What Every Real Estate Investor Needs In Their Financial Plan

BY CYNTHIA MEYER CFA®, CFP®, CHFC®

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What you'll get from this article: 

What does a real estate investor need in their personal financial plan? 

It is much more than choosing good properties.

As a rental property business owner and financial planner who works with fellow real estate investors, I answer this question every day. Real estate investors tend to be independent, DIY managers of their own finances. They also help each other, through local property owner associations, digital communities like Bigger Pockets, and Facebook groups. I have read so many posts from landlords who have a financial planning question -- but have not been able to find a financial advisor who will answer it without trying to sell them something.

That is why I am offering this framework of 10 essential financial planning elements for real estate investors that can be used both by: 

• Individual real estate investors; and
• CERTIFIED FINANCIAL PLANNERS™ who have clients with real estate investments, so they can better serve them.

A road map for your money, your real estate, and your life goals

Personal financial planning for real estate investors entails more than running the numbers for your properties. It covers all areas of your finances, including:

• Mitigating the unique risks that go along with investing in real estate
• Thinking like an entrepreneur to grow your real estate portfolio over time
• Understanding and minimizing your taxes
• Life events like getting married, having kids, career changes and taking care of older parents
• Managing money as a couple
• Protecting the people you love
• Choosing diverse investments to power specific life goals like college and retirement
• Preparing for unexpected events

Financial planning is a collaborative process of evaluating your personal and financial circumstances, planning, implementing, measuring progress, and adapting to changes which maximizes your potential for meeting your life goals. It involves so much more than making good investments. Purchasing a profitable rental property or choosing good mutual funds in your Roth IRA are ways to implement your financial plan – but choosing smart investments is just one piece of a bigger puzzle. 

Continue reading below...

The 10 essential elements of a real estate investor’s financial plan

Financial planning for those who own individual properties requires a shift in mindset. Although real estate income is categorized as “passive income,” it requires effort, attention, and financial organization. Owning individual properties requires a business mindset. 

You need 10 basic elements as a real estate investor in your overall financial plan:

#1 - Implement a strategy to build and maintain business cash reserves.

Building cash reserves is the first financial goal of a new property owner and maintaining adequate cash reserves is an ongoing task. They are the “emergency fund” for your real estate investments. Business cash reserves help you:

• Weather vacancies and repairs
• Help you save for the down payment on your next rental property.
• Allow you to remain solvent if your tenants cannot pay the rent due to COVID-19, while you still have to pay your mortgage, taxes, insurance and maintenance.

Keep your cash reserves in secure, liquid savings. Those are things like high yield checking accounts, money market funds and savings accounts. This is not a place to take risks with your money. 

#2 - Run a retirement projection and update it annually. 

Financial wellness research shows that the most important single factor in getting on track and staying on track for your retirement goals is to run a retirement projection every single year. Think of it as a scoreboard for your retirement savings. 

There are lots of helpful retirement planning tools out there, and this is relatively easy to do. Yet according to the Fidelity 2019 Retirement Mindset Study, less than one in five respondents (18 percent) have created a comprehensive plan for their retirement.

I use a variety of tools to model a real estate investor’s retirement projection, including financial planning software and spreadsheet models. There are abundant DIY tools – some useful and some too simplistic. If you are the kind of person who wants to understand how different retirement calculators work, see this helpful consumer guide from the Society of Actuaries.

#3 - Create a plan for risk management. 

Risk management is evaluating and forecasting financial risks and identifying ways that you can avoid them or minimize their impact. Risk management is part of boosting your financial immune system. I like to break this down into three key areas. 

• Choosing the right legal structure. Are you going to incorporate or not? And if so, what type? 
• Making sure you have the right insurance. Every real estate investor, and in fact, every business owner, should be evaluating their insurance coverage annually, both business and personal. 
• Using financial ratios to help set some guidelines and goals for your real estate business. These are things like rental return, cap rate, vacancy rate, and a target debt to income ratio. 

There is risk in everything we do. The CFA curriculum says it best, “Risk management processes and tools make difficult business and financial problems easier to address in an uncertain world. Risk is not just a matter of fate; it is something that organizations can actively manage with their decisions, within a risk management framework.”

#4 - Make a plan to minimize taxes. 

Even if you only have one rental property, you can benefit from professional tax advice from a Certified Public Accountant or Enrolled Agent. Look for a tax professional who has real estate expertise and is knowledgeable about your state’s laws.

