## Financial Math III: Diagramming Cash Flows

This post will wrap up my series on Financial Math. I’ve previously written about:

In this article, I want to go over a fundamental mechanism any investor should at least be aware of: Cash Flow Diagrams. If you look to the right, you’ll see a common example.

The first line, that goes upwards, represents a burst of positive money you receive. The following payments, or negative cash flows, are essentially used to payback the initial cash flow. Do you recognize what common financial structure it is where you get a big chunk of cash up front, and then make small payments over a certain time period? That’s right, a loan.

For another cash flow, check out this one. It is the opposite. It shows a big chunk of cash being put out, followed by several small cash flows coming back. Can you think of any examples that match this? Buying a rental property and receiving monthly rent checks. Buying a big chunk of stock and then receiving dividend payouts.

At the heart of any financial transaction, investment, or purchase, you can probably see one of these two diagrams. When you are trying to make a choice on whether to buy a big chunk of stock OR put the money into a rental property, its useful to sit down and chart all the cash flows. Then, you can compare the two. The ratio between the the periodic payments and the invested cash is known as the cap rate, and it’s important to understand the cap rate for each usage of your money. When one opportunity yields less than the other, we refer to it as opportunity cost.

When you are about to pick a certain investment vehicle, it’s good to also make a list of the risks involved. Real estate has certain risks. Stocks have another. And paying off your mortgage early may carry fewer risks, but also consider the loss of opportunity if you don’t build up any positive cash flows in the future. Are you painting yourself into a corner of being house rich/cash poor?

Ever see those commercials where you can “get your cash now?” They are all about taking over your tiny positive cash flows, and swapping them with a big one right now. Believe me, those people make money. They simply calculate your cap rate, plug in a profit factor on top, and essentially calculate a smaller amount of cash to hand you than if you had kept the cash flows for yourself.

Hopefully, this series will have alerted you to the benefit in understanding some financial basics. Happy investing!

## Time to pay real estate taxes

That time of the year has arrived. I must send in checks paying property taxes on my rental properties. Last year, I contacted my lender and requested them to stop escrowing money to pay for taxes and insurance. Instead, I would pay it myself. This way, there is no confusion and quandary over how much money to set aside in escrow on top of pure P+I payments (principal and interest).

This has simplified things for me, because I can see exactly how much is owed on each unit. I don’t have parts of my net work tied up in escrow accounts that might be stocking up too little or too much. Instead, I have an annual cost that has to be paid and is instantly reflected when I make the payment in my net worth tracking spreadsheet.

As I wrote four hefty checks, it is a bit challenging, since property taxes in Texas are a bit steeper than Tennessee. But knowing that my tenants are paying off the mortgages at record pace and I’m earning top rent, I feel good that I’m developing strong, cash flowing assets that will build strong retirement wealth down the road. And I’m constantly reminding myself that real estate is one of the strongest investments one can make in growing wealth.

Happy investing!

## Where have you been? Retail investors vs. macroeconomic investors

It may seem as if this blog has fallen off the planet. There’s a good reason. At the end of May, I signed a contract to write the technical book Learning Spring Boot. Suffice it to say, that effort has consume all my spare time in the evening. Since my work couldn’t stop, the thing that suffered was this blog. If you ever run into a chance to tap your cognitive surplus, I suggest you go for it!

Technical writing aside, I was drawn into a discussion on Bigger Pockets. In the article, Jeff Brown shows how so many investors are focused on formulae, tricks, tactics, but never on the end results.

People have horrendous savings. They aren’t loading up their 401K plans, their personal savings accounts, or anything else, on average. In fact, whenever I hear this brought up, it reminds me of a finance show on TV years ago where Ben Stein was commented how “Americans aren’t saving enough money.” I didn’t think much at the time, but the comment, by itself, is incredibly insightful. The first step towards successfully building retirement wealth is recognizing when you AREN’T.

Jeff Brown has written a couple recent posts pointing out how even IF you can rack up \$1MM in your 401K plan, you’re not DOING ENOUGH. Given that almost everyone has less than \$100,000, the issue should drive anyone CRAZY with panic.

In the comments, someone nonetheless brought up “retail investors,” a term minted to refer to people that buy turn key rental property. Instead of buying good deals, i.e. making money when you buy, “retail investors” typically buy what they can find and, on average, crash and burn when Murphy visits, nixing their cash flow.

I wouldn’t stand for this short sighted characterization and remarked that the path to retirement wealth isn’t confined to fix-it-up rentals. I created the expression “macroeconomic investor” since I have invested in Texas-based rental properties. Texas has shown tremendous job growth. In fact, 2006-2011 demonstrated a stronger job growth that all other states COMBINED.

