I grew up in property management. Even still, I cringe at the idea of bad tenants and bad investments.

I do not want to lose my ass.

I made a commitment to you to share everything I have learned as I research my real estate investments. Many people, like me, dive into real estate investing with mixed results because we did not fully develop a strategy and had so many conflicting messages about how to measure success.

While at Colorado State University, I developed a property management business plan for my capstone thesis. My final presentation was in front of five venture capitalists who appreciated my approach. That business is becoming wildly successful for the company I consulted while I earned a grade. However, my education did not truly start until I found my first tenants.

Believe me, my first tenants gave me a crash course on property management.

The first part of your business plan is to know your market.

In an earlier post I touched on the Denver Market “crunch” that we are experiencing.  I had wanted to downsize my house, without downgrading, and I am especially feeling the crunch.  Given that interest rate has increased, given closing costs, given capital gains tax (a future post), I really don’t come out ahead.  Plus, everything that I’ve been able to look at is not the quality I’d like in my downsize.

The second part of your business plan is to…

Know Your Value Proposition:

I was asked so many questions from my first tenants that I learned tons about my role and how to talk them through these issues without making their issues my issues.

As the questions kept rolling in, I had flashbacks to my experience as a Trust Advisor educating clients on legal guidelines as it pertains to their situation; explaining rules with your client’s interest in mind given that those documents were likely written and signed long before your client’s needs were in the picture.

Part of my legacy and a huge reason I call this blog “Sharing the Legacy,” are the business lessons I learned from my grandpa. My grandpa always helped his tenants out and in return, most tenants were good to my grandpa and his properties.

This idea drives me in my approach to every business and career venture I undertake.

The third part of your business plan is to…

Know Your Investment

In the last post, we covered three of the four main sources of income from owning this investment property.

1) Cash Flow
2) Depreciation
3) Amortization

Now, we’ve come to

4) Appreciation and capital gains.  Capital gains will get its own post soon.

You can take a deeper look at appreciation and your investment by looking at leverage.

Leverage

When you take a loan to purchase the property, the loan is collateralized with the asset and will give you a better interest rate. In addition, your investment is leveraged.

What does leverage mean? Well, this gets fun. I tried to explain it to my husband, and his eyes glazed over. I totally lost him. However, I did not draw a picture, so I am going to attempt to explain it to you but with visuals. Let’s say you purchased your property for $100,000. You put 10%, or $10,000 down payment and obtained a loan with a fixed interest rate of 4.5% for 30 years. You have now paid $10,000 for control of a $100,000 asset.

Now, your property has appreciated by 1%. You have a gain of $1,000 on your $10,000 investment which is a 10% return. I told you this gets fun.

Say your property appreciates by 5%. You’ve now gained $5,000 value on your $10,000 investment. A 50% return – very fun!

The one major caveat – if you personally pay the loan each month, then your returns diminish. However, real estate investing is a long-term plan, and it is feasible to ride out the remainder of your mortgage terms with a renter paying the mortgage.

Leverage is one reason not to pay down the mortgage.  This method is not a cash flow generator. If you only earn an extra $50 per month, that is still a positive cash flow! The benefit is from the tax shelter it creates (you will not deduct your principal payment but you will deduct many of your other expenses, including interest expense), and from the potential increase in capital.

Now there was a time in the not so distant past where there were three guarantees in life: death, taxes, and appreciation. We watched that bubble burst. We all felt the impact of it. And now we are all wearier to rest our hats on the idea that real estate will always increase in value.

Sad, but true.

Sad but, oh, so true.

In upcoming posts, I’m going to cover criteria you must check – often – to determine if your investment is working for you or if you need to sell. One of the biggest lessons entrepreneurs learn is how to let go and walk away when it simply isn’t working anymore.

I’m also getting the question my husband debates me on: so you have an extra $100 each month, now what!?!?!?

While residence duration increases with age, on average, people move every two to five years. So the probability is that you will lose money on your purchase. That, there, is my first gripe about purchasing real estate to live in, yourself. Extreme markets aside, it is usually not a good idea..

Why? There is a term in the finance world, “real estate rich, cash poor.” This means that things change, and we need a level of liquidity to be able to adjust. We get married; we get divorced. We have kids; we die. We change jobs. We adopt puppies. Putting all of your savings into a house is not an investment, it is not a retirement plan, and it certainly does not put food on the table when you’ve exhausted your income sources.