Common ways real estate investors minimize taxes are:

• Depreciating properties on your income taxes. This will minimize current income taxes, which is powerful. When real estate investors talk about "cash flow" they mean "net real estate income before depreciation expense."  While depreciation may seem miraculous, remember that you "recapture" that depreciation if you later sell the property and realize the income on the sale (e.g., no 1031 exchange). 
• Contributing to tax-deferred retirement accounts. Every taxpayer with earned income can contribute to a traditional IRA account (individual retirement account.) Many can contribute to a tax-free Roth IRA if they fit within certain income limits. If you have a profitable real estate business, think about setting up a Roth 401(k) or a solo 401(k), or a pre-tax SEP plan for your business so you can make additional tax-advantaged contributions. 
• If you are selling a property and plan to stay invested in real estate, consider a 1031 exchange into a like-kind property (another income-producing property). Again, that is a good question for your tax professional before you make a final decision on it, but a 1031 exchange is a helpful strategy to defer gains into the future. See IRS Real Estate Tax Tips for Like Kind Exchanges.

I am not a big fan of owning individual income-producing properties within a self-directed retirement account (SD-IRA). Real estate owners miss out on the benefits and flexibility of real estate income and often get tripped up by unexpected tax consequences in SD-IRAs. I prefer to use retirement accounts as tax-advantaged vehicles for building sources of flexible income (see #6). 

#5 - Utilize a target debt-to-income ratio.

The biggest mistake that I have seen real estate investors make over all my years of being a financial planner is being over-leveraged. They borrow a lot in mortgages and equity lines during an enthusiastic upturn in the real estate markets and the economy. When the downturn or the recession inevitably hits, they have got vacancies or a property they cannot sell, and boom -- they blow themselves up. 

Calculating your debt to income ratio

Leverage magnifies returns, but it also magnifies losses. One way to avoid getting over-leveraged is to have a target debt-to-income ratio in your overall personal and business financial plan. By “debt to income ratio,” I mean total monthly debt payments divided by total monthly income:  

• Debt payments include things like your personal mortgage, your rental property mortgages, any other contractual obligations that you have such as a car payment, or credit card payments, student loans, personal lines of credit, and home equity lines.
• Income includes salary, rental income, other business income, pension, Social Security, interest and dividends and any other income.

Your debt-to-income ratio can be influenced by your personal risk tolerance and by your net worth. The lower the real estate investor’s risk tolerance and the lower the net worth, the lower the target debt-to-income ratio. The higher the risk tolerance and the higher the net worth, the higher it can be. Generally, real estate investors should keep their target debt to income ratio at 35% or below.

#6 - Develop sources of both fixed and flexible income. 

Real estate income is generally considered fixed income.  You will also want to have some sources of flexible income, especially when you head into retirement or are have a goal for work to be optional. 

Ideally, you will have sources of fixed income to cover fixed expenses, and flexible income to cover flexible expenses:

• Fixed income sources are predictable monthly sources like rental property income, annuities, Social Security, pension, and regular business income that continues after you are retired. Earmark fixed income to cover your fixed monthly, must-pay expenses, like your housing, healthcare, groceries, and transportation.
• Flexible income sources are generally things like IRAs or Roth IRAs, 401k or some other employer-sponsored retirement plan, and taxable brokerage accounts. Earmark flexible income to cover flexible expenses -- to take that big trip, put a new roof on your house, install a new furnace, buy a new car, or handle a large dental or medical expense.

In general, you want to plan for both sources of fixed and flexible income. While there is no set prescription as to what investments go where and in what proportions,  a financial planner can help you figure out what is the percentage of fixed and flexible income that you are likely to need when you are living on your investments alone.

Real estate owners can benefit from developing an overall Investment Policy Statement (IPS), which includes your real estate, securities and other portfolio holdings in a comprehensive and systematic investment strategy.

# 7 - Envision an exit strategy for each individual property that you own.

Real estate is illiquid, which means that you cannot convert it to cash easily. In addition, each property has carrying costs, like a mortgage, taxes, insurance, maintenance, water, and garbage, which the property owner must continue to pay even if the property is not generating rental income. Clearly defining your exit strategy before you buy a property will maximize profits and minimize risks.
Set some guidelines in the beginning so you will know when to make certain types of decisions. Components of exit strategy for each property include:

• Define success for yourself, both in terms of income and potential appreciation of the property. That way you will know when you are hitting your goals – and when you are not. What level of appreciation in the property would make you inclined to sell it? What are your goals for rental return and expected property expenses?
• Figure out under what circumstances would you sell the property. How long would you give it before an investment that is not working out would be sold? And when would you want to cut your losses if they occur? 
• Decide if how you manage your properties changes in retirement. If you manage your own properties now, would you hire a property manager when you are older? 

The right exit strategy varies by real estate investor. Consider factors including whether the property needs work or renovations, your personal financial position, your tax situation, the local market, the potential for appreciation and current rental income. Many real estate investors find it helpful to have multiple exit strategies based on different market and personal conditions.

#8 Design a personal budget and a business budget and update them annually. 