When a flood of people are headed to a particular thanks to a booming economy, there is a natural consequence. They all need a place to sleep. I went on to comment:

So…I can either invest a lot of time and effort locally, or I can take my investment capital to Texas and invest there. One option requires that I invest a lot item, even potentially ending my successful career as a software engineer to get the maximum cash flow. The other option says I can invest where I’ll get higher yield, better tenant options, and newer, fresher properties, if I’m willing to sacrifice a certain overhead for others to manage it.

People love to show off their rentals. Even better, they pride themselves on finding something local and able to drive by it and show it off! Sorry, but that is amateur. Critical thing is to look at total results, and see if your fix-it-up property can generate a better yield rate than buying new properties remotely and incurring the overhead of property managers.

I have had Murphy strike twice and knock me down to 75% occupancy. Thanks to having a pro team support me, I have been cash flow positive, despite pouring an extra \$1000/month into one of the mortgages to pay it off faster.

I can’t guarantee I’ll blog as frequently as I did before my current writing endeavor. But I just couldn’t keep this to myself. (Seeing some  of my past readers comment how they enjoyed my writing was inspirational as well!)

## Mutual funds are just fine…if you’re rich

I listened to a famous financial radio host talking on another radio show this morning. The question was asked, “do you still believe in the 401k?”

His answer? “I invest in some mutual funds in a 401k along with rental property I pay cash for.”

I listened to this and could immediately see the fallacies in such a statement. Let’s dig in and examine them.

First of all, the key to building a retirement portfolio is putting money there. Duh! The reason many of us read a report or a prospectus is because we don’t have gobs of money to fund a portfolio. Instead we have much less so we must lean on the power of ROI and compound interest.

What do I mean? Imagine you made \$1,000,000 each and every year. What if you could live off just half of that? I promise you: saving \$500,000 every year for twenty years will set you up real nice.

With no growth at all, that adds up to \$10 million. And if you bought something that yielded a paltry 1%, you would be raking in \$100,000 forever without dipping into the principle.

Instead of plowing half a million into some 1% CD, what if you peeled away half of that and bought a new rental every year all cash? I think accumulating twenty rentals would be very nice.

\$5 million in rental equity could easily yield \$20,000/month in rent. Apply Murphy’s rule and assume you only get half due to repairs, maintenance costs, vacancies, etc. \$10,000 is still pretty good.

Combine that with an adjusted \$4000/month in CD interest, and you will do just fine.

As a side effect, people would probably stand up and take notice. The synergistic effect would let you write books that would sell like hot cakes because everyone would want to know how you did it.

So how did you do it? The secret is the original business you built that generated all that capital in the first place!

If none of us become entrepreneurs, we have to think up other ways to scrape up some capital. If your rich, you can afford to pay all cash. Not rich? Then your stunting your returns by going too debt-is-evil. There are good ways to take in debt and mitigate the risk.

Make no mistake. We can still accumulate \$5-10 million in rental property. We just have to be ready to take on strategic debt, hire the right experts and do things smarter. We have to keep our eye on the ball.

We can become very successful. Sadly no one will want to read a book about how we did it. Oh well. You win some you lose some

But it irritates me when certain rich people go out of their way to tell us that mutual funds are great for everybody. They’re not. They suck. It just doesn’t matter how badly they suck when your pile of gold is really big.

To generalize that this approach to building retirement wealth works for eveyone is ridiculous. History doesn’t support it. And this is where I must part ways with this radio host when he begins to talk about investing.

## Rental property requires patience…and cash

It looks like we finally have tenants for my unit that has been vacant since the end of January. We’re talking three months of lost rent. In that time frame, I have had to pay for utilities. I will also have to pay a finders fee to my agent that located these tenants.

Last year I instituted paying an extra chunk of change on the smallest mortgage. Basically I was pushing the bonus rent into that mortgage to pay off as fast as possible. Turning it off was too hard, and I assume it would get filled quickly, so I never turned that off. It has made me cash flow negative for this short time frame.

Perhaps I should have turned it off immediately. I need to think that through, make a plan, and go through with it the next time we have a vacancy.

Do NOT act desperately

Having one applicant fall through, another possible applicant pass on behest of finding a better deal has given me every reason to get desperate. What do I mean?

Just last week, I had an applicant shoot to get the unit. The trick was, they had been foreclosed on and actually had a huge outstanding judgment to pay. I wanted a tenant, but I knew I might be taking on someone that would cost a lot more money to get out of. So I passed. And then in the middle of this week, I got a couple college kids who have their parents ready to co-sign.

Things looked much more solid, so I jumped at it. They want to move in today. Not sure all the paperwork can get pushed through that quick. But it will be nice to get the rent flowing again.

