Capex wipes out cash flow for a year?

74 Replies

So long question short, my rental property averages about $150 a month cash flow after regular maintenance expenses and minor repairs. But for a capex expense, my next one being a bath tub replacement or replacing the carpet with LVP. Is it normal that a minor $3k expense such as those would wipe out my year's worth of cash flow, and leave me in the red on paper? Justified by the fact it's not a normal yearly expense, Or does my rental just suck? Mortgage PITI is $900, rent is $1300. Mortgage is high as it's year 4 of a 15 year mortgage.

Thanks,

Bill

First mistake, never do a 15 year mortgage.  It increases your monthly payment, the payment your tenant was paying for you, and as in this case, leaves little room for any added expenses.

Second mistake, relying on the CF to pay for CAPEX. You're seeing why that doesn't work now.

Third mistake, probably buying a property that only cash flows $150/month on a good day.  That's negative CF just waiting to happen.

Joe said it all and said it all well.  Will only add that this is why you should have a capex number in addition to vacancy and maintenance.  This way you are setting it aside as a different bucket of cash to use for these types of expenses.  In the end it doesn't matter because the cash to you is the the same but when analyzing a deal if you had worked in a capex number on your sheet you would see you cash flow less then 150 a month and maybe that would have changed your mind on the deal. 

If you plan a long term hold you will save on interest with the 15 vs a 30 but the first 15 years might be tough.  

@Bill Ward it is absolutely possible for all your CF to be  used in any one year; I have a 12 unit that cash flows 60-70k a year but I don't have a mortgage; if I did and had a roof replacement I'd lose money in that year. But so what? I won't have another roof replacement for 25 years. That's why we build a reserve pile.

Originally posted by @Bill Ward :

So long question short, my rental property averages about $150 a month cash flow after regular maintenance expenses and minor repairs. But for a capex expense, my next one being a bath tub replacement or replacing the carpet with LVP. Is it normal that a minor $3k expense such as those would wipe out my year's worth of cash flow, and leave me in the red on paper? Justified by the fact it's not a normal yearly expense, Or does my rental just suck? Mortgage PITI is $900, rent is $1300. Mortgage is high as it's year 4 of a 15 year mortgage.

Thanks,

Bill

 Comes down to your goal. Me personally? I would switch to a 30 year with first five years intrest only, get the cash flow. Also my minimum requirement for a rental is at least $400 net cash flow per door.....

@Steven Wilson the goal now seems to be to have it paid off to maximize cash flow when I'm eligible to leave my current job. About 6 more years and I'm eligible, and 10 years left on mortgage. I could refinance now and drop mortgage from 900 to 500 or so. House value 170k, balance $78k. $500 a month currently goes to principal.

Thanks guys

@Joe Villeneuve You're right, and it wasn't bought as a rental it was my old primary home. Rented it when I moved out to get a little more when I sell, which I have done with payoff and appreciation. Refinanced to 15 loan a year before I moved out (hadn't planned on moving). At the time I moved out, 2018, it had all new appliances and roof. If I end up selling now I've already accomplished my goal of increasing my income when I sell. Kinda on the fence of digging into be a long term rental property or just selling to simplify. 

Why are you looking at the whole cost as an expense this year? The bath tub may cost $3,000 to replace, but it's going to last 30 years. Mentally viewing it as a $3,000 cost this year and having zero free cash flow this year is the mistake. If it lasts 30 years, then it costs $100 a year. You should be applying a $100 cost of this item to each year. 

Big expenses happen. So it wiped out your FCF for a year. BFD. You need to spread that cost over the life of the improvement. You also need to recognize that it added value to the property. 

And a 15 year mortgage is not a mistake. The mistake is that many people on these forums think everyone has the same goals as them and should invest like them. I find the idea of having a small number of fully paid off, high cash flowing properties vastly more appealing than having a lot of highly leveraged properties that cash flow a little each. To me, one is a retirement plan and the other is a job.

Keep in mind that most bath tubs last 40 years and LVP should last 15 years. Maybe you spend $3000 to replace a tub, but the real cost over 40 years is $6.25 per month. Another factor is tax treatment of improvements like this. You are likely able to take bonus depreciation on both expenses, which means for the 2021 tax year, 100% expense. Assuming you are in the 25% tax bracket, that is like getting 25% back on your taxes. 

As others said, you chose to finance over 15 years which increases your debt service and further decreases cash flow. That is great in 11 years when it is paid off, but probably means break even or even subsidizing it some years. The principal repayment portion of your loan builds owner equity, so it is really not considered an expense.

Originally posted by @Bjorn Ahlblad :

@Bill Ward it is absolutely possible for all your CF to be  used in any one year; I have a 12 unit that cash flows 60-70k a year but I don't have a mortgage; if I did and had a roof replacement I'd lose money in that year. But so what? I won't have another roof replacement for 25 years. That's why we build a reserve pile.

