Back in May, I was a guest on Maggie Germano’s Podcast, “The Money Circle.” I shared some of our background and how we started investing in real estate. We brushed on topics like establishing an LLC, tax advantages, and how you don’t need to start big to just get started. It was a brand new experience for me, but I’m passionate about our real estate experiences, and I loved being able to share. I hope you’ll check it out!
The common goal in the FI/RE (Financial Independence, Retire Early) community is to reach a point where your net worth is 25x your annual spending, meaning your expenses are 4% of your net worth. This is an extreme oversimplification of things because of the number of variables associated with where your net worth might be, and how to access it. For example, retirement accounts have requirements to be met before drawing funds; while you may have hit the 4% expense to net worth ratio, it may not mean that you have that money liquid to cover your spending.
When the ODAs started down the path of FI/RE, we did it with a real estate rental portfolio. This path of net worth growth really doesn’t fit the traditional mold. It provides regular cash flow, rather than an account with a balance that’s drawn down.
As mentioned in previous posts, there are numerous ways to make money in real estate. The path we have taken is probably one of the simplest and most repeatable for anyone. We own a portfolio of single family rental houses, most of which were bought straight from the MLS. These basic properties are in basic neighborhoods with regular tenants. Nothing special. We acquired these properties by focusing on the 1% rule in real estate – try to secure 1% of the property’s purchase price in monthly rent. Another oversimplification of how things really go, but if we were able to find a $100k property that rents for $1,000 a month, we know we’re going to make money long term.
For these properties, we typically put 20%-25% down and finance the rest through a conventional mortgage. We find a tenant, and then the 4 ways to make money in real estate go to work for us: appreciation, tenant mortgage pay-down, tax advantages, and most importantly for our situation and FI/RE – cash flow.
I want to talk about how we can reach a FI/RE number through real estate cash flow differently and more quickly than using traditional stock market investing.
The $100k house had a 20% down payment and mortgage rate at 5% interest, which brings the monthly principal and interest payment to $429. Add another $121 for taxes and insurance (using round numbers here!), $100 for maintenance and capital expenditures savings, and $100 for a property manager; this comes to $750 worth of monthly expenses. At $1,000 per month of income, you have $250 per month of cash flow in your pocket. $250 per month equates to $3,000 per year of cash flow. With the $20,000 down payment and about $5K in closing costs, it means that our $25k investment nets us $3k per year in cash flow.
Circling back to the 4% rule for stock market investments, $3k in cash flow requires a savings of $75k. But we only had to invest $25k! We’re banking on the monthly cash flow, rather than a “stagnant” savings.
We took that math and ran with it. Our rental portfolio has 12 houses in it. While we’ve shown in prior posts that each house’s numbers aren’t as clean and simple as this example (some better, some worse), if we take that $3k annually and multiply by the 12 properties, we have $36k in annual cashflow for only $300k invested.
What would you rather need to produce $36k income – $300k or $900k?
Can you scale a rental portfolio to reach enough annual cashflow such that you can live off the cash flow?
Rental property investing is not completely passive. We have tenants to manage, properties to maintain, property managers to manage, income and expenses to track for taxes, lending efficiencies to explore, and the list goes on. But if you’re willing to put in a little work to reach financial independence (the FI part), you can do it substantially faster by finding strong properties to provide significant cash flow than if you were to take the totally passive route of simple stock market (index fund) investing.
Note, there’s nothing wrong with that – we have a substantial position in the stock market due to the tax free growth benefits of retirement accounts. The power of real estate investing saw our net worth grow faster than we’d have ever dreamed since we bought our first rental in 2016. The proof is in the pudding and we advocate to anyone to just get started!
When people talk about having rental properties, usually the first thing we hear is, “I don’t want to hear about a clogged toilet at midnight.” Does your toilet clog at midnight? No. So why do people think that tenants have issues that you wouldn’t typically see in your own house? A tenant can’t expect service faster than you’d get on your own property.
Even when there’s a month that requires a lot of our attention to be on rental properties, it’s still always worth the income/expense ratio. 2020 was a year of big expenses. However, I kept the perspective that we had several properties that we didn’t even hear from, and this was just one year of 4 so far.
Here’s a look back at what happened with our rental properties in 2020.
