Investor · Milwaukee - Mequon, WI · Member since 2010 · 5k+ posts · 7k+ votes
This is a classic new investor trap. Every new investor learns to budget for repairs and maintenance. Its a line item in every calculator or spreadsheet when you are running the numbers. I have always had a problem with that.
First of all, the 5% most investors are using is not enough, except maybe with new construction. Second, you'll never turn a profit this way. You get used to paying for repairs out of cash flow and pretty soon this becomes the norm: cash flow is just paying for everything.
If your cash flow is an average $200/mo and after 6 years you need a new roof, it wipes out all of the cash flow. And 3 years later you need a new HVAC, which wipes it out again. A kitchen remodel may cost you 10 or 15 years of cash flow. And if the building is 60 years old, you'll need to replace these galvanized pipes pretty soon. And the cracked-up driveway.
It gets worse. I spoke with an investor last year who owns 30 duplexes and has been operating them for over 40 years. He's old and wants to retire, but he can't because they are low value 100 year old buildings from the 1920s and even though he does most of the work himself, they are constant money drains.
@Marcus Auerbach - Agree with your sentiments. I think incorporating appropriate CapEx at the beginning of the analysis is a key step. Then, the property should cash flow "above and beyond" all the expenses, including CapEx/reserves. It protects you some, but I think most don't retain enough funding.
@Marcus Auerbach - Agree with your sentiments. I think incorporating appropriate CapEx at the beginning of the analysis is a key step. Then, the property should cash flow "above and beyond" all the expenses, including CapEx/reserves. It protects you some, but I think most don't retain enough funding.
No! That is what everyone is trained to do, but I think it's wrong - at least long term. Short term you have to do what you have to do. But cash flow is meant to be profit; that's the reward for doing all the work.
@Marcus Auerbach i typically agree with your sentiment but not necessarily here (but I do agree many investors under estimate maintenance/cap ex and seem to use a percentage of rent that is virtually arbitrary). I am in the @Greg Kasmer ‘s camp. I do not consider the cap ex to come out of cash flow because my cash flow projection has already “correctly” allocated for the cap ex.
Not properly including cap ex in your cash flow calculation is deceiving yourself. If you cannot produce a return with realistic sustained expense projections and accurate projected vacancy then it is not a good investment.
I run my numbers including cap ex that is derived by using expected lifetimes and expected replacement costs on all items to derive maintenance/cap ex. My cash flow calculation includes vacancy projection, maintenance/cap ex projections, PITI, asset protection, bookkeeping/tax prep. Basically I include everything for sustained rental ownership.
There are markets with poor appreciation. Those markets need to cover the expenses via the cash flow. The issue is virtually all the high initial cash flow markets do not have good long term cash flow due to poor appreciation. These markets will be challenged to make money in the long term as the long term cash flow will be poor and the appreciation will be poor. I believe this is your primary point.
But there are other markets that have great appreciation and great long term cash flow (if no value is extracted).
Most rentals in San Diego are apartments and they average just under 2 BR. San Diego’s median rents:
recognize if you purchased a unit in San Diego in the year 2000, your rent has increased ~$2250/month. Similar crazy rent increase for purchases in 2010 or 2020. This produces revenue that can cover sustained expenses including cap ex.
Do accurate and conservative underwriting. Anything else is deceiving yourself.
You should include R&M, vacancies and credit losses (evictions) as provisions in your model. The CoC/profit would be measured after all of these. In real life, you put those provisions apart (may be in a money market) and add them to your initial reserve, so that when the time arrives to make that big expense you have the money ready.
Marcus, I see your point, especially with older properties where one major repair can wipe out years of cash flow.
But to me, if a property consistently needs more capital than it generates, the bigger question is whether it's actually a good investment in the first place.
That's always a good question, but if you make the timeframe long enough, the answer is almost always that capex will exceed cash flow. Investors don't realize that the first 5-10 years, because while they pocket the cash flow, every component on the property is aging.
So you can defer for a while, but 10 years will usually get you to a point where you see it.
A single family rental will need a full rehab every 30 years. We average about 70k for a full rehab, give or take. And in my estimation I will have to do that again in 30 years, because neither roof nor kitchens last thats long. Plus the occasional item in between for components that have a service life under 30 years like water heater and HVAC. If you assume $200 in cashflow x 360 months that's 72k. So it wipes it out clean.
That's why you need appreciation. Everyone treats appreciation as icing on the cake, but I'd say it is in fact the entire cake! And without long term appreciation you have done all the work basically for nothing.
Marcus, I see where you are coming from, especially with older properties. But I wouldn't necessarily call appreciation the entire cake.
If a $70K rehab wipes out 30 years of cash flow, I'd argue that property wasn't generating much of a cash return to begin with, once you account for its long-term capital needs.
Appreciation and principal paydown certainly contribute to the overall return, but appreciation isn't guaranteed. If the investment only makes sense because we're counting on property values going up, that's a different investment strategy altogether.