Your budget is your financial plan expressed in numbers. Developing financial projections which integrate your personal and real estate budgets gives you a tool to assess whether you are ready to buy your first – or your tenth – rental property. A real estate investor can benefit from having two budgets:

• A budget or spending plan for your real estate business. In our rental property business, we break these down by individual property, and then also do an aggregate of our entire property portfolio. We prefer a cashflow budget, which outlines what comes in every month and what goes out every month. That way we can plan both for regular monthly expenses and for those things that are more flexible throughout the year. We compare our actual results to our rental portfolio and per property budget at least once per year.
• A personal budget or spending plan. Our net rental cash flow is added to the Income category in our personal budget, along with income from my financial planning business and income from other investments. My husband Steve and I have different preferences when it comes to personal budgeting. I am the one with the gazillion worksheets in a detailed Excel spreadsheet. We have a one-page summary with major categories that my husband prefers. Both of those things work. Figure out what is right for you. 

At least once a year, do a budget versus actual to see if your projections were realistic. This will help you set better goals for the upcoming year. The more you budget and compare results over time, the more accurate your budget projections will become. 

#9 - Know how your real estate investments impact college planning.

College costs continue to rise faster than inflation. My hope for you is that you will do so well in your financial life that your kids will not need financial aid. Parents planning to send kids to college need to prepare for how to pay the costs, as well as understand the impacts of your rental properties and securities investments on the financial aid formula. 

College planning for real estate investors has an extra layer of complexity. There are a few things to keep in mind and plan for several years in advance of submitting the Free Application For Federal Student Aid (the FAFSA). 

• Rental property income does count in the determination of total income and it does affect the formula of how much your family is expected to pay for your student's college expenses. This may affect any tax strategies that you use to manage your income, such as claiming depreciation or not claiming depreciation. 
• The federal financial aid formula considers the equity in your properties asset that could be tapped to pay for college. Real estate investments are considered investments just like mutual funds, stocks, and bonds. Since real estate is not something that is liquid, you are going to want to be prepared for alternative sources of funds for tuition payments, such as 529 accounts or a home equity line of credit (HELOC).
• The choice of business structure can affect financial aid. You may also want to research the possible exemption in the financial aid formula for closely held family businesses with less than 100 employees. 

Start thinking about these strategies years in advance before you start to apply for financial aid and your student is applying to schools. These are considerations you are going to want to plan for with your financial planner and tax advisor many years before you fill out that FAFSA. 

#10 - Prepare an estate plan. 

What happens to everything that you own should you pass away? And what happens to your digital life, too? 

There are three general categories that are included in the estate planning process for a real estate investor:

• Titling and beneficiaries -- Make sure that you are updating regularly how things have changed in terms of properties you have bought or sold and in terms of your personal situation and making sure everything is aligned. 
• The five basic estate planning documents -- This applies to everybody, by the way, not just real estate investors. That includes either a will and/or living trust, a guardianship provision if you have minor children, a living will (healthcare directive) and durable powers of attorney for healthcare and finances. 
• A digital estate plan to take care of your digital and online presence. This can be everything from personal social media accounts and emails to your business website to logins for your bank accounts and for your property management software. 

It is not fun to think about this subject. Estate planning is the part of financial planning that a lot of people resist doing the most. However, not planning for your estate could leave your survivors with legal and financial headaches -- and possibly tie their hands in running your rental property business.

Find a FEE-Only CERTIFIED FINANCIAL PLANNER™ who understands and appreciates real estate  

Although nearly 1 in 8 Americans are residential real estate investors, the real estate community is largely underserved by traditional financial planning. Many real estate investors have told me stories of an advisor who counseled them to sell all their real estate or refused take them as a client because they did not meet the minimum for assets under management. 

My mission is to mentor a new generation of real estate investors, as well as the financial planners who serve them. In my networks of FEE-Only financial planners (the XY Planning Network and the National Association of Personal Financial Advisors) the number of excellent, fiduciary financial planners who work with real estate investors is growing. In XYPN we formed our own real estate study group where we focus on expanding our financial planning knowledge and sharing best practices to better serve real estate investors.

Follow the Real Life Planning Blog for the entire real estate financial planning series

This post introduces the framework for personal financial planning for real estate investors and offers a big picture overview. Over the next three months, I will dive deeper into each topic on the blog and in videos. I invite you will follow along and send me your ideas and feedback about this framework at info@reallifeplanning.com.

This blog is for general financial education purposes. Information contained in this blog should not be construed as financial, tax, real estate, legal or investment advice. For educational purposes, blog posts may contain links to other websites which are not under the control or and are not maintained by Real Life Planning. Real Life Planning has provided those links for your convenience but does not necessarily endorse all the material on those sites. Please consult your financial, real estate, legal, or tax advisor for advice specific to your situation.