House #7 required a roof replacement. We have dealt with leaks since we purchased the house, and the time finally came that the replacement was more cost effective. This house also required HVAC repairs and plumbing replacement. Since we purchased the house, we had issues with the upstairs bathroom sink not draining properly. After several attempts to unclog it, our plumber finally made the call – it wasn’t a matter of cleaning a clog, it was time to replace corroded copper pipes… from the second floor to the crawl space. And so we did that. We then had to pay someone else to repair the drywall. All together, this house cost us $7,600. However, about $4k of that was the roof, which has to be depreciated over 27.5 years, so we only claim about $75 of that cost this year.
House #1’s roof has also troubled us from the start, but it’s under HOA control. We had a leak that was bad enough to require the HOA’s attention. It was a multi-week process to get them to even acknowledge me, and I have no intention to ever own a townhome again. I like having more control over my property than being in a position to hound an HOA to address a water-related issue as I watch more rain in the forecast. In the end, they repaired it, but we’re responsible for the drywall repair, which was $76.
House #6 required the main sewer line from the street to the house to be replaced, which was $4k including the scoping trip to put a camera in the pipe and see how deteriorated it was.
We had quite a few HVAC issues this year, after only having 1 issue on all our houses (well 2, but that second one was someone driving over our unit and insurance covered it). We had House #3 require a new fan, which was $635. House #9 had an entire HVAC replacement at $5k, depreciated 27.5 years. House #12 required HVAC work at $500.
We had to replace a dishwasher, stove, washing machine, and refrigerator among the properties as well. These were the major purchases and don’t account for several smaller plumber and electrician trips that were needed among the properties.
On the positive side of things, we paid off one loan, paid $23,500 paid towards another, and refinanced a property (reducing our monthly payment by $104).
Of 12 properties, we had to turnover 3. Turnover is the most time consuming to us personally because it requires our attention to touch up paint, fix things, order appliances, and coordinate any other maintenance issues. Then we need to handle listing the property and showing it when we don’t have a property manager, which was the case for 2 of our properties.
In March, we had the tenant at House #11 request a renewal of their lease. A couple of weeks after signing the renewal, they requested to be released from the lease because they were moving to another state. We worked with them, for a fee, to be released from the lease, and they vacated the house as of April 30. I had to repaint, clean the bathrooms and kitchen, fix a few things, and clean the carpet (which was only a year old at this point). We listed the house, had several inquiries, and had it rented on May 7.
In September, we had the tenant at House #7 request to be released from her lease because she was buying a house to take advantage of low interest rates. The Fall isn’t a good time to be listed a house for rent, but it’s hard to not help someone help themselves like that! We agreed to release her from the lease for 2 months worth of rent. Shortly after that agreement, an old tenant of ours reached out asking if we had something coming available in October or November, and this house fit her request perfectly. I met her to show her the house and had a November 1st lease signed the next week. We asked the new tenant if she could move out before October 31st, and we would refund her for the days she left early. We spent two days touching up paint, fixing an old water leak patch (the roof had since been replaced by the drywall work in the laundry room hadn’t been addressed), and cleaning the house. Our paint touch up was far from perfect, but we didn’t have time to repaint the whole house. I offered the new tenant an incentive of $50 per room and $25 per paint can if she wanted to paint herself, and she actually did 3 rooms so far.
The final house that had turnover is managed by a property manager. Our house was the first the tenants had rented, and they didn’t quite understand all the details of having to give notice that they were leaving. We worked with them while they went back and forth deciding if they wanted to renew or leave. While our lease stipulates that we require 60 days notice if they plan to leave at the end of the lease, we wouldn’t typically post the house for rent more than 3 weeks out. They eventually decided they wanted to leave the house, but then at the last minute asked for more time. We had a lease lined up for two weeks after they were going to vacate, so we were able to give them an extra 10 days in the house. Once they left, we had the carpet and house professional cleaned, and I touched up some paint. The property manager handled the listing, showing, and background checks. The new tenants haven’t asked for anything since they moved in back in July.
We were not heavily impacted by the pandemic. We hadn’t realized it until the Spring, but nearly all our tenants work in health care, which is just an interesting coincidence. During 2020, we only had one tenant that we had to constantly keep up with regarding her employment and ability to pay rent. She didn’t always pay on time, but we would have all the month’s rent before the end of the month each time. Then we had a tenant here or there that needed another week or two to pay rent in full, which we had no problem allowing. We didn’t collect any late fees in 2020.
