Online real estate gurus boast about adding rental property as a ‘side hustle’ to produce monthly passive cashflow. In real life this is often harder to achieve than advertised. First off you must know where you are in the your investment lifecycle. If you are in the accumulation phase of investing, its likely that most of the income will be redirected to the property’s carrying cost. One of the attributes often cited in the real estate vs stock debate is the ease of using leverage. Buying rentals with leverage at the higher LTV ratios most folks elect will not allow you to pull any significant cashflow from the property based on current cap rates in most markets in 2020. You’ll be lucky to make $100 – $200/month on an average SFH rental in most markets and that’s actually generous. However, during the accumulation phase, that’s just fine as your equity is growing every month as the tenants pay for the rental and it appreciates, hopefully. As you get further into your investing career, the spread between the growing rental price and fixed mortgage should allow for more cashflow. Even further down the line, free and clear properties will add significantly to the monthly cashflow. But how do you ensure a regular monthly payment from your rental pension plan?
It’s all in the numbers. You’ll need to use a good property ‘proforma’ tool or spreadsheet and create a full outlay of income and expenses. Hopefully you’ll have some historical information on the properties to make these numbers as accurate as possible. There are multiple ways to set this up, but let me provide my method.
First, you’ll need to determine the expected cashflow from your portfolio based on the calculations above. Move those dollars from your rental property account to your personal account automatically, monthly as an owner’s distribution. Read ‘Profit First’ by Mike Michalowicz for more information on the importance of paying yourself first.
Secondly, you’ll need a reserves account for those unexpected large ticket items like a plumbing leak in a cracked slab or a hot water heater explosion. This account also holds expected cap ex expenditures like a new roof. You’ve planned for these expenses in your initial calculations. There is money flowing into this account each month to keep it full in case of a large expense. Replacing a roof shouldn’t reduce your cash flow if planned out accordingly. You may need to fund this account with a starting balance initially, again refer back to the math. The Covid-19 pandemic has shed light on the importance of reserves. Most advocate at least 6 months of all property expenses including mortgage payment. This amount can be adapted based on the number of properties you have but this is the location to keep those funds. I’d suggest keeping the reserves in an interest bearing account with low risk of volatility.
Lastly, the money in the account after you’ve paid yourself and skimmed some off for reserves should be enough to cover ongoing expected expenses such as property management, routine cleaning and maintenance, taxes, insurance, debt service, etc. This is your operating account. If the account gets low and you find yourself having to move money back in, owner contribution, you’ve made some errors in your initial calculations.
This will not be a set it and forget it situation. You’ll need to review the numbers quarterly at first and make any needed adjustments but as time passes and the calculations prove accurate, your hands off rental pension plan can truly be a passive income stream as promised by so many.