Normal is not the same as average.
That’s a theme we’ll revisit time and again over the next five minutes. We’ll start by breaking down two years in the life of a rental property and look at how a normal month looks very different from the monthly average.
In rental management and in life, money doesn’t flow regularly like a tranquil creek.
Rather, it moves along steadily for a while, then a storm of expenses hits and it’s thrown radically off course. Then the storm subsides, and the creek slips back to its normal flow.
We’ll use rental cash flow for visualization, but then we’ll tie these lessons back to personal finance and household budgeting. Stick with us even if you’re not a landlord, because we’ll be illustrating a larger point about budgeting and how money flows. After all, who can’t use a little bump in their budget?
Two Years in the Rental Lifecycle
Congratulations! You own a rental property. Your property (let’s call it Treehorn for fun) rents for $1,000/month.
Your mortgage on Treehorn costs $450/month, including taxes and insurance. Treehorn’s property management expenses include 8 percent of the collected rent, plus a one-month fee for placing new tenants. (Whether or not you have a property manager is irrelevant – you should be paying yourself for management if you manage the property yourself.)
That means in a quiet, “normal” month, your expenses are $450 for the mortgage and $80 for management. For the “I hate math” crowd, that’s $470 in cash flow on a normal month, which is all fine and dandy, until occasional-but-very-real expenses rear up and start breathing fire at you.
Take a look at your rents and expenses over these two years:
There are plenty of quiet months. But there are plenty of months with extra expenses, too.
Here’s another graph, showing your take-home cash flow each month over these two years:
What’s the difference between “normal” and “average”?
In a “normal” month, your cash flow is $470. But averaged over time, your cash flow comes to $179.46/month—and that’s the important number.
Expenses: Irregular but Real
In our example here (which is based on a real property of mine), Treehorn’s roof needed a major repair in March of Year 1, which set you back $1,458.
Later that year, you coughed up $200 for Treehorn’s furnace to be serviced in September.
Then, at the end of November, the tenants gave you notice that they were moving out. In December, you sent in a painting crew, who repainted the inside of the unit to the tune of $1,850.
Making matters worse, Treehorn spent two lonely months vacant as you marketed it for rent. By mid-January, your property manager found a new renter, who moved in on February 1st.
Kiss goodbye a one-month fee for placing the new tenant. When added to the regular 8 percent of February’s rent, you were left with property management and labor expenses of $1,080 for February.
Treehorn then performed for you for a little while, until a repair bill of $375 slapped you in July.
October brought a maintenance bill of $250 to fix an ailing thingamajig.
You closed out Year 2 quietly. And for that, we thank Treehorn.
The Cost of Turnovers (Not Fun) & a Sankey Diagram (Fun)
Whether you think these repair and maintenance costs were high or not (I don’t think they were), they pale in comparison to the turnover costs.
I harp on this all the time to our online students: turnovers are a landlord’s worst enemy.
Consider the example above: the turnover cost $2,000 in lost rent, $1,850 in repainting (which only needs to be done during turnovers), and $1,000 in labor to place a new tenant. That’s almost $5,000 in costs caused by one stupid little turnover!
By contrast, the maintenance and repairs costs above totaled $2,283. And at the very least, the property was materially younger and in better shape for those costs.
The same can’t be said of the turnover expenses. Even the paintjob is effectively lost money – the new tenants will leave their marks on those walls, which will probably need to be repainted again come the next turnover.
When most landlords want to improve their cash flow, the first thing they jump to is raising the rent. And sure, that improves cash flow in a “normal” month.
But I’ve found that the best way to improve my real cash flow, my long-term average profit, is by doing everything possible to cut my turnover rate.
Treehorn’s average monthly cash flow was $179.46, and here’s what that average monthly cash flow looks like:
As a final thought for landlords, imagine you prioritized tenant retention and reducing turnovers. Instead of Treehorn turning over every two years, it turns over every four. When you chop those turnover costs in half, the average monthly cashflow surges from $179.46 to $277.17.
Not a bad bump in profits, right?
What Rental Cash Flow Teaches Us About Personal Cash Flow
“This is all well and good,” you say, “but I’m not a landlord.”
And you’re still reading? That’s amazing.
By now, it should be clear that cash flow is about averaging out the peaks and valleys of irregular expenses. Experienced landlords know this, and new landlords need to learn it fast to succeed.
But how is this lesson relevant in our personal cash flow and budgeting?
It’s relevant because the same thing happens in our personal budgets, just not as obviously.
You may not have to budget for turnovers, but you have other irregular costs. Homeowners have to budget for property repairs just like landlords do. Cars also need maintenance and repairs, just like houses. All of us have occasional medical bills, large and small (one might call these our own personal maintenance and repairs costs).
I bet if you added up every penny that you spent on gifts over the past 12 months, you’d be shocked at the total. (Seriously – between holiday shopping, birthdays, weddings, showers, and other arbitrary occasions when we’re supposed to buy people presents, most of us spend an undocumented fortune.) It’s these irregular – but very real – expenses that throw the proverbial wrench in our budgets.
Sure, everyone knows how to budget for their rent or mortgage, and their car payment. But how often have you said to yourself, “Well, this month was different because I had to put Cindy’s wedding present on my credit card. I’ll make it up next month.” Except next month it’s, “Well, it was Little Johnny’s birthday this month, and we wanted to make it special. But next month will be different. We don’t have to buy any presents next month!”
Then next month you get hit with an unexpected $500 medical bill. The month after that it’s an $800 car repair.
Seeing a pattern here?
Budget for the Irregular
If you’re a landlord, you (hopefully) have an expense checking account set up for each property. You put money into it every month, based on your average monthly cash flow calculations for expenses like repairs, maintenance, vacancies, etc.
The lesson for all of us is to do the same with our irregular personal expenses. Set up a special account with the sole purpose of covering irregular personal expenses: gifts, unexpected medical bills, car repairs, and so on.
How much you put toward it is a personal decision, but if the account ever gets below $200, you’ll know you need to be putting more into it.
At the end of the year, if you have extra money in the account, good for you! You can shift some of it to an investment account for real estate, stocks, notes, whatever.
You know these expenses are coming. You’re an intelligent adult. Now budget for them, so you’ll never be surprised again when irregular expenses pop up and make a grab for your wallet!