Cash Flow Adjustments For Modeling/Sim

[matchewed]

Just a breakout from the other topic.

So this is a question for you veteran landlords, or anyone else who wants to jump in; how much do you adjust your on paper cash flow for modeling/prediction purposes? I know that each circumstance will be wildly different but is there a rough rule of thumb you'd use or a flat percentage cut that you'd use to simulate the inevitable valleys of cash flow?

[SwordGuy]

I think I understand what you are asking.

If so, for example, you're swimming along collecting rent when a $5000 HVAC unit needs to be installed. 
Or the place is vacant so there's no rent coming in?

So your cashflow drops.

Is that correct?

If it is, I don't forecast that at all.

Instead, I make my best estimate of what percentage of each year the place will be vacant and subtract that % (and associated costs) from the estimated gross rent.

I do the same thing for repairs.  I make my best estimate of what repair costs will be on average and subtract that from the estimated gross rent.

Example:

I think the place will be absent 6% of the time each year.   Each time it's rented the property management company charges an extra $89.  Gross rents are $820 a month.

12 months * $820 a month equals $9,840 gross annual rent. 

6% vacancy rate * $9,840 = $590.40 annual rent lost to vacancy.  Add $89 to that amount and we're up to $679.40.  That works out to $56.62 of rent lost each month to vacancy costs.

I plan for $820 - $56.62 or $763.38 in monthly rents.   If I take in more this month because it's rented, I know I'll take in less some month in the future and it will all wash out.  Unless, of course, I happens before I build up a reserve to cover it by setting aside that $56.62 enough months in a row to cover future expenses when the place isn't rented out.  Moral: have some reserves when you're starting out.  You'll need them.

For maintenance expenses, I know that HVAC systems have a given lifespan.  I need to start setting aside some money to replace it in the future.   

Let's say the one I have would cost $5000 to replace and can be expected to last another 15 years.  That would be $5000 / (12 months * 15 years) or $27.78 a month.   I could set aside $27.78 a month to replace it in the future.  The problem is that inflation will make that unit cost more than $5,000 ten to twenty years from now.  So, since I know I'll raise rents to cover inflation, I'll index the replacement cost to the rent.  $27.78 is 3.4% of the rent.  If I set aside 3.4% of gross rents each month I can expect to be able to cover the cost of a new HVAC.   Again, I'll want some cash reserves to cover an early replacement need.

The roof, water heater, plumbing fixtures, carpet, flooring, paint, etc. all have estimated lifespans and costs and can be set aside in the same way.

As long as I have enough reserves to handle some early dammit repairs all should work out for the best.

Hope that helps.

And if someone has a better idea, let me know!

[matchewed]

Less unanticipated expenses more instability in how much you can charge for rent in your market.

[bobechs]

Less unanticipated expenses more instability in how much you can charge for rent in your market.

What do those words mean, in that particular order?  Or any particular order?

[Another Reader]

I think this is a breakout from the 4 percent rule for real estate discussion.

Back in the late 1980's and early 1990's, when Really Big and Complicated Discounted Cash Flow spreadsheets became popular, appraisers and real estate analysts used programs such as Pro-ject and Office to model cash flows from large shopping centers, Manhattan office buildings, 500 unit apartment complexes, and the like.  Discounted cash flow was touted as a more "accurate" way to estimate value than direct capitalization, because of the explicitly projected cash flows. 

The models were very precise, but users noticed immediately that small changes in the growth rates of income and expenses produces very different values.  Lots of banks and syndication investors lost a lot of money when the models were tweaked to benefit the borrowers and the syndicators.  Watching that blow up substantially lessened my reliance on explicit net real estate income projections over long periods of time.

The 4 percent rule for paper assets is derived from various combinations of what actually happened in the paper asset markets over their histories, or at least their more recent histories with organized markets and exchanges.  There is no corresponding data set for real estate income. There is is some fairly generic (and often inaccurate) rent information out there.  Cap rates, gross rent multipliers, and discount rates vary over time, depending on the strength of the real estate market and competing investments.  Expenses ebb and flow to some extent as well.  Since market value is a snapshot on a particular date, you can use market conditions as of that date with some confidence to estimate value, if you do your homework.  However, good luck modeling future cash flows accurately with the available information.

Yet, with all that uncertainty, investors are out buying real estate.  Are we all stupid, taking on unmeasurable risks?  My theory is that most successful small investors are practical, rule of thumb people that rely on relatively recent (i.e. the last 5, 10 or 15 years) trends to make decisions.  The rental market in 1950 is not particularly relevant to them today.  They are more business people than they are passive investors.  They project out maybe 5 or 10 years, but don't bother beyond that.  Projecting cash flow out 20 years is not possible, except maybe to guess current trends continue, more or less. 

So, how does one "model" real estate income for a 40 year plus retirement?  I don't have a good answer for that.  Investment real estate is a business, not a collection of passively owned assets, and business conditions change dramatically over time, often over very short periods.  I don't think any of the retirement income calculators model business income, at least not the ones I looked at.  If someone has a good answer, I'm all ears.

[Jim2001]

Following.

[matchewed]

Less unanticipated expenses more instability in how much you can charge for rent in your market.

What do those words mean, in that particular order?  Or any particular order?

It was in response to SwordGuy. Basically shorthand for "I'm not asking about unanticipated expenses. I am asking about over long periods of time how do you anticipate/model variable cash flow due to your rents not increasing in line with inflation during certain periods." This was mostly in response to this post from Rebs.

[totoro]

I don't model based on rents keeping up with inflation. I know that our equity will increase due to mortgage pay down and we are in a hcol market with a historical rate of home appreciation of 4 percent.  Later we will either refinance and invest or sell some units when the market is up and other income low. If we want to travel extensively we will rent our primary residence out to do so.  I expect at some point later in life we just won't want to be landlords anymore. Even after capital gains tax we should be good.

[Blindsquirrel]

   Totoro, watch out for recapture of depreciation, when you sell investment RE outside of a 1031, every penny taken in depreciation gets added back to sale price.

[hoping2retire35]

what if instead of thinking in terms of cash flow consider all the things that could go wrong on each unit and its associated costs all added up for each one. so like

HVAC; $5000
ROOF; $4000
New Appliances: $2000
Basic remodel and flooring; $4000
insurance covers catastrophic things

whatever. just figure out all the things that could go wrong X each unit and have that total saved in liquid assests before you retire. As to the inflation and slow decline of cash flow; you would just have to pay attention and react when the time comes.

Would that work?

[totoro]

   Totoro, watch out for recapture of depreciation, when you sell investment RE outside of a 1031, every penny taken in depreciation gets added back to sale price.

I'm in Canada and things are a bit different - like no 1031.  My primary residence with rental income is tax exempt on sale but I can't claim depreciation along the way.  I'm self-employed so I've chosen to take a lower earned income and not claim the depreciation so, to date, there will be no recapture.   This will occur a bit later.