Unless, of course, that real estate is generating cash flow for you.

Getting Started

Purchasing real estate is one of the most complicated purchases you will ever make. Make sure you are working with a realtor and a lender who know their craft and focus on educating you through the process. If you plan on investing in real estate, add a CPA, attorney, and experienced property manager to your speed dial list.

Some things you will be able to do on your own as a new landlord and these two resources helped me tremendously.

For Rent – Generating interest for rent is easier than putting a sign on your doorstep. Try Zillow to list for free.

Background Checks – TransUnion has created a rental application, credit check and background check called My Smart Move.

Cash Flow

Let’s say you purchase an investment property. The price is $100,000. You pay $10,000 as down payment and obtain a 30 year fixed loan for 4.5% for the remaining $90,000. Heads up, I am going to use this assumption throughout my property management series.

General rule of thumb is that rent price is 1% of your purchase price. One percent of $100,000 is $1,000.

You get a tenant – great! You are earning $1,000 per month – even better! Cash flow is simple to measure. Rent comes in, and payments go out, what is left over is cash in your pocket. All this tells you, however, is whether or not you have positive cash flow – your number one metric when you evaluate your investment.

If, in the following month, you have to fix a broken furnace for $200, your cash flow may be a negative $150 for the month. As a side, you can not tap into the security deposit if you have added expenses. The security deposit is not yours, and you are merely holding it in case the tenants default on their lease. You will want to build up an emergency fund to carry you if you have emergency repairs or vacancies, and if you are not there yet, you’ll have to tap into your savings.

Positive cash flow is your number one metric when you evaluate your investment. However, if you dig a little deeper, you can use this analysis to optimize your investment and plan for anything that comes up – like, repairs and vacancies.

Tax Statement

Your Taxes are calculated from your operating income on your Income Statement. You will start with your rent income for the year, $1,000 * 12. You will deduct your interest paid, management fee, and property taxes – these are considered operating expenses. You will subtract any capital improvements you make to the property as well as repairs and supplies.

What’s the difference between repairs and capital improvements?  For example, if you paint the walls or fix a toilet, this is considered repairs and supplies and is deducted as an expense. If, for instance, you purchase new windows for $2,000, this is a capital improvement because it increases the value and the life of the property. You can depreciate capital improvements.

Last, depreciation. You are allowed to deduct depreciation expense on your investment property. Land is not considered a depreciable asset since land does not wear out, so you will subtract the value of the land from the purchase price. I am assuming that 10% of the value of the property is for land and I will depreciate the value of the property, $90,000, on a straight-line basis for 27.5 years since it is a residential property.

Once you have taken all of your deductions, your Net Taxable Amount is the amount from which you will calculate your taxes due. A loss on your net taxable amount is a good thing! No taxes are due! You will want to be in the red, but as close to zero as possible since there is no additional benefit below zero.

Because every line item on this income statement is somewhat predictable, I also use it to plan my budget for capital improvements and repairs. Based on Year 1, I know that I will have roughly $1,250 to spend in order to maximize my tax benefit.

Statement of Cash Flow

When making decisions on things as whether to hire out property management or replace a piece of crap sliding glass door, you will also want a deeper look at your cash flow. The Statement of Cash Flow breaks down your activities into Operating, Investing and Financing activities for the period (month, quarter, year).

For example, your mortgage payment may be further broken down into principal, interest, and escrow accounts. Interest, tax, and PMI escrows are considered operating costs. These are the costs of doing business. The principal payment, on the other hand, is a financing activity as it is paying down the loan you took out to purchase the asset.

My Statement of Cash Flow looks like this. It tells me I have a positive cash flow – number 1 metric. I also have a negative net income, so I have optimized my tax benefit creating additional cash flow. Also, my mortgage has been paid down. By this analysis, I know that I have hit three of the four primary sources of income from owning this investment property. 1) Cash Flow, 2) Depreciation, 3) Amortization (mortgage principal is paid down). The last – and, I will tackle this topic in my next post – is 4) Appreciation and capital gains.

With a few extra dollars in my pocket from my investment properties, I now have a foundation for my argument with my husband whether to pay down the mortgage or invest. Because I know where my cash flow is going, and I can plan and prepare for my expenses. However, there is still work to be done. Also, I will share it with you.