Help me in understanding estimating financial goals. Am I understanding it correctly?

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Help me in understanding estimating financial goals. Am I understanding it correctly?

Emily B.
Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes

I’m trying to set some financial goals for myself and I keep hearing how I should be specific so that I know exactly what I’m working towards. With that, I want to make sure I’m understanding some of the calculations when trying to figure out how many properties I may need to get to said goal, so I was hoping someone could check my understanding here. I want to get into long-term buy and holds, single family to start but possibly MF as I get more comfortable with what I'm doing.

Here’s my practice example:

Say I have a property that I’ve bought and worked on with my after-tax dollars from my job so that, essentially, I own it without a mortgage payment. And then I rent it for $1,000/mo. Using that, am I correct in planning that I should take 50% of that and put it into a reserve for expenses ($500), pay taxes and insurance ($250), which then leaves me with $250 in positive cash-flow? Which then, essentially, means $3,000 cash-flow for the year before taxation ($250x12).

Again, I’m trying to learn more about the financial planning aspect, and I know this is a fairly simple example. I just want to make sure I’m at least on the right track.

If I am, let’s take it another step. What percentage is that yearly cash-flow taxed at? In other words, how can I estimate what I will actually net from that? I hear all the time that passive income is subject to a lower taxation than what I make at my job (earned income), but how does one estimate what percentage that is?

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Chris Simmons
Real Estate Agent · Owasso, OK · Member since 2014 · 517 posts · 400 votes
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The 50% rule is a general guide and is both market and property specific.  It is generally a good starting point but once you get into the business, your historical costs will likely differ.  

My recommendation is to use your historical expense ratio or 50%, whichever is higher.  If you buy an old turd of a property that has not been recently overhauled and updated....plumbing, electric, roof etc...not just paint and carpet....then you could easily exceed 50%.  On the other hand, buy into relatively new construction or properly overhauled homes and the expenses can be less.  If your numbers come out to 60% expense ration, then stick with that for future properties you buy in similar condition.  If your expense ration comes out to 35%, until you have a long history with multiple properties to show this isn't a lucky streak, i would stick with 50% and just hope you don't use it all.

Now, for your question....property taxes and insurance is part of the 50%.  So with your scenario of a house that rents for $1,000/month, you should expect to AVERAGE 50% or $500/month for operating expenses and general upkeep.  This includes property management, insurance, taxes, general upkeep and repairs...occasional plumber visit etc.  This is an average so at the end of the year when you have set aside $6000 for expenses and only paid $1200 in taxes and $900 in insurance and somehow managed to avoid any maintenance calls or property management fees because you self manage, don't just go spend that left over expense fund just yet.  Your $3,000 sewer line replacement, $5,000 roof or $8,000 eviction & home repair bill might be right around the corner so keep that money set aside and hope the big expenses like that are far far away.  

The other 50% that is left should be available to service debt...not needed in your scenario or to spend if you want.  Personal opinion again....i would sock everything away into a large expense fund and once I had $10,000 or so...plenty for most major scenarios...then you can start spending money for whatever you want....perhaps another house.

Regarding passive income tax....at this point in the game, this is all pass through income to you and just adds on to whatever you make elsewhere.  This does not count as capital gains or dividend payouts like big investors get.  You will need to talk to a tax person about this to understand your specifics, but learn about the tax breaks.  The biggest one is depreciation.  You basically get to write off the purchase of your property over 27.5 years.  So if your house cost $100,000....Cost...not worth...and the land is worth $10,000, you get to depreciate $90,000 over 27.5 years for a paper expense that you really don't pay of $3272.72/year.  So basically, your $12,000 in income minus expenses paid...not budgeted...gets you your taxable income that just gets added to all of your other earned income.  $12,000 income minus $1200 in taxes, minus $900 insurance, minus $3273 depreciation, minus property management if you paid for that and then minus your general business expense like your marketing expenses if any, your mileage and whatever other expenses you have in operation the business and you get your taxable income.  

Hope this helps.

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  • Chris Simmons
    Real Estate Agent · Owasso, OK · Member since 2014 · 517 posts · 400 votes
    11y

    The 50% rule is a general guide and is both market and property specific.  It is generally a good starting point but once you get into the business, your historical costs will likely differ.  