While a year of several big expenses can be overwhelming, it’s helpful to know that this has not been our norm and the issues were centralized to a few houses. It also helps that 5 of our houses have long term renters (renewed more than once). Having a tenant renew their lease saves us time and money.
I manage all the financials for my family. Mr. ODA makes the maneuvers, and I record them. Excel is where our organization lives and dies. Sure, I have a degree in Finance and Information Technology Management (i.e., Excel), but it doesn’t need to be complicated or difficult to make tax prep easy for you.
This level of organization allows us to do our own taxes. After the first year of purchasing rental properties, we thought we’d have to hire someone to do our taxes because it would be complicated. It’s not any different than filing your own personal taxes. The software systems available online walk you through the entire process. Each property’s income and expenses have to be entered separately, which is time consuming if you have several properties, but it isn’t difficult.
The most important thing to be ready for your taxes is to make it a whole year activity. If you record income and expenses as they occur, it’s less of a hurdle when the year is over. By recording the activity all year, it then becomes a verification process when the year is over, thereby reducing the possibility of missing something or recording something wrong.
At the beginning of each year, I create a projection of income and expenses, which helps Mr. ODA adjust his W2 tax bracket throughout the year so that we break as close to even or owe very little when it comes to tax filing. Let me dive into that aside quickly.
Go back to Mr. ODA’s tax posts:
– TAXES! Part 1 – What are Marginal Tax Brackets?
– TAXES! Part 2 – Is Your Bonus at Work “Really” taxed more?
Taxes Part 2 is what I’m particularly referring to, but you may need the lesson in Part 1 to know what that means. There are IRS penalties if you fail to pay your proper estimated tax (when you don’t pay enough taxes due for the year with your quarterly estimated tax payments, or through withholding, when required). Title 26 of the United States Code covers the penalties. Essentially, the IRS is saying, “You have to estimate your annual taxes owed, and you’re not allowed to only pay us taxes on April 15th every year, but you have to pay the taxes over the course of the year.” People get excited to receive a refund from their taxes, but really that’s just an interest-free loan you’ve given the government. Perhaps some people do need that forced savings, but wouldn’t it be nicer to have that extra money in your pocket throughout the year?
Back to the point…
I create a new workbook every year with each house having its own spreadsheet. Schedule E is going to require you to put your income and expenses, per property, not as a whole, so it’s important to have expenses assigned to a particular house. I set up each spreadsheet in an Excel workbook to identify all known costs for the coming year. Not all of these apply, but these are typically the categories of my known costs for each year: property management, HOA, utilities (City of Richmond bills the owner (not tenant) for sewer fees), property taxes, insurance, annual mortgage interest, cost basis depreciation, and prepaid points depreciation. There’s also a chance that you’re carrying appliance depreciation costs (meaning, the purchase of a washer, dryer, refrigerator, etc. aren’t recorded as an actual expense in the year purchased, but are required to be depreciated over its useful life).
As the year goes on, I record any mileage (record the actual miles along with the mileage cost) and maintenance costs. The IRS posts the standard mileage rate for each year here. If a roundtrip to a rental property is 40 miles, then the expense is calculated as 40 miles multiplied by the standard mileage rate, which is $0.56 for 2021. I’ve learned over the years that the software systems just request your miles and do the calculation for you (which is smart and safer on the calculation side), but we want to know what the calculation is going to be, so I enter it as $22.40 in my spreadsheet.
You’ll be expected to input the days your property was vacant, so record that once it’s known.
Each spreadsheet is linked to a master sheet at the beginning of the workbook that shows the net income and expenses for each property. The difference of these amounts are what Mr. ODA uses to adjust his W4 deductions.
I personally assign costs month by month so I can keep track of them, but it doesn’t even need to be that fancy. A running list of these expenses are enough.
The categories are based on what’s going to be requested through Schedule E.
Then in January/February of the following year, I go through my filing cabinet and my email to ensure I’ve captured all of the expenses that I have receipts for, and vice versa to ensure that if I’ve recorded an expense, I have a receipt for it. Having already captured the expenses throughout the year serves as ‘checks and balances’ and doesn’t make the task feel too overwhelming.