Rental Property Café™: Episode 12: Cash Flow Per Door and the Impact of Rising Rates

In this episode, Cynthia Meyer and Veronica Woods tackle the impact of rising mortgage rates on cash flow per door. Are good deals still available? How can real estate investors adapt to rising rates?

In this episode of the Rental Property Café Video Podcast they cover:

Takeaway Quotes:

“Changing [interest] rates are a fact of business of being a real estate investor.” - Cynthia Meyer

“Each segment of the rental market kind of has different dynamics to consider and as long as you're solving the problem, we know interest rates are going, inflation's going, I think there's still room to play.” - Veronica Woods

Resources: 

Mortgage comparison at different rates  [00:10:51]:  https://ffcalcs.com/5obgYR

About the Rental Property Café™: 

The Rental Property Café™ video podcast offers a real estate tool kit for busy professionals who are building a real estate portfolio. In each episode, co-hosts Cynthia Meyer & Veronica Woods explore ways to grow a successful real estate business while growing your career.

About Cynthia Meyer

Cynthia Meyer is a financial mentor, CERTIFIED FINANCIAL PLANNER™, CFA® Charterholder, real estate investor, blogger, and the founder of Real Life Planning. She offers unbiased financial planning and learning resources to real estate investors. Cynthia is a first-generation rental property owner, who built a rental property portfolio with her husband, Steve, while they were both building their careers. She lives in NJ, where she balances teenagers, her financial planning practice, and a rental property business.

About Veronica Woods

 Veronica Woods of Daniel Woods Real Estate, real estate advisor and investor, is passionate about helping her clients create wealth, legacy, and lifestyle through real estate. She works with people to buy, sell, rent, and develop residential and small commercial real estate in Delaware County and Philadelphia, PA. An MBA in finance from the Wharton School, Veronica also shares her real estate wisdom with new investors on her YouTube channel. 

Connect with Cynthia Meyer:

• Cynthia on Facebook
• Cynthia on LinkedIn 
• Cynthia on Twitter 
• Cynthia on Instagram 
• Cynthia on Pinterest 
• Email: cynthia@reallifeplanning.com  

Connect with Veronica Woods of Daniel Woods Real Estate:

• Veronica Woods - Let's Connect

Transcript -  Rental Property Café™ - Episode 12

[00:00:00] Cynthia: How can you figure out what your real cash flow per door will be and what the impact of financing is in this wacky real estate market that we're in right now? Hi, I'm Cynthia Meyer with Real Life Planning.

[00:00:15] Veronica: Hi, I'm Veronica Woods with Daniel Woods Real Estate.

[00:00:31] Cynthia: And this is episode 12 of the Rental Property Café™.

Today, we'll be talking about cash flow per door, the impact of financing, and the effect of the other things happening in this market. Low inventory, for example, impacts how we calculate cash flow per door. And Veronica and I have been having this conversation behind the scenes regarding what we're seeing with our clients today.

Tell me a little bit more or explain to our listeners, Veronica, what are some of the things we've been talking about?

[00:01:02] Veronica: One thing we've been talking about is everybody thinks it's tougher to get the cash flow number per door. Maybe they were looking at five years ago, wondering, does it still make sense to move forward with the investment if that number is smaller than they were hoping their spreadsheet would show?

[00:01:22] Cynthia: We can get anchored to a previous price. We all remember what it was like to have a 2.75 or a 3% mortgage or even a throw a 3.25% mortgage for an investment property. It's easy to get stuck on that.

[00:01:35] Veronica: I tell people it's not 2018. This is the environment now. I think it's imperative that we get into some details of evaluating the investment for where we are now. The best you can do is figure out the numbers the way they are now.

[00:01:55] Cynthia: That's real estate mindfulness. This is number two in the series we wanted to create about running your numbers. In the last episode 11, we talked about the 1% rule, and does that still work, and when it might be valuable in the real estate process? We're noodling on it all the time. We want to talk today about how much this matters. When we have our weekly conversations, we discuss the fundamental trade-off between appreciation and cash flow. I like to say that cash flow is the cake, and appreciation is the frosting. You don't just eat frosting. But we don't always agree on that.

