Every month I write about my Alternative Income, which is a measure of “passive-ish” cash flow. For a long time, I was completely confused about how to value our real estate accidental “empire”. The three properties don’t make money each month, which is to say that make any cash flow. Usually real estate investors are looking to make money each month (have positive cash flow).
We’re not typical, because our real estate was mostly accidental. My wife and I bought independently near the market highs and then we moved across the country for different career opportunities. Selling at a loss wasn’t a good option, so we became landlords and refinanced them with a double HARP refinance opting for 15-year fixed mortgages (better rates – yay!) at market lows in 2012. We added another property around 2011. These aren’t big expensive properties… they are condos worth around $500,000 in total.
It seems fairly easy to say, “zero cash flow property is worth $0.” However, my goal is to measure progress in growing cash flow. It doesn’t feel very good to say that they are $0, but then magically become worth $3000 a month when the mortgages are paid off. That’s too Boolean even for the computer scientist in me. It’s really a perception problem:
“It’s all about the exposure, the lens I told her. The angles were all wrong now.”
Paramore – Brick By Brick which is great financial advice!
We could do either of the following and get cash flow out of them:
- Refinance the remaining principle into 30 year fixed mortgages. This lowers the monthly costs and we could pocket several hundred dollars a month.
- Sell the property with the most equity and payoff 1.5 properties. We aren’t going to sell a property just to make the math work better when I calculate cash flow. Also, paying off half a property doesn’t lead to better cash flow number.
The angles were all wrong because neither of them is a very realistic scenario. In fact, they are very unrealistic. Neither of them really assessed the progress we were making to owning them outright.
The “Right” Formula to Calculate the Cash Flow Value of Cash Flowless Real Estate
I don’t know if there’s a “right” formula, but I created what I feel is right for our situation. I’d love your thoughts on this, especially if you are into real estate investing.
The formula is:
(EquityInAllProperties/TotalValueOfProperties) * ((MonthlyEstimatedZillowRent + MonthlyActualRent)/2)
Let’s make that a little prettier:
(This is my first time trying to format a formula for the web, so I apologize if it isn’t as good as it could be. I only promised it would be a little prettier.)
The left side of the equation is meant to calculate the percentage of equity you own. When you first buy, you might put down 20%. Over time the hope is that this grows to 100% and you own the property completely. I calculate the value of the properties using Zillow, but use whatever you feel comfortable with. That’s the denominator. You can subtract the amount you have outstanding from your mortgage statement from that total value calculation to get the equity you have in the properties (the numerator.)
The right side of the equation is meant to calculate the monthly rent that you’ll be getting from all the properties. I average the Zillow expected rent because we give some great tenants a bit of a discount. It makes me feel a little better about the numbers to know that we can and will likely raise the rent to market levels eventually. You could, of course, skip this. For us the numbers are close to the same anyway, so it isn’t a big difference.
As a real life example, we own 43.1% of the total value in our properties. It’s up 36.4% from earlier this year. This is due to the value of the properties increasing as well as the mortgages getting paid down. Our expected rents from all the properties (factoring Zillow) is $3225.
Essentially, the left side tells you how much of the pie you own. The right side tells you the size of the pie. Multiply them together and you get a number representing the amount of virtual cash flow you own. Over time both numbers will grow. That makes tracking the progress of this number.
You’ll want to take out HOAs, taxes, insurance, and some reasonable amount for maintenance, etc. As commenter Jaime below mentions, it could be more or less than 25% of your cash flow. I think I’ve estimated it to be closer to 20% of what I project, but 25% is a good safe number. I like to take it out of the right side of the equation, but the order of operations doesn’t matter mathematically.
I thought I’d test out something a little different today and cover multi-level marketing in a section called MLM Corner. The goal is raise visibility of how such companies operate. I’m getting a lot of feedback from you that MLMs are crowding your Facebook and you are sick of it. I’ve covered quite a few such as Youngevity, It Works, and Le-Vel. Typically MLM Corner will highlight other perspectives of MLM from around the web.
I’d like to kick it off with MLMs and Me from Oakes’ of Righteousness. Rachel walks the reader through the cold recruitment (not sales) pitch from a friend who hadn’t talked to her in two years. She covers a lot of MLM in a fairly brief personal story. If you are interested in this kind of thing, it is worth reading (and sharing.)