Investment Property Business Life Cycle
Like all businesses, a rental property has a life cycle that investors can plan for or ignore at their own peril. Proper planning and execution start at day one and must continue throughout the duration of the investment. This article outlines a framework that an investor seeking passive income can follow to build an investment real estate portfolio that will continue to provide reliable cash flow year in and year out. The different real estate strategies for making money range from fix and flip to buy, rent and hold with a myriad of modifications in between. Tim and Tracey do not engage in house flipping and therefore, have no expertise in that discipline.
Tim and Tracey define passive income as money generated from minimal day to day effort and time. Don’t confuse our definition of passive with the IRS definition of passive. The tax code considers rental property an active investment provided that the investor participates in the major decisions related to the rental property. This type of money generation requires patience and discipline. An investor will not get rich quick following this strategy but will build passive income over time while managing risk.
Successful investing always starts with the initial asset purchase. Annual rent that considers a realistic vacancy rate should provide positive cash flow after paying for financing (a mortgage in most cases), property management fees (a passive investment), insurance, taxes, repairs, and maintenance. If the property’s expenses exceed the property’s revenue, then you are using your wages from your job to subsidize your “passive investment” and reducing your disposable income versus increasing it. In other words, the new investment will make your financial life harder instead of easier. The goal for most investors is to generate money so that they can eventually buy more freedom and time.
In the early years of all successful businesses, cash flow generated from the business is reinvested in the business to achieve self-sustaining scale. The same goes for an investment real estate portfolio. The initial positive cash flow should be plowed back into the property in the form of maintenance reserves and paying off the financing as needed to provide a financial cushion should the real estate market turn south. There are some that argue reducing your leverage will hamper or delay the growth of your portfolio and result in paying more taxes than necessary. Tim and Tracey have helped many over-leveraged people that have been burned by making financial decisions focused on reducing taxes versus managing risk. Once the first investment has the needed maintenance reserves and appropriate leverage, then the investor can and should look for new opportunities. The process can be accelerated by injecting new capital into your investment real estate business as part of your overall investment strategy. Tim and Tracey spent the first twenty years using the positive cash flow and providing fresh capital from their earnings to increase their real estate portfolio.
The real estate investor may want to put their investment real estate property in one or more limited liability corporations (LLCs) to:
- Shield their other assets from the legal liability associated with accidents at the rental properties.
- Run their portfolio as a business versus just a hobby.
- Separate their real estate business accounting from their personal finances.
- Expense items from business revenue you cannot write off in a personal tax return.
Like all businesses and investments, your real estate business should provide revenue growth that supports your financial objectives. First and foremost, investment real estate is a natural hedge against inflation since the monthly cost of housing is a major percentage of a household’s monthly expenses and influences inflation. Rent increases will typically mirror the local inflation rate. The positive cash flow from the LLC can:
- Build reserves for future repairs and remodels.
- Finance additional real estate acquisitions.
- Pay owners (you) as dividends.
If the business is throwing off more cash (desired outcome) than you can effectively invest back into the business, then pay a dividend and either deploy the cash in an investment that generates better returns or enjoy spending it.
One error that some real estate investors make is failing to recognize, acknowledge, and resolve negative cash flow from a rental property that has little upside. Some revenue shortfalls can and should be resolved by pulling cash out through a refinance to pay for a remodel that will generate sufficient cash flow. If refinancing and remodeling does not solve the negative cash flow problem, then the real estate investor should sell the property and deploy the funds in an investment that has a higher probability of providing positive returns. Stott Property Management, LLC manages several undercapitalized rental properties that attract problem tenants and generate poor cash flow. The owners cannot afford to make the necessary repairs to attract better tenants and the resulting negative business cycle creates financial and sometimes personal distress. In some cases, owners hold on because they do not want to pay capital gains taxes. If that is the case, then conduct a 1031 exchange. Do not suffer negative cash flow over an extended time for tax reasons. It just does not make sense.
Real estate investing is no different from any other business. Try to keep emotions out of the equation since both excessive optimism and despair can lead to poor financial decisions and distress. Successful businesspeople seek long-term growth while managing risks.