[00:02:32] Veronica: I'm a finance person by nature. I do think that it can't start and end with cash flow. There are other benefits to real estate investing.

[00:02:42] Cynthia: How much does this matter? The whole trade-off between appreciation cash flow.

[00:02:46] Veronica: Let's say you have two potential investments. One has more cash flow, but one has more growth potential. There is appreciation 10% a year. You see economic development. I will not tell someone to pick the one with the higher cash flow. Although some people, this being a strict interpretation of cash flow, is king, they'll go after the one with the highest cash flow. But if you're looking over the long-term investment horizon. That may not be the best solution.

[00:03:19] Cynthia: We must connect it back to our goals. Ideally, there's a balance between appreciation and cash flow. That you have a little bit of both, it's not one or the other. But depending on the market that somebody is looking in, connecting it back to, do they need to live off this money or are they trying to grow and scale it into a portfolio? Are they looking to do a BRRRR strategy by rehab, rent, refinance, repeat? They're looking to build equity and then take equity out of the property for the next deal. The most important thing, and tell me if you agree, is that we can't be cash-flow negative. You at least have to be cash flow neutral, even if you're an appreciation investor. Real estate has carrying costs, and you don't want to have money out the door against your monthly savings to maintain a property. That's my point of view. Anyway.

[00:04:08] Veronica: I agree with that. But I think it's hard to make that decision in isolation without understanding where you are with your financial portfolio and without getting too speculative. That's the risk when people are betting purely on the appreciation. It's less fundamentals. It's more this kind of like going to Atlantic City gambling. I don't think that's real estate investing.

[00:04:34] Cynthia: Sometimes people look in the rearview mirror, especially if they're in markets like the San Francisco Bay Area or Austin, Texas, for example, where the value of just regular old homes are just skyrocketing. It seems like a combination of demand from new household formations—the demand from people who are looking to relocate from different states.  And the demand from investors. Investors with cash. You took profits from other deals in a 1031 exchange and are looking to make a firm offer. There's a lot of demand for properties, pushing our prices. It makes it harder to find that good cash flow positive deal, but it's still there. I see people doing it every day.

[00:05:18] Veronica: But I think it is shrinking with the go-to metrics.

[00:05:24] Cynthia: Although I prefer cash flow in my personal real estate investing, I encourage clients to make sure they do not lose money monthly on a rental property.

If you overemphasize cash flow, it could steer an investor towards a C or a D property that might not be consistent with their overall goals and objectives in the long run. Cash flow could be good, but it could be higher maintenance costs, higher vacancy rates, or something of that nature.

[00:05:51] Veronica: Just thinking about the property that looks good on paper- higher cash flow. That might be a more challenging cash flow to achieve monthly. One point I wanted to bring up is that the number on the spreadsheet is a plan. It has a lot of assumptions. But in real life, you want an excellent team to manage the execution of that plan. There are a lot of variables on a month-to-month basis. It's not like a straight line where the cash flow is the same each month. You never know when you have to prematurely replace all the unit flooring, or a water heater goes out. Some of these things are especially true of older homes. I would say even some newer homes or newly rehabbed homes. It's also the strength of the team that did the repairs and how predictable your operating expense budget will be.

[00:06:46] Cynthia: That makes a lot of sense. Over the years, I've seen people underestimate costs in a spending planner budget for their rental property in the ongoing maintenance and capital expenditures category. People think, "Oh, it's just been rehabbed. My maintenance will be like 500 bucks a year." And they forget to use typical ratios to develop the cash reserve of that property. It's unpredictable when something is going to happen. Make sure you're reserving for your insurance deductibles and putting some money away every month in cash reserves for the inevitable things you know will happen.

You don't know precisely what they're going to be. Some expenses will occur to maintain the property, just like maintaining your residence, and you have to set aside some money for it, or it can send you into a financial tailspin.