    My recommendation is to use your historical expense ratio or 50%, whichever is higher.  If you buy an old turd of a property that has not been recently overhauled and updated....plumbing, electric, roof etc...not just paint and carpet....then you could easily exceed 50%.  On the other hand, buy into relatively new construction or properly overhauled homes and the expenses can be less.  If your numbers come out to 60% expense ration, then stick with that for future properties you buy in similar condition.  If your expense ration comes out to 35%, until you have a long history with multiple properties to show this isn't a lucky streak, i would stick with 50% and just hope you don't use it all.

    Now, for your question....property taxes and insurance is part of the 50%.  So with your scenario of a house that rents for $1,000/month, you should expect to AVERAGE 50% or $500/month for operating expenses and general upkeep.  This includes property management, insurance, taxes, general upkeep and repairs...occasional plumber visit etc.  This is an average so at the end of the year when you have set aside $6000 for expenses and only paid $1200 in taxes and $900 in insurance and somehow managed to avoid any maintenance calls or property management fees because you self manage, don't just go spend that left over expense fund just yet.  Your $3,000 sewer line replacement, $5,000 roof or $8,000 eviction & home repair bill might be right around the corner so keep that money set aside and hope the big expenses like that are far far away.  

    The other 50% that is left should be available to service debt...not needed in your scenario or to spend if you want.  Personal opinion again....i would sock everything away into a large expense fund and once I had $10,000 or so...plenty for most major scenarios...then you can start spending money for whatever you want....perhaps another house.

    Regarding passive income tax....at this point in the game, this is all pass through income to you and just adds on to whatever you make elsewhere.  This does not count as capital gains or dividend payouts like big investors get.  You will need to talk to a tax person about this to understand your specifics, but learn about the tax breaks.  The biggest one is depreciation.  You basically get to write off the purchase of your property over 27.5 years.  So if your house cost $100,000....Cost...not worth...and the land is worth $10,000, you get to depreciate $90,000 over 27.5 years for a paper expense that you really don't pay of $3272.72/year.  So basically, your $12,000 in income minus expenses paid...not budgeted...gets you your taxable income that just gets added to all of your other earned income.  $12,000 income minus $1200 in taxes, minus $900 insurance, minus $3273 depreciation, minus property management if you paid for that and then minus your general business expense like your marketing expenses if any, your mileage and whatever other expenses you have in operation the business and you get your taxable income.  

    Hope this helps.

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    Thanks @Chris Simmons , it does! So, essentially that first 50% that I set aside is what I use for expenses. And, if I had say, only $200 worth of expenses in a month to cover something, then the remaining $300 would be saved (hence the reserve fund that accumulates), right? I thought that the 50% off the top was just socked away in a reserve fund for future large repairs (like a roof, furnace, etc.) and not touched, but your explanation makes more sense. I was running into cases where taking 50% off the top and not touching it made it seem impossible to actually make any money, so I appreciate you clarifying that for me.

    Regarding depreciation - so if I purchase a property below it's value, do I not get to claim any depreciation? I've been looking at area auction properties, which can sell for a few thousand dollars (and obviously need work put into them). If I buy a property for 5k but it's worth 40k, am I out depreciation? Obviously I would be spending my after-tax dollars to fix it up, so would that be where I could claim some depreciation?

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  • Chris Simmons
    Real Estate Agent · Owasso, OK · Member since 2014 · 517 posts · 400 votes
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    You get to claim depreciation for what you paid....not the value.  If you pay $10,000 for the house and then invested $30,000 into it, you can depreciate $40,000 minus the value of the land....your realistic opinion.  I always go with the county assessors land value so there is no disputing my opinion in case the IRS ever wants to get involved.  If this same property that you invested a total of $40,000 in now appraises for $200,000....you can only depreciate what you have invested....the actual value of the property is not relevant.  

    Before you get too far along, talk with a tax adviser.  There are ways to adjust depreciation to your favor.  In the simplest form, you take all that you have invested in the property...purchase price, acquisition costs, rehab etc.  That gives you a depreciable base from which you can depreciate using straight line depreciation over 27.5 years.  That may be fine for you, but i take a different approach.  

    Different things have different life spans and thus different rates of depreciation as allowed by the IRS.  If you take the straight line depreciation of everything over 27.5 years...you are depreciating the roof, hvac, appliances, carpet and counter tops at the same rate as the windows, brick, foundation, driveway etc.  Your tax adviser can work with you so that you can identify the different categories of items to depreciate at what time periods.  I don't have them memorized.  It is more work, but allows you to depreciate, "expense" more items sooner than later and thus reduce your taxable income.  