Do what makes sense, NOT what feels better

Most of this time, I had a persistent feeling that having an empty unit was bad. It pushed on me, stressed me, and strained me. But I KNEW that I needed to pick up a solid tenant. The cost of not waiting for such would probably any carrying costs.

I also knew I had a LOT of cash in the bank and could ride this out. Too little cash, and desperation can easily become reality. I had the benefit, thanks to Jeff Brown’s insistence on cash reserves, to weather this storm until a good tenant could be found. Well things look solid, but only time will tell if I picked the right people to rent out my unit.

And I get to through this again next month as another one of my units becomes available at the end of this semester!

## When dealing with banks, assume NOTHING

My four rental property mortgages came up way short in escrows this year. It meant they were going to increase my monthly payments by a huge amount. I discussed it with my real estate broker and my mortgage broker. It was agreed that it would be better to plunk down the cash to pay off the shortages. But that isn’t the point of this article.

You see, a month ago I sent checks in to pay off the shortfall. This was needed before I could request they stop collecting escrows. As this month’s payments went through, I noticed a shortfall still being reported on the website. I called them up, and sure enough, they had NOT applied the checks towards the escrow shortfall. Despite the checks being labeled as explicitly to be paid towards the shortfall.

Instead, the bank put the money towards this month’s payments. The extra cash in a couple of the checks was applied towards principle. When discussing this over the phone, I asked if they could reapply the checks. “No.” Essentially, what was done, was done.

I had dropped a chunk of cash and my issue wasn’t resolved. I hammered things out to get the balances paid off. It was quite a bit of cash to straighten things out.

Not only does this reaffirm the need to carry big cash reserves, it also highlights that anytime you need do anything different than make a standard monthly payment, don’t assume the bank will do it right. Call them up and make sure they are doing what you want with your money.

## Checking ALL the facts

Skimming some financial forums, I once again spot people making gross assumptions with inadequate facts.

One popular discussion is whether or not you should pull out your 401K money, pay all those taxes including the extra penalty, and buy rental property.

People LOVE to point out the superior option of rolling your 401K money into a self directed IRA and using that to buy property without any tax repercussions.

And once again, such advice is rarely challenged as not a good bet. People seem ignorant that no bank will write you a note for only 25-30% down if it’s from an IRA. For a non-recourse loan, they will probably want more like 40-50% down.

It kind of kills the whole effect. If they are cutting the number of rentals you can buy in half, what’s the point of dodging the taxes?

Factor this too. IRA funded rentals require all proceeds to go back to the account. You can’t “touch”‘any of the money. It’s not an option to write a check at Home Depot for things and fix it yourself. You have to hire a contractor.

With the net effect canceling out your tax savings, you might as well just pull out your money and leave all those pesky regulations in the rear view mirror. After a few years, the penalties will probably become a distant memory.

## Having the right team pays BIG!

Once again, having the right boots-on-the-ground team to manage my real estate has paid off. I mentioned before about a tenant that received military travel orders to report to another base at the end of January and had to break his lease.

Fast forward to March, and we still don’t have a new tenant. We had one lined up a month ago, but their ability to sell their previous house fell through.

I received an email that a couple that had sold their prior house and was building a new one. Until their new home is ready, they are asking for a special short term lease (eight months). To support such a special lease, a premium of \$200-300 was suggested by the property manager.

I picked up the phone and called my real estate agent that finds tenants. She boiled it down real simple. My unit was the only one in the area ready to go RIGHT NOW. The wife is a realtor and the husband works for the police department. When I first read that, it sounded like two people that probably had solid character. My local agent was able to tell me that she actually knew them and gave me a good read on things.

Don’t get sucked into analysis paralysis

I had already punched in \$300 x 8 months and saw that I could recover the lost rent from two months of vacancy. And if things drag out, they might have to stay longer. That combined with the solid reputation these potential tenants had, it was a no brainer. I told my agent to pull the trigger and start the application process.

It’s important when opportunities rise, to jump on them and not waste too much time calculating things. Having a local professional that understands the local market is invaluable. I can follow a lot of things, but being able to call my agent or Jeff Brown and have them boil away all the irrelevancies while focusing on key factors is important.

My agent explained that there were more units that would be coming on the market soon, but mine was the only single-floor home available RIGHT NOW. I told her to pull the trigger!

When this short lease runs out, I’ll call her again and we’ll see what rents rates are like at that time. But it will feel good to catch up cash flow wise and even pull ahead.

## Financial math often isn’t straightforward

When you decide to pick up the gauntlet of investing for retirement and step away from passively throwing money into your company’s 401K plan, you may enter a perplexing world. Don’t be afraid!

