There's an old saying among experienced real estate investors that goes, "You make your money when you BUY." This refers to the traditional (and, in my opinion, correct) thinking that a property is a good investment only when it's purchased at a below market price, or with financing terms that are better than those offered by conventional lenders.

Unfortunately, with the recent decline in interest rates and the higher-than-average appreciation in real estate values, new investors are getting a different kind of advice: that it's OK to pay close to retail price for a property, because 
the low interest rates guarantee cash flow, and the yearly inflation in value will allow the investor to build equity quickly.

In some of the strategies we discussed earlier, it's obvious that you can't pay retail: if your intention is to repair and sell the property quickly, or to wholesale it to another investor immediately, your profit is only guaranteed if you pay an under-market price. But many new investors who plan to hold their properties long-term for rental fall prey to the thinking that paying full price is OK for the reasons mentioned above. There are several problems with this strategy that, unfortunately, only become clear AFTER the property is purchased.

The first problem is that, even with interest rates in the 6% range, most rental properties, when purchased at retail price with retail terms, will NOT produce a true positive cash flow when all expenses are taken into account. Let's look at an example:

In most of the country, a decent 3 bedroom single family home in a relatively nice area can be purchase for around 
$90,000 (if you don't happen to live in one of these areas, do the math for the higher or lower values and rents-you'll find that the overall numbers remain pretty much the same). This property will rent for about 1% of it's total value per month, or $900.

Retail lenders-that is, banks and savings and loans-require that investors who do not plan to live in a property make a 
down payment of 20% of the purchase price of the property. In this example, that downpayment would be $18,000. In 
addition, these lenders charge application fees, points, closing costs, appraisal fees, and title insurance premiums 
that average, when all is said and done, about $2,500 per loan. So borrowing $72,000 to purchase this $90,000 requires an up-front investment of $20,500.

Because these "non-owner occupied" loans are considered more risky that loans to homeowners, most lenders require a 
shorter payback period, as well. 15, 20, or 25 years are common amortization periods-it's possible for investors to get 
30 year loans, but they are normally adjustable rate loans, not fixed interest.

The payment on a $72,000 loan amortized over 25 years at 6% interest is $463.90. Add in property taxes and insurance, 
and the number grows to approximately $600 per month. If the property rents for $900 per month, the cash flow based on 
these expenses is

     $900/month rent
     $600/month principal, interest, taxes, and insurance payment 
     $300/month cash flow, or $3,600 per year in profit.

BUT, this calculation does not take into account the real expenses of owning rental property. For instance, the average 
tenant stays in a property for one year. When he moves, the unit must be "turned over" (that is, painted, cleaned, 
carpeted, and made ready for the next tenant). The cost of a simple turnover averages $1,500-and no, this money cannot 
be taken out of the tenant's damage deposit if the repairs were a result of "normal wear and tear". Therefore, the 
annual profit is reduced by this amount:

     $3,600/year profit
   - $1,500 turnover 
     cost $2,100/year 
     profit

It also takes an average of one month to turn over a unit, get it on the market, find and screen the next tenant, and 
get the first month's rent and damage deposit from the next tenant. During this month, no rent is received, so the 
annual profit is reduced by one month's cash flow:

     $2,100/year profit
   - $300 "vacancy loss" for one month's unpaid rent 
     $1,800/year profit


During this month where the property is not occupied, the investor must still keep the utilities on so that the property 
can be turned over and shown. Depending on the part of the country and the time of the year, this could mean heating or 
cooling the unit as well as keeping the lights and water running. And, of course, the property must be advertised for an 
average of 2 weeks, which again reduces the yearly cash flow:

     $1,800/year profit
   - $100 utility costs
   - $200 advertising 
     costs $ 1,500/year 
     profit

Now, $1,500 per year may sound like positive cash flow-although it's a return of less than 10% on the cash you invested 
to buy the property-but there's still one major expense unaccounted for. In fact, it's a major expense that very few new 
investors are even aware of-an expense called replacement reserves.

Replacement reserves are a way of accounting for the fact that parts of the building are deteriorating each year, and 
will eventually have to be replaced. A roof, for instance, has a life span of about 20 years, and costs about $3,000 to 
replace. Most investors look at the replacement of the roof as a once-every-20-year expense that reduces the cash flow 
FOR THAT YEAR ONLY by $3,000. But the proper way to look at it is an expense that accrues each year in the amount of the 
replacement cost divided by the life span-in this case, $3,000/20 years or $150/year. After all, the roof doesn't 
actually go bad all at once in year 20—it loses 1/20th of it's usefulness each year for 20 years. And because the 
usefulness of the roof declines each year, it should be deducted from that year's income.

In fact, a smart investor actually sets aside the cash each year from the income of the property so that the money to 
replace the roof is available when the roof needs to be replaced. Otherwise, the investor must come out of pocket that 
year to make the repair-remember, this property only produces $1,500 per year in positive cash flow, and the roof costs 
$3,000 to replace!

But here's the kicker about replacement reserves: there are many, many items in a rental unit that depreciate from year 
to year! Here's a partial list-the range in life spans for same items is a function of the type of unit and area. For 
instance, a refrigerator in a 4 bedroom home will be used more that one in an efficiency apartment, and will therefore 
last for a shorter period of time.

   Item           Life span          Replacement cost        Annual reserve 
   Refrigerators  5-10 years         $500                    $50-$100 
   Oven/Ranges    5-10 years         $300                    $30-$60 
   Dishwashers    3-5 years          $225                    $45-$75 
   Carpeting      1-3 years          $9/yard                 $3-$9 per yard per year 

   A/C units 
   Window         5-10 years         $250                    $25-$50 
   Central air    20 years           $1500                   $75

   Roof 

   Flat,          roll 10 years
   Flat, membrane 20 years
   Sloped, asphalt shingle 20 years 

Heating Systems

   Boiler         30-50 years
   Gas forced air furnace  20-30 years
   Water heaters  10-15 years 


So the cash flow on your 3 bedroom home with it's refrigerator, stove, dishwasher, 5 rooms of carpet, central air, gas 
forced air furnace, asphalt shingle roof, and water heater now has to be reduced by $1,340 per year, leaving
$1,500/year cash flow - $1,340/year replacement reserves $160/year cash flow

And, needless to say, $160 cash flow will quickly turn negative with an unexpectedly long vacancy period, or the costs 
of an eviction, or tenant damage, or an increase in property taxes, or any one of the dozens of other things that can 
happen with a rental property. In fact, the only thing that generally redeems a rental property for which the buyer has 
overpaid is the tax benefits-but remember, the depreciation the IRS allows on you rental must be "recaptured'-that is, 
paid back, when you sell.

 

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