 You don't lose money in that first year?  You obviously paid all cash if your don't have a mortgage.  That means you started out (whatever the price of the property was) in the hole...first.  You are losing money, you just paid for all the loses upfront.

Originally posted by @Bill Ward :

@Steven Wilson the goal now seems to be to have it paid off to maximize cash flow when I'm eligible to leave my current job. About 6 more years and I'm eligible, and 10 years left on mortgage. I could refinance now and drop mortgage from 900 to 500 or so. House value 170k, balance $78k. $500 a month currently goes to principal.

Thanks guys

 Any money that comes out of your pocket is a cost to you.  Any money that the tenant pays from the rent is a cost to the property...and the source of the funds is the tenant.  When you use your cash to pay down the mortgage, you're not saving money...you're just spending it all up front.  That added cf you think you are getting is an illusion.

Originally posted by @Bill Ward :

@Joe Villeneuve You're right, and it wasn't bought as a rental it was my old primary home. Rented it when I moved out to get a little more when I sell, which I have done with payoff and appreciation. Refinanced to 15 loan a year before I moved out (hadn't planned on moving). At the time I moved out, 2018, it had all new appliances and roof. If I end up selling now I've already accomplished my goal of increasing my income when I sell. Kinda on the fence of digging into be a long term rental property or just selling to simplify. 

 If you're the one paying down the mortgage, then you're not gaining anything...you're actually losing.  When you sell, the amount of cash you spent on the paydown isn't a gain.  You're just recovering your own money that you spent...unnecessarily. 

Originally posted by @Greg M. :

Why are you looking at the whole cost as an expense this year? The bath tub may cost $3,000 to replace, but it's going to last 30 years. Mentally viewing it as a $3,000 cost this year and having zero free cash flow this year is the mistake. If it lasts 30 years, then it costs $100 a year. You should be applying a $100 cost of this item to each year. 

Big expenses happen. So it wiped out your FCF for a year. BFD. You need to spread that cost over the life of the improvement. You also need to recognize that it added value to the property. 

And a 15 year mortgage is not a mistake. The mistake is that many people on these forums think everyone has the same goals as them and should invest like them. I find the idea of having a small number of fully paid off, high cash flowing properties vastly more appealing than having a lot of highly leveraged properties that cash flow a little each. To me, one is a retirement plan and the other is a job.

No, that $3000 tub IS a cost this year since this was the year it was spent. The cost to the REI is what they come out of pocket on. If that tub was financed, it would cost only what came out of pocket. What you're actually saying is it will take 30 years to recover the cash spent on that $3000 tub.

Buying equity, in any form, using your own cash, isn't a gain.  All that is happening is a transfer of the exact same funds from your bank (liquid) to your property (solid).  Both locations are equal to eachother.  When you let the tenant pay for it, any equity from that paydown IS a gain because the source of funds used comes from the tenant.

Originally posted by @Bjorn Ahlblad :

@Joe Villeneuve well yes and no. I'm 76 and no longer scaling so paying cash made sense for me; the property has made me  over 200k in 3 years. If I was your age Joe I'd be riding your coattails!

That is a completely different scenario...the end of the line (REI).

Originally posted by @Bill Ward :

@Joe Villeneuve I figure I can either refinance and make 800 over mortgage per month now but it not really ever increase, or 400 a month now for the next few years then it jumps to 1300. (basic formula, excluding rent raises for my point of view) 

 Not following.  It sounds like you're buying the added cash flow...that's not a gain...that's just a cost recovery.  Your tenant is already toing this for you for free.

The tenant is paying down the mortgage, there's just less excess cash now than if I refinanced. The same way that if you refinance a rental every couple of years you could technically make a few dollars more per month each time, but the rental would never be paid off and you'd be making only the cash flow per month forever.

If I refinance now to a 30 yr loan. I'll have 800 cash flow now. In 10 years very little will be paid off the mortgage and I'll still be at 800 cash flow (plus rent increase). If I keep my 400 cash flow now, in 10 years the entire mortgage is paid off and cash flow jumps to 1300 (plus rent increases) monthly forever. That's been the current goal. I'm not planning to leverage to buy any more properties or scale up. 

If the $150/month cash flow did not including cap ex estimate then you have no where near $150/month of cash flow.  Just a small rental size kitchen has cap ex of ~$40/month.  Not including an estimated cap ex in the cash flow is similar to not including a vacancy estimate or a maintenance estimate in the cash flow.  Not including estimates for these, and all other expenses, just provides a misleading cash flow estimate.  

My prediction is if your cash flow is $150/month without cap ex you likely have a true negative cash flow.  Every time a major cap ex/maintenance item occurs it will consume your cash flow for many months.