    Below is an example.  Again, I don't know the actual limits...i have a tax guy for this and i am operating from memory.  Let's say your $100,000 house is broken down into sub categories.  $100,000 total paid and invested.  Subtract 10,000 for the land leaving you $90,000 depreciable base.  Straight line over 27.5 years gets you $3273/year.  If you say that $12,000 is for carpet, linoleum, paint and appliances....they can be depreciated over 5 years.  If cabinets and counter tops represent $15,000 of the total, they can be depreciated over 10 years.  Then you have a $7000 hvac system that can be depreciated over 15 years and so on so forth.  Stopping here and assuming these numbers and rates of depreciation are accurate...that leaves you with $56,000 worth of house that still gets depreciated over 27.5 years.  

    So you go from $3273/year for 27.5 years....to $6403/year for years 1-5, $4003/yr for years 6-10, $2503/yr for years 11-15 and then $2036/yr for years 16-27.5.  You are front loading your depreciation expense vs spreading it out evenly over 27.5 years.  As you make improvements...new appliances, repaint, carpet etc....you get to add on more depreciation.  So that 4 or so years....maybe 10 years...whenever that point is that you have to go in an repaint, replace the carpet, buy new appliances....you then take that cost, divide it by the allowed depreciation rate and add that chunk of depreciation to your other depreciation.

    Hope this helps.

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    I can see how breaking it out and front loading can be of benefit. Are there instances where front loading isn't a good idea? By the end of 27.5 years using your example, the math comes out the same (to your point that I'm claiming what I paid, 90k in this example), just that I'm using up most of it within the first 5 years, until I roll new expenses back into it. Just wondering if there's a downside to this.

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  • Chris Simmons
    Real Estate Agent · Owasso, OK · Member since 2014 · 517 posts · 400 votes
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    The only downside could be that towards the end, you get to depreciate less and in all likelihood your rental revenue has increased, thus leaving you with a higher tax liability due to reduced expenses.  That said, you would need to avoid buying appliances, paint, carpet, water heaters, hvac, windows, roofs and whatever else for 27.5 years.  Good luck with that.

    Whenever possible, I depreciate anything i can, as quickly as i can.  If that leaves me with a higher potential tax liability in 10 years....so be it.  I want my deduction now.  Time value of money.  You want to deduct $5,000 in depreciation today or in 10 years?

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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    @Emily B. think in your post you have it right except that after you pay your taxes (250) you don't think of the balance as cash flow, but money you save for other short and long term repairs and expenses. So, 1,000 then take 500 and forget about it. Part of that might need to be saved for a new roof in 12 years. The other 500 goes to cash flow you can spend. Most use it for mortgage. Maybe your mortgage is 250 so then you have 250 cash flow.

    Unfortunately not everything fits into a neat and tidy little box. You could buy the property and have a sewer line collapse and need 5k before the place is inhabitable. The 50% rule can take many years to play out. You need to analyze the property and plan on repairs that 50% of the rent won't cover yet.

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    @Jeff S. If I'm understanding your post correctly, I was thinking that out of $1,000, I would need to take $500 off the top and put it away for short/long term repairs. That's where I was thinking I would be left with $500 to pay insurance/prop taxes, which after paying would leave me with $250 in this example. When I applied this theory to a property with a mortgage, that is when I started feeling as if it's very hard to get positive cash flow, when taking the first 50% off the top for reserve funds, and using whatever was left for everything else (mortgage payments, taxes, insurance, cashflow).

    Totally understand things won't fit into a tiny box, was just trying to make sure I was understanding some of these theories to start.

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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    Lets say you used 50% for PI (principal and interest) you would use the other 50% for everything else which includes maintenance, repairs, reserves for long-term improvements like the roof, furnace, siding, windows etc. and insurance, taxes, utilities etc.

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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    Lets just say if you use 50% for PI then you have a break-even. If your PI is less than 50% you have potential for cash flow IF your property doesn't need a lot of repaors upfront or early on. You could have negative cash flow for some time if you are dealing with a deferred maintenance property.

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    Is there a certain percent one should be aiming for to put into that long-term reserves fund? I would like to have cash-flow :)

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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    It depends on the age and condition of the property. This duplex is high but it is 100 years old. http://www.biggerpockets.com/files/user/Jeff1/file/income-and-expense.

