Treat Real Estate Investments Like A 401(k) Plan
Posted on December 29, 2006
Many new real estate investors doom their success right from the beginning because they fail to segregate investment funds from their other income. When rental income is co-mingled with earned income two things happen and both are bad. First, if the rental properties generate excess cash, it often gets spent rather than being used to build cash reserves or to reinvest and second, if properties that we call “alligators” produce negative cash flows, they can gradually eat up chunks of your earned income and either lower your standard of living or cause your credit card or other consumer debts to grow.
The income from rental properties should be enough to pay all current expenses including mortgage payments, plus produce enough extra cash to set aside a reserve to pay for replacing carpets, painting, new roofs, heat and air conditioning units and other deferred maintenance expenses that only come due periodically. Even if a property is brand new, the useful life of these items begins to decline the moment the first tenant moves in. For example, if carpets have a 5-10 year life, unless you are setting aside ten to twenty percent of the replacement cost each year, you may not have the funds available when it has to be replaced.
The wearing out of items like carpets, paint, appliances, roofs, heat and air conditioning systems, and other major expenses is referred to as deferred maintenance. Although the actual expenses may be deferred for years before they have to be paid, a portion of them are occurring each year. Unless you plan for these expenses and set aside money to cover them when they come due, you are setting yourself up for disaster.
When evaluating potential purchases, you should pay careful attention to these deferred maintenance items. If a roof has a life expectancy of 20 years and the one on a property being inspected is 10 years old, then you will need to reserve twice as much annually to cover the cost of re-roofing as you would if it was new. This same principal applies to all other deferred maintenance items.
Often new investors will purchase properties in relatively good condition, earn rents that seem to produce nice positive cash flows and then spend the excess cash only to find that five to ten years later, they are facing huge repair bills and don’t have the money to pay them. Without making the repairs, it can cause the quality of tenants to decline, rents to go down and vacancies to increase dramatically. As a result property values decline and other more experienced investors with cash reserves are able to step in and buy these properties at a steal. I have personally bought many investment properties in exactly this manner.
The real estate boom of the past few years is coming to a screeching halt and 2007 is going to bring a period when over-building; higher interest rates and reluctant buyers will cause prices to fall and produce some great deals for professional investors. The key to capitalizing on this phenomenon is to treat real estate investments like you would a 401-K retirement plan. Buy properties, build cash reserves and let the investments grow and mature.
Here’s a tip! Set up a separate investment account even before you buy your first property. You can make regular deposits to this account to start building cash reserves that will be in place when you make that first purchase. Don’t buy properties unless, after allowing for reasonable vacancies, the rents will produce enough income to pay current operating expenses, mortgage payments and have enough left over to set up a reserve for deferred maintenance. Put all income into the investment account, pay all bills from it and let the excess cash accumulate in the account. Over time, increasing rents and declining mortgages will increase the amounts of cash that builds up monthly in the account.
If you live off the income from a job and treat this investment account like you would a 401-K or other retirement account you will be surprised at how fast your assets will grow. As inflation increases the value of your properties and the rental income from tenants is used to pay down the mortgages, your net worth grows. By being patient and acquiring just one property a year, it won’t take long for your net worth to top a million dollars and the cash flow from your investments to enable you to retire. Granted, the more years you have for your investments to grow the more income you will have in retirement. For those of you who feel time is running out, look at it this way; if you only have a year or two before you plan to retire, the income from just one rental property is better than the income from no rental properties.
The next few years are going to bring extraordinary opportunities for people to improve their lives by investing in rental real estate. The way to capitalize on these opportunities is by keeping your investment funds segregated from your earnings and allowing them to build true wealth. The lack of patience is what keeps most ordinary working people from doing this.
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