Author Topic: How to count rental income  (Read 3402 times)

jnc

  • 5 O'Clock Shadow
  • *
  • Posts: 93
How to count rental income
« on: September 09, 2014, 04:49:56 AM »
Hello,
New mustachian on this forum here. I have read the reader case studies and I had a question as to how to account for rental properties in the calculations towards your FI goal. The case studies seemed to take the balance sheet approach with regards to property, i.e. list the asset (the value of the property) minus the liability (outstanding mortgage) and consider that the net asset.

If I have a cash flow positive rental property, that approach doesn't seem to match as I am not looking to sell the property and invest the net asset. Instead i'd like to keep it for the positive cash flow.

My approach is to leave it off the "balance sheet", calculate the SWR based on the other assets and then add the cash flow on top of the monthly amount that I get from the SWR?

Do you think this approach is flawed? Other thoughts?
Thanks!
- jnc

frugaliknowit

  • Handlebar Stache
  • *****
  • Posts: 1662
Re: How to count rental income
« Reply #1 on: September 09, 2014, 06:49:24 AM »
Adding "cashflow" instead of net income is flawed.  Much of the expenses with rental properties are uneven capital improvements over time (replacing roofs, furnaces, and expensive infrastructure) and vacancy allowance.  You need to have a good grasp of the property's expenses in order to produce an accurate income statement.

jnc

  • 5 O'Clock Shadow
  • *
  • Posts: 93
Re: How to count rental income
« Reply #2 on: September 09, 2014, 07:22:01 AM »
You're right in that expenses cannot be predicted accurately but I was planning to go with averages and deduct some reasonable amounts for vacancy, maintenance, etc...

What is your suggestion instead? Not sure I got it.

Thanks for the response. Appreciated.

MarciaB

  • Bristles
  • ***
  • Posts: 481
  • Age: 58
  • Location: Oregon
Re: How to count rental income
« Reply #3 on: September 09, 2014, 07:32:18 AM »
My approach is to leave it off the "balance sheet", calculate the SWR based on the other assets and then add the cash flow on top of the monthly amount that I get from the SWR?

I think you're doing this correctly, but as frugaliknowit rightly says, you've got to properly allow for all those expenses on the rentals.

From what I have been reading, the rule of thumb is that about 50% of gross rents will go (over time, not necessarily in every year) towards insurance/taxes/replacements/vacancy/maintenance/etc.

So - I would do what you're doing - that is 1) take the SWR from the other assets on the balance sheet, then 2) add 50% of gross rents to that.

And then of course if you've got a mortgage you need to do a 3) and subtract those payments. The 50% rule of thumb here doesn't include the financing arrangement(s).

I'm doing this very thing myself. For me the difficulty was trying to figure out how to put the property onto my balance sheet...what value would I put on it? The appraised value from 10 years ago? Some multiple of the purchase price? The taxed value from the property tax statement? What I know for certain is the cash flow coming off the property, so I go with that (well, 50% of that).

johnhenry

  • Bristles
  • ***
  • Posts: 304
  • Age: 39
  • Location: Midwest
Re: How to count rental income
« Reply #4 on: September 09, 2014, 07:44:27 AM »
I agree that if your goal is to calculate/estimate a net worth necessary to produce a SWR of a certain amount, it may make things clearer to basically have 2 balance sheets.  One for person assets, one for business/rental assets.  When I produce balance sheets, I like to see them separately and combined.

As you point out, like any business, a real estate rental business can produce a wide range of cash flows and returns, from year to year, based on the expenses and capital improvements required.  But then again, personal assets invested in an aggressive mix of index funds are volatile as well.  Of course, as retirement nears, the goal is to minimize volatility somewhat.

If I were to undertake this task of conservatively estimating cash flow available to fund living expenses in retirement, I would basically treat all business-related accounts (assets, mortgages, working capital accounts) as business assets that were not part of my personal SWR calculation.  Using averages and estimates of expenses and capital improvements, then calculate how much equity can be safely withdrawn from that business each year to fund living expenses.  Basically, you calculate/estimate a separate SWR for your rental business and add it to the SWR estimate from your personal assets.

Hope that helps.

jnc

  • 5 O'Clock Shadow
  • *
  • Posts: 93
Re: How to count rental income
« Reply #5 on: September 09, 2014, 07:58:33 AM »
My approach is to leave it off the "balance sheet", calculate the SWR based on the other assets and then add the cash flow on top of the monthly amount that I get from the SWR?

I think you're doing this correctly, but as frugaliknowit rightly says, you've got to properly allow for all those expenses on the rentals.

From what I have been reading, the rule of thumb is that about 50% of gross rents will go (over time, not necessarily in every year) towards insurance/taxes/replacements/vacancy/maintenance/etc.

So - I would do what you're doing - that is 1) take the SWR from the other assets on the balance sheet, then 2) add 50% of gross rents to that.

And then of course if you've got a mortgage you need to do a 3) and subtract those payments. The 50% rule of thumb here doesn't include the financing arrangement(s).

I'm doing this very thing myself. For me the difficulty was trying to figure out how to put the property onto my balance sheet...what value would I put on it? The appraised value from 10 years ago? Some multiple of the purchase price? The taxed value from the property tax statement? What I know for certain is the cash flow coming off the property, so I go with that (well, 50% of that).

Thanks Marcia! That is helpful.

Yeah I definitely found it weird to put it in the balance sheet since I am not planning to sell the property, nor am I planning to take out any equity I might have in it. Like JohnHenry suggested, I think it makes most sense to consider these as business assets and separately from my personal assets.