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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     That might not come through. Here are 2 places I own. These are total expenses over 20 years. A duplex had 11.6% in repairs and 5.3 in capex. This totals over 16%.

    A house same time frame had 4% in repairs and 12.43 in capex. Again around 16% total over many years.

    Put 16% away for repairs and capex and have available cash in case you are hit with repairs early on.

    My properties needed lots of work. You could have less with places that don't need much

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
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    Emily, they have you going down the right road being a landlord. Recognize that buying and holding RE is not going to provide the cash flow very fast to buy more properties, it may subsidize savings with other savings.

    There will be a point where leveraging purchases will be more beneficial, using a loan to some extent, it might be at 50% of the price, it might be 70%, depends on the price, the market and the expected rents. If you have a  good job and credit is okay, you can use the bank's money.

    What you want is the best use of your money, not really socking it away in a savings account.

    If you're making great money and can buy a house every year, then you may not care so much, but it doesn't sound like you'd be buying a quality mid range type like that. You certainly don't want trash houses unless you love doing repairs, I suggest you buy the best you can in a good location.

    You can look at a property as an investment widget, I'd suggest you use ten percent as your minimum return after everything shakes out, if you can't pull that you're doing something wrong.

    Getting caught up in rules of thumb are okay to estimate what a property will do, but as mentioned, your actual will never be what you estimate. If your real goal is long term, there was a recent thread "what do you invest for, cash flow or appreciation" might read that. Wealth is not really made from cash flow until you hold a lot of equity. Anytime you get others to pay a mortgage down, that's like money made tax free in that year, that continues until you sell it.

    So, look at alternatives in establishing you long term goals. We could do a book or several on this aspect, so talking to your tax guy would be prudent in setting real and realistic goals. Good luck :)

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    Thanks, @Bill Gulley thanks for sharing some of your property info! It helps to see how others apply some of these theories and make them work. Did you do a lot of fixing when you first bought these properties, or just over time as they were needed?

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  • Jeff S.
    Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes
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    @Emily B. when I bought I was essentially broke so just did cleaning and painting all myself. All future repairs came from the rents. This required serious frugality but you do what you have to.

    Some areas where the houses are cheap the counties aren't collecting taxes on a lot of houses so they  need to charge higher rates, rates that are not proportionate with the price of the house. If that is the case throw out the 50% rule because unusually high taxes can really hurt you.

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
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    Stop looking at low end trash, yes, the cash flow looks good but you're stuck with that as well as low end tenants, vacancies, repairs and headaches, you earn what you get out of them. Next issue is they are hard to finance, which means hard for you to  sell too. You don't want some 70 year old dump to be holding a 100 year old fixed place in what will probably be a worse location.

    Buy good properties in good locations, if you're going to hold to the day you die, don't go past a 10/15 year old property, but it's not really a good idea to hold residential properties that long, change out your inventory to keep up in good areas.

    Last week I made a post about what holding entails long term, bottom line, don't get caught up in some has been area as your wealth starts going south, rents run with inflation but held back to income levels of lower income tenants......not a good business model. :) 

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    Bill G. I'd like to look at better properties but they feel like they're out of reach. For example, here is one in a good neighborhood nearby, just came on the market. Was built in 06 and is listed at 195k (3 bedrooms, 3 baths, 1,700 sq ft). 20% down = 39k for a traditional mortgage and estimated payments, according to a quick online mortgage/taxes calculator, are around $982/mo. If I use the 1% rule, I should get at least $1,950 for rent and I don't know of anyone around here getting that in rents. This is why I have been asking about understanding how to analyze deals better because to me this doesn't look like a good deal. Maybe I need to look at other areas? Or is it? Am I missing something?
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  • Anna Shaver
    South Lake Tahoe, CA · Member since 2014 · 111 posts · 37 votes
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    @Emily B.   You may also want to keep in mind your first 4 loans will be much easier to get so you may not want to waste them on really inexpensive properties that require you to come up with a fair amount of money out of your pocket to fix.  If you look for a property in a better condition that doesn't need quite as much work you are financing the money you would have had to put in anyway (depending on the price point you start at).  Obviously, each property has its own pro's and con's.  Just be careful to not buy in bad areas.

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  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    11y

    Emily, you need to go back to RE fundamentals, seems you began all this jumping into investor stuff first and went from there.

