What's Your Real Estate Investing Performance Ratio?
Did you know that Carleton Sheets has been on the television practically every night for close to twenty years? Were you aware that during that entire time his "positive cashflow" numbers have remained essentially the same? Yes, that's right. Almost twenty years ago, Carleton began preaching about receiving rents that were $100 to $150 more than your payment. Anyone recall what the average payment was way back then? I sure don't, but my guess is that it was around $400. I find it strange that those numbers are still being spouted as a decent "positive cashflow" today..
Bankers and finance folks have a term called "debt service coverage ratio" (DSCR). Essentially, what that defines is how much is justify over to cover debt after paying expenses. So, if you have a property that annually generates $20,000 in gross income, $5,000 in expenses, and $10,000 in debt, your DSCR would be 1.5 ($15,000/$10,000), meaning your property throws off an extra 50% above and beyond your debt service. It's simply an objective measurement of financial strength.
Having spent a good portion of my adult life dealing with financial analysis, I no longer want to get bogged down with financial terms so I've come up with a simpler variation of DSCR. I call it your "Performance Ratio". It's an easy concept to grasp and it's this. Ignoring all expenses except
vacancy, how many performing properties does it take to cover one vacancy?
By that, I mean if you have four properties with an average payment of $900 per month, how many of your other properties have to be performing for the "positive cashflow" from those to cover one $900 per month vacancy? If you're using the standard $150 per month as your gross spread (your receipts are $150 more than your payment), you would need six of your properties to perform to cover one vacancy. Oops, you only have four in total. And that doesn't even take into consideration normal maintenance repairs, capital reserves for large item replacements (roofs, A/C's, etc.) Hmmm...
But wait. It gets even better. What if you ran out and purchased a large number of these and had payments in the $1,200 to $1,800 range? Let's split it and take $1,500 as our average payment. That means that if our average gross spread is $150 per property, we only need TEN properties to be performing to cover one vacancy. If you didn't pick up on it yet, please note the heavy sarcasm here.
This is absolutely a model for failure, bankruptcy, and every other imaginable financial catastrophe. If you're building your business this way, STOP IT NOW! As soon as the market throws a speed bump in front of you, it will not just slow you down as expected, it will total your vehicle.
My opinion is that the average Performance Ratio for your portfolio should be no more than three to one (3:1). What that means is that in the first scenario of owning four properties, that the gross spread from three of the properties should cover the payment on the fourth. To say it another way, your gross spread on your property should be one-third of your payment.
Here's another benefit this "formula" provides. For those not familiar with the 75% rent credit that lenders use in calculating your income and debt numbers when you attempt to qualify for a loan, this will greatly decrease your risk level in the lenders' eyes. On a monthly basis using our four property scenario, you receive $4,800 per month in rents ($1,200 rent per property equals the one-third gross spread) against $3,600 in payments. The lender multiplies your gross of $4,800 times 75% and allows you $3,600 in income against $3,600 in payments. It's not an exact wash on your debt to income ratios, but it sure helps.
Why does the lender do that? Because the 25% deduction accounts for normal operating expenses. I promise you that even with single family houses and even if you manage them yourself, that your expenses over time will average at least 25% of your gross income.
Where does that leave us? Well, if we ignore expenses, a Performance Ratio of 3:1 is a self-sustaining business model from the payment perspective . If we ignore vacancies, a Performance Ratio of 3:1 is a self-sustaining business model from the expenses perspective. Won't we have both expenses and vacancies? Absolutely.
RRRRRRRRRRRIIIIIIIIIIIIIIINNNNNNNNNNNNNGGGGGGGGG!!!!
That's the alarm clock going off, hopefully waking you up to the incredible foolishness of using a nominal, arbitrary number like $150 per month as a desired gross spread. Again, it worked when Carleton first aired because the spread PERCENTAGE worked; the payments were $400 or less.
Do I know what the "right" number for you in your market is? Of course not. Does this mean you don't buy a certain property because it doesn't meet this litmus test? Of course not.
However, I do want you to give this some serious thought in relation to your current portfolio or the one you plan to build. Don't ignore the numbers as they are real. Know going in where you want to end up so that your business has good odds of succeeding and weathering the tough times.