I believe in leverage as long as it does not result in being over extended.  I am not adamant that 30 year fixed is the ideal loan for everyone, but it it my personal preference.  The 15 year mortgage is negatively impacting the cash flow.  This would be critical if you needed to rely on the cash flow.  The 15 year mortgage results in greater equity pay down and quicker loan payoff.  The negative, it hurts the cash flow and reduces the leverage.  If cash flow is a primary goal, it can be improved by extending the loan duration.  For me the bigger driver to the 30 year loan would be to better leverage the money (at this point I care so little about cash flow - None of my properties on their best month of cash flow has achieved their average monthly appreciation over my hold period.  

You investment seems fine.  The cash flow calculation can use some work.  The 15 year loan is negatively impacting the cash flow and the ability to leverage your assets.

Good luck

@Dan Heuschele Thanks, I agree. It is obviously hurting the cash flow now, there's no debating that. I don't need the cash flow right now, and honestly if I had an extra couple hundred from it right now per month cash flow I would just spend it on toys or in maybe in savings. I do like the quicker pay down and I am setting it up for greater cash flow in the future, will be paid off when I'm 46. It's my only rental and I have no immediate plans to change it. I don't have anything to cash out refinance and reinvest that money right now either. So the quicker it's paid down the more I'll have access if I decide to do it in the future.

Are the numbers great? No, but I didn't buy it as a rental either. It's just a home I held onto for 3 years of renting so far, and right now I could sell and make 75k, where if I sold when I moved I probably would have made 20k. So mission already accomplished on that front. The repairs and maintenance stuff that comes up are things I would have taken care of anyone to sell. So as long as I'm close to breaking even on cash flow, I look at it like the tenants are paying for stuff I would have had to pay for anyways. 

Landlords often go through this.  I "scratch" on a few properties a year, all because of cap-ex.   My last capital expenditure was a new roof on a property.  It wiped out the cash flow for two years.  

Originally posted by @Bill Ward :

@Dan Heuschele Thanks, I agree. It is obviously hurting the cash flow now, there's no debating that. I don't need the cash flow right now, and honestly if I had an extra couple hundred from it right now per month cash flow I would just spend it on toys or in maybe in savings. I do like the quicker pay down and I am setting it up for greater cash flow in the future, will be paid off when I'm 46. It's my only rental and I have no immediate plans to change it. I don't have anything to cash out refinance and reinvest that money right now either. So the quicker it's paid down the more I'll have access if I decide to do it in the future.

Are the numbers great? No, but I didn't buy it as a rental either. It's just a home I held onto for 3 years of renting so far, and right now I could sell and make 75k, where if I sold when I moved I probably would have made 20k. So mission already accomplished on that front. The repairs and maintenance stuff that comes up are things I would have taken care of anyone to sell. So as long as I'm close to breaking even on cash flow, I look at it like the tenants are paying for stuff I would have had to pay for anyways. 

My worse RE investment is my ex-home (it has still been a great investment), so I understand that aspect.

As for the leverage, here are some things to consider:

  • You do not seem in danger of over leverage.  I do not advocate anyone over extend.  To me I am over extended if I cannot handle a Great Recession like event.  Some may think it a once in a lifetime event, but to me if it can happen once in a lifetime I want to be able to be able to handle it.
  • There is no cheaper money than convention OO loan. The difference between what you can earn with the money and the amount the loan costs is profit. You indicated your PITI but not your rate. I will use 3% for example which if your loan was OO, 15 year it could/should be less. If you invested in S&P 500 (passive, minimal long term risk) it has a lifetime return approaching 10% so there would be 7% profit. If you invested in an RE syndication (passive, but likely more risk than long term S&P investment) you could get 15% for a 12% spread. If you perform a BRRRR or flip a property I expect 50% ROI (lots of work and fair amount of risk) for a 47% spread.
  • If I own a property at 95% LTV and the RE appreciates 10%, I made 200% return from the appreciation. If I own the same property with no loan (0% LTV), that 10% appreciation results in a 10% return from appreciation.

My point is there are many investment options (with various levels of risk and effort) that are likely to produce higher return than your conventional RE loan rate.  In addition, the higher the leverage on a property the higher the rate of return achieved from any appreciation.  You are already aware what the 30 year loan does to the cash flow versus the 15 year loan.

With the appreciation of RE over the last decade, we have refinanced many times.  Pulled money out at low rates and re-invested it achieving far higher return than the loan rate.

Something for you consider is do you want that money to be working for you better than it is currently?  I would want my money to produce better return than you are currently achieving with the equity above what the loan requires.

Good luck

@Bill Ward you mentioned moving out in 2018 which was 3 years ago. Assuming you lived in it for the 2 years prior to 2018, you may still be able to sell and not pay any capital gains. Lived in the property 2 out of last 5 years. Something to keep in mind.