@Marcus Auerbach we do pay repairs out of cash flow, but the trick for us is what happens before the first tenant moves in. When we buy, we renovate the whole house to a high finish level, not just the big items but the small things too. With that approach we budget about 7% for maintenance and it holds. If you buy an old house and rent it as is, I agree, the cash flow will end up paying for the roof.
Yes we take the same approach, you have a nicer property, rents faster, you get better tenants, less turnover, higher rent and less wear and tear, because they usually take good care of the property. Absolutely worth it. And 7% for repairs is solid on a fully renovated property. But you made my point: that initial rehab did not come out of cash flow. It came out of equity, assuming you bought the property at a good enough price (I usually fail that test, at least a little).
But how long do you think it will take before you have to do a full rehab again? Milwaukee home prices have doubled over the last 10 years, at least for the metro area. But not every neighborhood has, there are some parts that are basically selling for the same price as they did 10 years ago. And that's where it gets you: see my example of the guy who owns 30 duplxes for 40 years and is basically broke
Marcus, I agree with the core of it, and here is how I run it. On my Memphis houses, the rent has to cover vacancy, repairs, CapEx, property management, taxes, insurance, and the loan payment, or the deal does not work. A 3-bedroom at $1,395 to $1,950 a month has to clear all of that and still pass the 1% rule against an ARV of $180,000 to $265,000. If I have to skip the CapEx reserve to make the cash flow look good, I am not making the deal better, I am hiding the cost. A rehab does reset some of that clock, and my typical $40,000 rehab does mean fewer big surprises early, but roofs and systems still age. I would rather pass on a deal that only works without CapEx than own a house that eats the cash flow later.
And so you are saying you are trying to fund Capex out of cash flow? I don't think that can work.
Even on your highest rent of $1950 on 265k house your PITI is $1750-ish, so you have about $200 left for repairs, maintenance, vacancies, property management, hopefully some cash flow (profit) - AND CAPEX? So how much do you use for Capex? That can't work. Over any 10-year period, you are losing money. What am I missing?
Agreed, probably very few properties actually cash flow in the long-run when fully accounting for all capital expenditures. Like other businesses, properties periodically need fresh capital to fund larger, one-time or infrequent expenses. Rentals are a great way to store and accumulate wealth over time using financial leverage (loan) and labor (the tenant) to pay down the mortgage and gain the appreciation upside. All it takes is a capital expenditure or two to wipe out years of cash flow.
An initial knee-jerk reaction to your post title by us investors may be: well the cash flow should pay for the cap ex. But I think most real estate investors know practically speaking in their own experience this is not the reality.
Yes "should" is the operative word! The title is of course provocative, but it is also 100% not understood by new investors. They think they fill out the boxes at the calculator and it will work. Actually, now that I think about it, there should be an input for "building degradation" in the calculator; basically, an approximation of component service life. You can still set it to zero, but the reality is, it's not zero. And if you don't have the appreciation to create the long-term equity to pay for it, it will eat up the cash flow.
I'd frame it slightly differently: capex isn't something cash flow pays for later. It's an expense you subtract before calling anything cash flow.
The flat 5% is the real trap. Pricing each component works better: a $15k roof with 8 years left is $156/mo, an $8k HVAC with 5 years left is $133/mo, and a $1.5k water heater with 3 years left is $42/mo.
If the deal still works after that, great. If not, that $200 was never cash flow.
This is the correct view. Your “cashflow” isn’t paying for your maintenance, your repairs, or your vacancy just as it isn’t paying for your capex. Your cashflow is what’s left after all your budgeted “deductions” (Because they aren’t really current period expenses I used deductions.)
This is really a market by market and property by property problem. If you count appliances, ac units or water heaters as capex, that’s the only capex I’ve had in almost 30 years. And it’s been minimal. But that’s the difference between buying 10 year old stucco sided, sloped and tile roofed SFRs in an area with no freeze / thaw, hurricanes or tornadoes. If you’re buying 80 year old, wood sided, asphalt shingled, flat roofed homes in the Midwest you might not go 5 years without capex. That has to be sort of your deduction BEFORE you calculate cashflow. You talk in 30 year periods. But in that period or less you will also own the property outright. That’s just as valuable to me as cashflow.
Ps. All that being said I would never buy in a market where I didn’t expect appreciation. I’ve made way more from appreciation than rental income. Even a paid off property can “earn” more from appreciation than rental income, especially if you consider it’s tax free. I’ve purchased homes with negative cashflow for those two reasons. They paid off more debt than the negative cashflow and the appreciation can be 25-100% per year if calculated against cash invested. “Appreciation on cash”? Instead of cash on cash.
Not incorrect, but based on that math, there are exactly zero deals that cash flow. Depending on your climate 35% to 45% of your home's replacement value (ask your insurance) is components that have a life expectation of under 30 years. Now you can buy a house for 200k in some market, but the replacement value will be more than 200k. The insurance company knows what it costs to replace a burned-down house. But even if it did not burn, you'll have to replace at least 35% of that. When you use that number, you will never find a deal that is cash flow positive or even close to break even. My point is, you need appreciation (equity) to pay periodically for major system replacements. Without appreciation, the math does not work.