When did your part time rental business depend on rental income?

Question

This question is directed mostly toward those of you who have a "day job" and real estate is only supplemental to your income and/or retirement fund.

I will likely be buying a third property (for a total of two rentals and one primary residence) by the end of this year. At that point, I will be a the absolute theshhold of debt that I can manage with my paycheck if (in theory) my two rentals went vacant for a prolonged period of time. Any rentals I acquire after my third property will absolutely have to perform to pay for itself. So, future property number 4 will be a on a different psychological level in regards to risk.

So, I was just wondering, have any of you come up to this threshold I have described? Was it even something you considered?  Did it change your approach to subsequent properties? Did it cause you to have larger cash reserves? Did you decide to form an LLC?

Really just looking for food for thought for an investor approaching this point in his/her portfolio life.

Larry K. · Answer

Brian Hoyt, what I have to say is akin to what Jeff said.

I think it is probably best to have the mindset that each property stand as it's own business.  That being said it is good for you to think conservatively about how you would "back this property up" should there be problems.  But I'd look to...
1) having at least 20% in the property
2) 50% rule (so you are realistic with your expectations)
3) cash reserves

I think the amount of properties you'll own would become limited by the chunks of money required for down payments and renovation costs, not so much by lack of cash-flow.

Watson Smith · Answer

I do real estate on the side.  I have a full time job but still manage my (7) properties.  I have near 6 months reserves for all of them.  My properties are also distributed around my city and not all in one spot.  They all pay for themselves very easily and I try to net $500 from each per month. I also don't have a dime of my money in any of the properties... I rather use the banks ;)

You need to form a company to put your properties in. LLC is okay but I prefer Incorporated.  You reduce your liability by doing this.  You could form a company for each property you have so in case something happened they couldn't come after your other rentals as well.  Regardless you need to get them out of your name.  Another good idea is to carry an umbrella policy up to 2 million or so.  Its like $250 a year and well worth it.  People will sue for anything these days.

Steve L. · Answer

I think the bigger your business comes the less you worry about this kind of stuff.  That would be like a McDonald's franchisee saying they're not going to build another restaurant just in case they have 3 freak months with revenue plummeting.

Before any business expands (a part time or full time), they need to have a criteria (for McDonalds: cash reserves, traffic count, area income, local competition, etc).  Many people here have already mentioned their formulas.

You need to change your mindset to grow.  If you're buying right, have sufficient reserves and have a disaster plan (maybe liquidating a property, negotiate a temporary assistance plan with lender, personal income) you should never have to depend on your job income to support your real estate business (except in the event of expansion).

Growing is such an enjoyable part of this business.  I ran such a tight ship in the hyper growth mode.  Unfortunately it's a lot less feasible for to have my hands on everything nowadays.

Dale Osborn · Answer

One of the criteria you might want to lock in is for each property you buy to be self sufficient. Each one should pay for all expenses and have cash flow left over each month. By doing this you can supplement wherever you want with funds from the day job.

Harry M. · Answer

Hey Brian,
I'm at almost exactly the same stage in the game as you. We've got two properties, and are expecting to be ready for #3 by the beginning of next year. In the price range we're buying, we can get up to about 6 and handle PITI from my day job (barely) with 100% vacancy. From there on out, the risk gradually increases. At property #6, we can withstand 100% vacancy, by #12, only 50%, by 18, only 33% and so on.
We plan to mitigate that by building appropriate reserves, and just as important only picking up properties that produce enough income to rebuild those reserves should they be called upon.

The reserves are something we are working on now, in parallel to saving for more properties. I believe that even when you are in a position to bail out your business with your day job, that you should still run your business as if you didn't have that ability. Hence building reserves now when they are technically less needed rather than waiting until later. We have a baseline amount that we will not allow our bank account to fall below. That is our family cash emergency fund plus reserves for properties. Each time we add a property, we will add 6 months PITI for the new property to the baseline.

Jeff S. · Answer

Michael B. I disagree that properties are unlikely to become vacant at the same time. My bigger problems with vacancies resulted from outside economic forces that affected all properties at the same time. First time was easy financing where tenants moved out to buy homes and the second time was the tech bubble bursting when I was investing in the tech corridor.

Hans Langsholt · Answer

Agree on that you need to use a other strategy in the next house.  Have you thought off investing in others projects, with returns on invested amount? This way you go outside the repairs and other hassles. If you do all  work yourself, it must be timeconsuming ?

Michael B. · Answer

Here's how I approach the issue:  How much reserves are needed for the 'neediest' property? How much will that property cost you if it goes vacant? Then I figure 6 months of carrying cost for that property and put away that cash. That allows me to survive if that property goes vacant or has repairs. So, lets say the most expensive property needs $8,000 to keep you solvent for 6 months.

Then I use the square root rule. The idea is that it's unlikely that both properties will fall vacant at once. So my reserves for 2 properties will be SQRT(2) * $8,000 or $11,300. For 3 properties my reserves would be SQRT(3) * $8,000 or about $13,800. And once I have this in place I'm ready to start saving for the next.

The issue comes if you ever have more than 1 empty. If that happens you have to act quickly. Maybe lessen tenant screening, maybe lower rent to get one filled. But having reserves allows you to react to the challenge. But keeping the reserves lower than 2X for 2 houses allows you to start saving for the next soon.

Will Browm · Answer

I have a personal house with a slightly underwater mortgage and two paid for homes in a C level area.  Both rented out yesterday!  My plan is to not depend on any income on my rentals.  I do not have the credit nor desire to borrow so my next house(s) will be cash buys.  Conceptually, I would want to hit 10 or more homes before I start collecting any income.

Brian, I too have spent most nights and every weekend for the past 8 weeks doing my part in the rehabs.  I am beat!  I hope to sub out more work in the future.  We will see.

James H. · Answer

John Chapman,

Thank you for that great feedback.

I agree about the cash reserves and each unit supporting itsef regardless of my seperate income. My only rental property thus far is free and clear and my next will have a PITI of 450 and rent will be 750. It works out to be about 115/month profit after 50 percent rule, but I believe it will initially be much more profitable. It is in very good condition and I will self manage, -  so should not be a problem. Any future rentals I hope to operate on a similar model.

I also agree that the acquisition and rehab are the number one time eaters. I can see the rehab that I did during nights and weekends over two months taking more time than regular management over the course of three years.

When did your part time rental business depend on rental income?

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