I have a client who recently bought some older multi-families in a small town in Pennsylvania. In the first year, even though that client had the properties inspected with a good inspector, stuff just wore out. Things happened all at the same time. A new water heater. A tenant didn't pay rent in a unit and didn't ask for rental assistance. Other maintenance issues and a confluence of circumstances that happened all in the first year spooked them a little, thinking, "Was this going to happen every year?" And no, probably it's not going to happen every year. It could all happen at once sometimes.

[00:08:11] Veronica: I was going to add when you don't have those cash reserves and aren't able to take care of a repair. You delay what could have been a $500 repair and didn't impact that month could turn into a $1,500 repair six months later. It's crucial to manage your overall budget to maximize your cash flow. How good are you at planning for expenses? Sometimes it may make sense to do rehab in phases. Let's say a duplex. You get one unit up in the running and start collecting rent, which helps fund the repairs on the second unit. There are things you can do to manage cash flow, which is why I think this is not a positive black and white cash flow issue or even just looking at cash return in the first year. Sometimes it's deceiving because there are things you can do to manage expenses over time better.

[00:09:08] Cynthia: Keeping abundant liquidity as a real estate investor is risk management. Make sure that you can meet needs for those kinds of expenses through cash reserves or through access to an equity line of credit. That is one of the biggest risks in real estate investing. You have this large illiquid investment. You can't easily convert it to cash or monetize it even to get a loan against a property. A new loan against property is a very time-consuming process. There's no guarantee it's going to happen.

When you first start, how can I make sure I can continue to be financially nimble with my cash flow? You never want to get overstretched cash-wise because that could spill into your personal finances and cause you to liquidate something that you don't want to liquidate or cause the whole thing to come tumbling down.

What about how things are changing with rising rates? Yesterday, as we record this, the fed has just announced they're going to raise rates again, another 50 basis points or one-half of 1%. There could be more of those coming over the next year to combat rising inflation.

How have you been dealing with this with your personal portfolio and clients?

[00:10:23] Veronica: The numbers must work in this new interest rate environment. And if you go back and look at this a year ago, people were running the numbers that may be at a 3% rate. You'll show a visual of the monthly payments, at 3% versus 5% versus what we could be pushing 7%. You have to run the numbers based on the current rates.

[00:10:51] Cynthia: Let's look at that because we put an example together of a comparison of what a typical purchase would look like at different rates. Now, for those of you who are in the New York City area, like I am, these numbers will look a little low because he can't buy anything for $250,000 in the New York City area. But for many parts of the country, this can hold up, and it sounds like this is a good example of something that might happen in the Philadelphia area.

[00:11:17] Veronica: We were thinking in terms of a duplex. A $250,000 and what the varying payment would be at different levels of interest rates.

[00:11:26] Cynthia: For the investor buying a $250,000 sample property with 25% down, if they'd bought it last summer, their monthly payment on the 30-year loan would be a little less than $800, $791. And with homeowners insurance and taxes, that total. Cash to subtractive from the rent and expenses would be $1,041. And with current rates, five and a half percent, that same monthly mortgage payment will be $1,065 in total, out of pocket at $1,315.

Six months or a year from now, if rates continue to go up at six and a half percent, for example, the mortgage payment has gone up to $1,185 from $791 at 3%, and a total monthly payment in that same scenario at $1,435. This is just an example. We'll put this in the show notes so you can see where we got these calculations.

But if you're tight on cash flow, if somebody was running the numbers last summer and they were cash flowing a couple of hundred dollars per door, that might look great. It might not look great at a six-and-a-half percent mortgage rate. You have to run those individual numbers and make sure it still makes sense. Now the other thing I will say, even at six and a half percent, that is not the highest they've been. If we look at where mortgage rates have been since 1990, at the beginning of the dot com boom, you can see rates were already starting at about six and a half percent, went up almost to 9% in the early 2000s, and then have been falling steadily ever since.