Thank you for the 50% rule of thumb. Was not aware of that. My properties in the Memphis area rent for around 700-725$/mo and after expenses including mortgage, property tax, insurance and even property management yield about $300/mo cash flow. I will factor in an 8% vacancy (which seems pretty standard in these sorts of calculations) and a reasonable amount for maintenance and consider that my net income from the property.

jnc

  • 5 O'Clock Shadow
  • *
  • Posts: 93
Re: How to count rental income
« Reply #6 on: September 09, 2014, 07:59:32 AM »
I agree that if your goal is to calculate/estimate a net worth necessary to produce a SWR of a certain amount, it may make things clearer to basically have 2 balance sheets.  One for person assets, one for business/rental assets.  When I produce balance sheets, I like to see them separately and combined.

As you point out, like any business, a real estate rental business can produce a wide range of cash flows and returns, from year to year, based on the expenses and capital improvements required.  But then again, personal assets invested in an aggressive mix of index funds are volatile as well.  Of course, as retirement nears, the goal is to minimize volatility somewhat.

If I were to undertake this task of conservatively estimating cash flow available to fund living expenses in retirement, I would basically treat all business-related accounts (assets, mortgages, working capital accounts) as business assets that were not part of my personal SWR calculation.  Using averages and estimates of expenses and capital improvements, then calculate how much equity can be safely withdrawn from that business each year to fund living expenses.  Basically, you calculate/estimate a separate SWR for your rental business and add it to the SWR estimate from your personal assets.

Hope that helps.

Thank you JohnHenry. That is a really good way of thinking about it. I will heed your suggestion :)

- jnc

MarciaB

  • Bristles
  • ***
  • Posts: 481
  • Age: 58
  • Location: Oregon
Re: How to count rental income
« Reply #7 on: September 09, 2014, 08:09:38 AM »
If you spend some time on the Landlording forum here, and other blogs/forums out there in internet land, you'll encounter the 50% rule of thumb and a number of other general rules to go by.

BiggerPockets.com is one of those, and there are others. Poking around was helpful to me.

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 27892
  • Age: -999
  • Location: Traveling the World
Re: How to count rental income
« Reply #8 on: September 09, 2014, 01:07:54 PM »
So you definitely should count it in net worth as asset value minus liability (mortgage).

For FIRE calculation purposes, here's what I'd do:
1) Calculate what you will net on it, on average, after all expenses (including setting aside money for vacancy and capital expenditures).  Keep a healthy reserve fund to deal with those things.
2) Subtract your net rental income from your FIRE budget.

The number that is left is your expenses not covered by your rental income.  The amount you need to save in your investment portfolio is 25x (at a 4% SWR) that number.

Your rental value, while calculated in your net worth, is not a part of your investment portfolio, so its value won't affect that number you need for a 4% SWR.

So, as an example, I'll make up some numbers.

Let's say you have a rental that nets you $12,000 annually after all expenses, paying the mortgage, and setting aside for reserves (say it actually nets you 17000 in a year with little expenses and no vacancy, and you set aside 5k, that nets you 12).  Let's say your FIRE budget is 35k, and your net worth is 600,000, of which 200,000 is your rental and 400k is invested in the market.

Your budget of 35k - 12k net rental income = 23k you need to cover with withdrawals from a portfolio.  25x 23k = 575000.  You only have 400k in your portfolio (your net worth minus the value of the rental), so you need to get another 175k to be FI.

Did that make sense? :)
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

jnc

  • 5 O'Clock Shadow
  • *
  • Posts: 93
Re: How to count rental income
« Reply #9 on: September 09, 2014, 01:27:15 PM »
So you definitely should count it in net worth as asset value minus liability (mortgage).

For FIRE calculation purposes, here's what I'd do:
1) Calculate what you will net on it, on average, after all expenses (including setting aside money for vacancy and capital expenditures).  Keep a healthy reserve fund to deal with those things.
2) Subtract your net rental income from your FIRE budget.

The number that is left is your expenses not covered by your rental income.  The amount you need to save in your investment portfolio is 25x (at a 4% SWR) that number.

Your rental value, while calculated in your net worth, is not a part of your investment portfolio, so its value won't affect that number you need for a 4% SWR.

So, as an example, I'll make up some numbers.

Let's say you have a rental that nets you $12,000 annually after all expenses, paying the mortgage, and setting aside for reserves (say it actually nets you 17000 in a year with little expenses and no vacancy, and you set aside 5k, that nets you 12).  Let's say your FIRE budget is 35k, and your net worth is 600,000, of which 200,000 is your rental and 400k is invested in the market.

Your budget of 35k - 12k net rental income = 23k you need to cover with withdrawals from a portfolio.  25x 23k = 575000.  You only have 400k in your portfolio (your net worth minus the value of the rental), so you need to get another 175k to be FI.

Did that make sense? :)

Yes, makes sense. Thank you for your response. Though in order to prevent mistakes of double counting the value from the rental (i.e. first for the net rental income and then incorporating it again when calculating the SWR), I am going to track the rental in a separate sheet in my spreadsheet.

It does amount to exactly the same though. Thanks very much for chiming in.
- jnc

Thanks again!

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 27892
  • Age: -999
  • Location: Traveling the World
Re: How to count rental income
« Reply #10 on: September 09, 2014, 01:37:48 PM »
That's fine, track in the way that works best for you.

I think the simplest explanation is: Your investment portfolio (what's invested in your AA, which does not count rental equity) must cover at a 4% SWR your FIRE Expenses minus net rental income.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.