I got a great question from a client last week. He came to me to talk about buying a rental property, and after looking over the cash flow potentials for a number of properties, he wasn’t finding what he wanted.
“My dad has been buying rentals for years, and he tells me that he’s making a few hundred dollars a month on everything he has. Why can’t I find something that has a good positive cash flow?”
Here’s the simple explanation. When you buy a property to rent out to someone else, you just bought a small business. You invested money at the beginning, you may add additional money at some time in the future to improve the property or cover a short month or two, you take some nice tax benefits along the way, and in the end, you hope the business you own is worth more money than you have in it.
Let’s look a bit more closely. You have income, almost always and almost entirely in the form of rent. Your tenant pays you rent. Once in awhile, you have income from the laundry machines or a parking space, but it’s basically all rent.
Expenses are a bit more complicated. You have yearly property taxes to pay. If you have any sense about what you’re doing, you pay for an insurance policy to cover losses from fire, water intrusion, liability from a law suit when someone falls down your staircase, etc. Maintenance costs cover the costs of cleaning up between tenants, mowing the lawn, new flooring occasionally, a new roof every other decade, and whatever else comes up. You may pay for the use of water and sewer, trash removal, and possibly even heating and electricity. Your manager, if you have one, doesn’t work for free either.
The big one, though, is the mortgage. If you have one, it’s by far your biggest monthly expense. Statistically, most landlords pay between 50-75% of their expenses in principal and interest on a mortgage.
Now step back and look at the big picture, this time taking inflation into account. You don’t own this small business in a vacuum.
Rents don’t stay where they are over the years. They change. Usually, they go up. That’s called inflation. For this example, let’s say your rental income this year is $10,000. If the rate of inflation is around 3%, the rent for next year will increase about 3%. ALL of the rent. You can expect your rental income next year to be $10,300.
Your expenses will also increase about 3%. The property taxes, insurance, all of your maintenance costs and utilities – ALL of them will increase about 3% in an average year.
Except one. The biggest expense you have, your mortgage payment, will stay the same. If you have a 15- or 30-year fixed rate mortgage, the principal and interest payment will stay the same. And again, that’s the lion’s share of your expenses.
Big picture again. You have income and expenses. On a yearly basis, 100% of your income will increase. Less than half of your expenses will increase. That means that every year, you make more money in the form of cash flow.
Turns out that my client’s father had purchased all of his real estate at a break even or small positive cash flow at the times that he bought them. After a number of years, they were all making him nice positive incomes in the average month.
It’s all in the arithmetic. Fact is that most of the time, real estate as an investment, taken over time, just keeps getting better.
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Enjoy the day,