In terms of the economic cycle, we could see rates continue to rise for a while until the next recession, and then they will probably fall again and, later on in our lifetime, rise again. Changing rates is a fact of business as a real estate investor.

When you took your firstborn, do you remember what the rate was?

[00:13:23] Veronica: No, I don't. I first bought a property in 2000. I don't even remember what that rate was, but, by the chart, it was much higher than we're paying right now. I would say that one point I wanted to make about my client is the first strategy in this environment is trickier in terms of if a rehab takes longer than you planned, and rates move, you're stuck if you need to distill the money that you've planned out, you may have to adjust, you may have to leave more in just because the rate changed. That's something for the BRRRR investors. Even if you're doing, rehab, rent and repeat, that has been tough. That impacted me. I could tell you by that the lay of two months and finding a tenant impacted what rate we got on the way out. There's something that I've experienced personally. All we could do was, "Hey, this still makes sense. They're still cash flow positive. We should still take the money out with the plan to reinvest and buy something else." It's a little unnerving, and I understand that many of my clients are nervous about the rate changes.

[00:14:37] Cynthia: Sure, it can affect the bottom line and may make someone change their strategy. It could be that someone originally thought they would refinance and use that money for the down payment on the next property, and now maybe they won't. Maybe they'll rent it and look for other ways to improve or raise the rent return over time.

For those folks who haven't been through a big recession yet as a real estate investor, I don't think we're in a recession right now. The economy's still good. It's great to be a rental property owner. We are in a rising rent environment. We're in a rising property value environment. And it's a wonderful time to be an investor right now. I've been around for a while, and things go up and down. And thinking about what works in a specific market environment makes the most sense. You have to adapt your model to changing rates, and chances are, of course, we don't know for sure we don't have a crystal ball, but chances are, there'll be a point in the future when rates go down again and then you can refinance.

[00:15:33] Veronica: You must also look at the overall economic environment. There are different segments of the rental market even. What I do see is there's a demand for affordable rentals. If you're going after rentals that are serving that market, it's just really a lot of cities have unmet needs. Now, if you're going to the luxury end, that's a different story. Each rental market segment has different dynamics to consider, and as long as you're solving the problem, we know interest rates are going, inflation's going, and I think there's still room to play.

I think that's an excellent point. What about having a workflow for raising rents that is consistent with inflation and maintains a good tenant base that you want to serve in your business?

[00:16:22] Cynthia: I know you also have a property management component to your business. In our real estate business, we tend to raise the rent when there's a vacancy and then raise them typically a small amount consistently every time the lease is renewed. And sometimes we'll do a multi-year lease with a step up in rent raises over two or three years if we ever have an awesome tenant.

Do you also do that? Or what do you do differently?

[00:16:47] Veronica: I think that's market-specific. What works in Austin will not work in suburban Philadelphia type of tenants you're attracting. I would say turnover is the easiest time to do a rent...

[00:17:02] Cynthia: Easiest time to do a renovation too.

[00:17:04] Veronica: Yes. It's almost impossible to do a major renovation around the tenant, but that's typically when I make the biggest adjustments, ahead of doing some renovations. But you must justify it to the tenant beyond just a general inflation statement.

It's kind of like, expenses. Guess you're seeing inflation but in different ways. I'm about to make this improvement. Costs have gone up. The property manager or landlord is explaining to the tenant why you must adjust the rent on an ongoing basis.

There still is a feeling, depending on the market, back to what I was saying of the kind of the working-class market, how have their wages caught up with affordability? Like it's in terms of the percentage of their income devoted to rent. There are limits. You want to get this in rent, and you do the little analysis that says the median rent is this. But if your applicants coming to you consistently are capped at this income, you're also capped. That's why the neighborhood is really important to think about.

[00:18:14] Cynthia: That's an excellent point. And that explains a lot of the differences in the philosophy behind rental returns in an expensive Metro area versus rental returns in a suburban Midwestern town because it's expensive in, say, the New York City area, for example, that the rental returns as a percentage of the investment tend to be lower. That natural cap on how much you can charge somebody for it.