The Carleton Sheets scenario is similar to Kirosawa (sp?) in that he figured if he made $80 per month on a property, he could take deals like that all day long. I had issues with this notion, because there are lots of hidden expenses that most folks do not budget in, such as phone calls to utility companies to ensure that there are utilities on when there is no tenant, lawn services are called when you don't have time to mow, etc. Several other points to ponder - if you have to put money down (yes, sometimes you have to put money down, especially for investment property that you will buy and hold), you need to ensure that you are paying yourself back on that investment. You should model that down payment as though you have a second mortgage on the rental property. After you consider this, are you really getting a payback on the investment, or are you just sheerly banking on the property appreciation?
I have not read Sheets, but "Rich Dad" guy and others I have read imply the $80 or more is after ALL other things including vacancy is taken into account. I have never read something that would imply otherwise. If Sheets doesn't do this he is pretty irresponsible.
Ron
Great Article. This is a good rule of thumb to go by.
The problem with this article, as well as many other articles like this, is it has no relationship with prices in my market.
I live in a rural area of California, where houses are selling for 300 times gross monthly rents, junky 50+ year old houses badly in need of a rehab or duplexes, fourplexes are selling for 150 times monthly rent. That means the junkers will have a negative cash flow of -250$ per month, and that is BEFORE any repair and vacancy costs.
It is possible that with alot of lowball offers and hunting for pocket listings and calling out of state owners etc. one might find a house that has a cash flow of -0, a break even house, but that is still before repairs, and that house is likely to be a house that will soon need a large repair like a roof or a furnace.
The housing market has been red hot here for three or four years now, so maybe it will slow down, and bargains:motivated sellers will exist once more. But for now, if you wish to enter the market, you will be taking on negative cash flow. On the positive side, I have increased rents by 11% this year, and expect to increase them more in the year to come. So to ignore appreciation is irrational.
Sheets has a biggy problem, he does not update his books. Time for corrected edition and frankly if you have become a Guru and are not active your information quickly becomes Out of Date. Way back in 1956 I wrote a book called "The Book Of Scams" The FBI and IRS etc. bought the book, but hardly any civilians. became an in thing in Federal Law Enforcement. After a while I could not even get a copy. I was asked to write a sequal. Still the same Scams but oh my god have they changed. I will have to write a brand new book. Back then I used an Abacus and a quil pen.
When I buy income property, given the time I start with a crawl underneath and a whole contractor inspection. How many layers of shingles have been added if more then two next time around I must install a membrane of plywood strut 5 and remove everything. So from that point I go into the records. On going costs of operation. Vacancy factors,(what is cause) Examination of repairs and check the costings. It goes on and on. I ignore pretty much the increase yearly in value. Like most things in these parts highly undependable best described as siliconese. I check payment records on existing mortgages watching carefully for due dates in relationship to rental collection dates. etc. etc. I check washing machines dryers etc. for income. I examine power bills and water usage. Oh deadly dull but necessary. Then I sit down and ponder, can I improve, are the facts for real or am I getting custard in the face. Then, while this is going on I examine the owners, financial statements confidential reports from various *****ociations etc. I try to find out real reason for selling. Sometimes I can buy out one of a multiple ownership, then pressure the others to sell. My original partial purchase was at large discount due to the need of that partner or particiant for money, drugs or whatever. Given this intelligence we start to negotiate. Sometimes thru an intermediary such as a Broker instructed to deal with hidden client (me) sometimes exposed. Goes on and on. By the time I buy I really know the whole story. Sometimes I am replacing mortgages with more advantageous mortgages, lower interest etc. Sometimes to make it all fly the owners must take back paper and that I try to influence the write so I can buy at discount on any little bump in their road. You see what I am saying, be flexible in your formulae. do not be afraid to abandon. For example Trash pickup cut the price by combining this with pool service and gardeners. Discount in exchange for using recommended roof repair. etc. etc.
Buying income or commercial property is a busy busy time. You must observe everything, you are the general and once again this is war. Stop, I am boring, You get my meaning? Just be careful in applying formulae,I love your reasoning but it reminds me of the nice Colonel who was giving me all the reasons why a ME 109 German Fighter could not shoot down a P-51. At the time I was gathering up my parachute having just used it cause some naughty kraut in a 109 had just shot me down. You just might miss the boat. Cheers Lucius
I do something similar...
I calculate my Break even cash flow point by either dropping rents or dropping the occupancy. I may find on my property I can afford to maintain my rents and break even at 60% occupancy OR stay around 95% occupied, but drop rents from say $550 to $440. This seems to provide the same type of information that your calculation does, if I'm not mistaken. Thanks for your thoughts.
So if all my properties have different expenses, can I assume that adding 1/3 of my total expenses to the total expenses itself would be a good way to gauge what I will charge my renters.