    First access the area, do you know the % of rentals to the area inventory? What's the mean or average rent level? What drives the economy of your area? How stable is that economy, if a major employer fell out, what income levels would take the direct hit?

    Know the rental market first. Begin at the middle of that market or down 10%, if the average rent is 900 a month, go down to 810/800. Start there, you can go up or down further if nothing is there. Don't get in a hurry to buy, RE moves in cycles, but it is always changing, prices move slowly but there are always distressed properties, that doesn't mean some junker, deals can be had at all price levels. 

    800 gross rents gives 400 PITI, 75%, 300 goes to P&I on the loan. Interest rates are say 5%, 30 year note with a $300 payment gives you a loan of 55,800, the loan is 75% of the price, 55,800/.75=74,512 0r a $75, 000.00 home. Now look in that price range.

    At a 55k loan, you're just over the minimum loan amount that is available.

    Your 3/3 home isn't a rental property. :)

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
    11y

    @Anna Shaver thanks for the tip! I will definitely keep that in mind.

    @Bill Gulley well, technically I haven't jumped into anything yet as I haven't bought a property. :)  But you're right, understanding markets is something that I'll sheepishly admit I don't quite know where to look for this type of information. I mean, finding an area's rent rates - does that translate to something as simply as looking at Craig's List postings to get a rough figure down, or are there other places I should look? I've noticed Zillow also offers area rent estimates, but sometimes they seem a bit off from what I may know from a neighborhood by word of mouth. I have seen rents as low as 550/mo (low-end, not good neighborhoods) to anywhere from 700-1,000 for better locations or desirable school districts. In other words, it seems like there are a few sources, but are there other resources I should be looking at instead? To answer your questions, no, I don't know the answer to the % of rentals in the area - how do I find that out?

    As for what drives the economy, being in central Michigan it used to be the auto industry, which is now long gone. I think the major employers in the area now are Michigan State University, the State of Michigan government offices, and local healthcare. This is my opinion and observations at this point. I also recognize that this area may not be the best place to grow long-term, which is why I want to better understand how actually analyze a market.

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  • Anna Shaver
    South Lake Tahoe, CA · Member since 2014 · 111 posts · 37 votes
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    @Emily B.   You can look on craigslist to see what property managers in your area come up a lot.  Check out their website, if they look professional and have good properties (look at their listings page), give them a call.   Let them know you are looking at buying some rental properties.  Find out what their rates are (the percentage they charge).  Ask which older working class neighborhoods rent well for them and see where they recommend you look.  They can tell you the range in rents and what to expect.

    Not everyone will be willing to help but if you let them know you are just looking for some basic feedback and are respectful of their time often you will get feedback.  If they don't know, you can also ask is their someone in their office who you should talk to.  It might not be they are unwilling to help but the person you are talking to hasn't really thought about it or worked with that side of it.

    You can also check out http://www.rentrange.com/for-rent-housing or rentometer.com

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  • Anna Shaver
    South Lake Tahoe, CA · Member since 2014 · 111 posts · 37 votes
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    @Emily B. I guess I should also clarify older neighborhood, in our area it would be built in the 60's or 70's.  The newer homes are much larger and a lot more expensive.  In many parts of the US, older would be a very old home and I wouldn't recommend that because you could have other challenges.  Each area has a typical decent entry level home with certain expectations that is easier to rent.  In our area that would be a 3/2/2 that is 1200-1400 sq ft.  In some areas in TN this would not have a garage but a carport and that would be ok.  It depends on what the expectations are where you buy.

    The sweet spot for rentals for me is a home that is in a safe area, may not be the best, but isn't bad, where a family would feel comfortable and could become a long term tenant.  With a long term tenant you don't have the turn over cost of possibly new carpet and paint and costs to get the property ready which would also include some vacancy.  This would be a lower cost home than the best areas but still command decent rent for its cost.

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  • Emily B.
    OP
    Rental Property Investor · Greater Lansing Area, MI · Member since 2014 · 196 posts · 55 votes
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    @Anna Shaver thanks for the resources and clarifications. Those too could be older neighborhoods in my area, but some can be even older than that, as in early 1900's, which I can't say I really want to get in to. Newer homes are more difficult to come by for a good deal, as I pointed out earlier. I think that's why I need to figure out how to understand and read market trends...if there aren't many new(er) homes around, I'm thinking it means that there could be better markets out there that have more growth and options than my area. So much to learn! :)

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