[00:18:38] Veronica: More people should think about having a systematic way of increasing rents because I think that's where some cash flow is left on the table. A lot of investors they're not thinking about adjusting rents over time.

[00:18:53] Cynthia: To compensate for the fact that their costs are going up over time. Their insurance is going up. Their water bills are going up. Their cost to maintain the property, the replacement costs for appliances, and things like that. All those things go up over time. Having a workflow for yourself, where you are consistently doing it over time, you don't have to reach back and try and make a huge rental increase, assuming that's allowed by the local jurisdiction, the local rental laws. It's just super helpful.

Is there anything we've forgotten to mention today about the cash flow per door and the impact of financing on that cash flow per door?

[00:19:29] Veronica: One other point I'd be willing to make, but we've been talking mostly about the monthly operating budget, but the budget decision made upfront when you purchase the property is important in terms of a lot of people have a vision of how they want, what kind of amenities they want to upgrade. If you're putting $2,000 a month amenities in an apartment that's only going to rent for a thousand a month, you're kind of starting in a hole. You're making the cash flow more negative than it should be because you're over-improving the property to where you'll never recoup your expenses. I had a client who had an environmental background, and she wanted to use a more environmentally sound or high-end water heater. If she did implement that in this triplex, this was going to blow out the numbers.

It made sense to give people living in certain communities access to new things, but she would never be able to charge rent to justify that, at least in the next 20 years. It just really didn't make sense. Really as an investor, when you're looking at that make-ready budget, you do need to figure out how quickly you'll be able to raise rents over time to be able to recruit some of your major outlays at the beginning of the investment.

[00:20:50] Cynthia: That's an excellent point. I remember when Steve and I were first investing in rental properties, our property manager and we still work with the same property manager. She's been an important part of scaling our rental property business and developing this profitable business because I would think that something had to be done or replaced, and she'd be like, "No, we don't need to do that for a couple of years." We're always taking care of safety issues and making sure everything is clean, and I'd be like, "Should we put in wood floors?" and she'd be like, "Oh, maybe we should just replace the carpet" or something. That's just an example of something she might say to try and do exactly that - don't over-improve, given who the target person will be moving in.

[00:21:31] Veronica: I think many of our clients want to be good landlords. They don't want to be slumlords. And they go too extreme, but you just have to be practical for what the demand is at a certain price point. That's going to keep you more in line or be able to hit those cash flow numbers.

[00:21:50] Cynthia: If you have a particular niche that you're trying to appeal to, for example, you want to make improvements that will appeal to that niche. If you're accepting pets and you take a pet nonrefundable pet deposit, for example, maybe you're going to do Pergo floors or something like that. Makes it easier for the pet owner. Or a gate into the kitchen door into the backyard or something like that. In general, I completely agree with that.

Just to sum up here, talking about in this series about running your numbers. Talking about cash flow per door. Thinking about the impact of changes in financing costs. How much does this matter? It does matter. But it still means we must connect this decision to our goals. As Veronica said, make-ready budget upfront and make sure it's realistic. Your budget will affect your cash flow, and things will change with rising rates. We will have to reevaluate each property on a deal-by-deal basis to make sure that it will make sense for those goals and objectives.

Any parting words?

[00:22:47] Veronica: I also say appreciation is good.

[00:22:50] Cynthia: If you haven't checked out the first in the series, episode 11, Does the 1% rule still work? Please go back and give it a listen, and then next in this series, we'll talk about the role of appreciation. We're going to dive more into appreciation and look at some examples. And then we're going to finish up with the other numbers you need to know in putting your rental property budget together besides rent and expenses. What are the other kind of guidelines that are helpful to use when developing a realistic real estate budget?

Veronica, as usual, you are one of my very favorite people to talk to you. And I hope to see you next time in the Rental Property Café™.

☕ See more financial planning guidance for real estate investors from Cynthia Meyer on the Real Life Planning blog

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