been trying to determine exactly how much of the cash flow needs to be dedicated to capital expenditures in order to ensure that my cash reserves do not run out, provided that I have no other income streams than my rental properties. I have read this article which breaks it down in a very easy-to-understand manner, and suggests that an amount of $182.75 be allotted each month to cap ex reserves to cover replacement of all of the discussed items.

Now, if you ask any investor in my area how much they dedicate to cap ex I can absolutely guarantee you that it is not this much. I think somewhere around $50 - $100 is probably more in line with what they are allotting for cap ex on a monthly basis. But, they can do this because they have separate businesses and other income streams. If a roof goes out, no big deal - just wholesale a house to pay for it. The thing is, I don't want to have to worry about doing something like this to cover an expense.

So, if that's the case, then do I need to more closely align myself and my criteria with what that article suggests, and make sure that I do not skimp on the cap ex?

Of course, there are more considerations. What if, for example, we take away everything from that list with a life span greater than 25 years (when the mortgage would be paid off)? In that case, the monthly cap ex allotment would be $141. Not a far cry from $182, but it improves cash flow a bit. The idea here being, that these things would likely not need to be addressed until after the mortgage is paid off, at which point cash flow will increase somewhat dramatically. But is this a safe way to think?

All in all, what I want is to be able to work as little as I want without having to worry about paying for expenses that my properties will incur. So, I guess what I'm wanting to know is how should I reasonably prepare for this without simultaneously being too conservative and passing on deals because I don't fully understand how this will play out over the long term?

[JD Martin]

My thoughts, in no particular order or without even a hint of coherence ;)

1. When you are talking about leveraged properties funding your life - i.e., you don't want to go to work, just live off the rental income - you are going to need *a lot* of properties. It would be unreasonable to believe you're going to quit your job off of 15 properties leveraged @80% bringing in $200/door. Income generated from "the business" needs to pay your salary AND the expenses of the business. In the beginning, when everything is off of borrowed money, that's going to be difficult. That's why you hear guys with 100 properties bringing in $100/door that still have day jobs. 

2. The article was only an example. Some things on that list would be low in my opinion (appliances, for example) and others would be high (paint, or floors). You have to create that cost estimate based on *your* property. On our houses, we include the costs of rehabbing the property (such that virtually everything on that list is in year Zero) into our total basis of the house, so that we are making offers & signing on the bottom line based on the value of the house as it is right now, needing these improvements. If you buy without including those costs, that's where you get killed.

3. Over time, the tenant pay-down on the units creates some equity that can cover some capital expenditures. In the right situation, the principle pay-down may equal the cap ex, meaning that those repairs are always covered by the tenant (i.e. you can refinance out the balance). 

4. I'm not sure how old you are but there's no magic bullet. I hear you say you don't want to wait 25 years before you don't have to go to work. In that case, you're going to have to do some serious ***-busting right now to gather up enough assets to cover you, the business, and contingencies which will include roofs, vacancies, bad tenants, and so on.