For starters, you might start visiting lots and LOTS of websites looking for opinions. Be aware: many people can and will state opinions wrapped in feel-good language like “think about…it makes sense”. It doesn’t make it right. That’s why you need to learn how to drive a spreadsheet and crunch numbers on a calculator.

The only way to really deduce if they are right is to do the math yourself. This might involve either using a calculator or a spreadsheet. Another tool to have at your beck and call is a mortgage calculator.

Let me pick one example. I have a primary residence, a vacation residence, and four rental properties. They all have mortgages. So what do you do if you stumble across a surplus of cash? Try googling “pay off mortgage early” and you’ll find loads of opinions. People often suggest paying off your primary residence first. Many will state it is way more important than paying off rental mortgages. They’ll probably mention a dozen different reasons.

But simply put, your permanent residence doesn’t yield cash. The only way to get that money back is to SELL your permanent residence. You ready for that? In my situation, no. I’m not moving anytime soon. Sinking any extra of today’s dollars would be flat out stupid.

The plan is to knock out the rental loans as fast as possible to make it an option to liquidate a unit when the time if right. That combined with the accelerated depreciation I’ve set up will generate the biggest bang for the buck.

A finer point in this example is exactly how various pay off scenarios impact the bottom line. Currently, I’m piping extra rent towards the smallest rental mortgage every month. I’m interested in throwing a one time payment against it next month. What impact would it have?

Learn how to drive a spreadsheet and a mortgage calculator

Like the title says, some things just aren’t intuitive. I found a mortgage calculator that includes the ability to add extra on a monthly, annual, and one time basis. The extra monthly amount I’ve been paying is bringing the pay off date from 2042 in to 2020. Nice! What does my tentative single payment next month do? It pulls the payoff date in six months. What?!?! I thought it would have a bigger impact. It doesn’t. The question arises: is this the best usage of such money?

This discovery also raises the question about what if I could make an annual contribution to the rental mortgage? I began to go down my laundry list of extra sources of cash. The two I can think of is using one of my 6-month bonus checks or one of my 6-month ESPP options. The bonus check is currently used to fund my vacation property. But what if I routed one of my two ESPP checks into that rental property? I hastily punched it into the mortgage calculator in lieu of the one time contribution. I see the payoff date move up to 2017, just three years away. That’s more like it!

I’m planning to have a review of everything with Jeff Brown. I’m going to tell him that I can pipe extra cash annually, or even twice a year courtesy of my ESPP. Who knows? Maybe I need one of them to pay for insurance and taxes. One question I have for him is whether or not it really makes sense to put that single lump sum payment on the loan, or perhaps use it to beef up my cash reserves.

To top things off, I used the same calculator to find out where my second smallest rental mortgage would be in 2017, and calculated when it would pay off assuming I apply all the rent from the first unit. Answer: 2020! So, with extra rent added on a monthly basis minus one mortgage payment and throwing in a chunk of ESPP once-a-year, I can pay off the first loan in five years, and the second one three years after that. Estimating the 3rd and 4th units is probably absurd at this point, because there is too much variance that can happen in the next eight years. But I can only imagine that pointing the rent from four units with only two mortgage payments will be grand.

Circling back to the original topic at hand: you need to understand some fundamental concepts and when to use the right calculators. Plug numbers into a spreadsheet on an annual basis, and see how the balance of your loan drops based on paying the minimum vs. an increased monthly/annual/one-time amount. Also consider how you would get your hands on that cash down the road, and think about what you would do with the money at that stage. Buy more rentals? Stocks? Fund another EIUL?

Kicking around some ideas? Send me a message and I’ll be happy to discuss things with you.

## Looking at a friend’s decision to sell off a rental

A close friend of mine recently completed a big shift in finances.

They had lived for years in a small home and managed to pay it off. Then they moved to a slightly bigger home and turn their first into a rental. Apparently they were able to use the rent from the first home to pay the mortgage on the second.

The big change is that last month they sold their old home at a profit from what they had originally bought it for. They took all their equity and paid off their current home’a mortgage.

He went on to tell me that somehow even with the rent he had a hard time making ends meet. He has never made close to what I make so I can’t sleight him for doing what was best for family.

He also said the stress was bad. They always feared getting a bad tenant that would trash the place. We have visited them countless tunes before they moves and I can testify it wasn’t a Class A place.

The final nail in the coffin was the amount of emotional attachment he had to the place.

This may not be what I would have done, but I don’t have his financial position, his stresses, or his situation. No way I can criticize something like that. He got good usage out of the equity of his old home and managed to work his way to a better situation. I can only wish him the best.