How To Be Needed

Working within Corporate America, I see many folks who are enamored with the idea that they are needed.  Their employees should not make decisions without consulting them.  Need to take a business trip? Get an approval.  Need to be reimbursed for said business trip?  Get an approval.  Have an idea for a better way of doing your work? Get an approval.  Want to start your next project?  Get an approval.

It sounds annoying but still innocuous, right?

Wrong.

All these approvals are “No” gates.  They’re just speed bumps on the way to someone at some level saying, “no”.  Just try taking action without approval though.  The entire system is set up to slow down and stop any action or change.

One of the reasons I’m so intrigued by real estate is the potential for passive income.  However, I’m not on the right path yet.  I’ve started setting up a system where I’m needed for everything.  And, it’s hard for me to change, even though I know I’m the only one in my way.

Let me explain.  I suffer from several personality flaws:

  1. I’m cheap
  2. I’m too curious about how things work
  3. I’m slow to trust
  4. Did I mention that I’m cheap?

To illustrate: we bought our condo, knowing that the interior needed to be completely refreshed.  My wife and I (and one of our good friends) spent almost 500 hours in 2 months tearing up carpeting, sanding, painting, installing flooring, cleaning, painting, installing trim, changing electrical outlets, painting, and managing 3 sets of contractors.  And that was on top of our day jobs.  We used contractors for the HVAC replacement, countertop installation, and appliance haul away and replacement.  Otherwise, it was all us.  I schlepped 800 sqft of flooring up 3 flights of stairs… hardly passive income.  That’s personality flaws 1 and 4 coming through.  We stretched our means to buy the property.  We knew going into the project that we needed to stick to our renovation budget, and that meant doing a lot of work ourselves.

Tim Ferriss’s Four Hour Work Week, Robert Kiosaki’s Rich Dad Poor Dad,  Paula at Afford Anything, Sam at Financial Samurai inspired us to act (affiliate links).  And I know they all started small, but I learned a new appreciation for the word hustle during this project.  Here’s the thing: they’ve all made it.  We’re just starting.  So, we don’t yet have systems in place to do the work for us.
When it came time to look for a tenant, we were hesitant to hire that out too.  We were curious to know who would be enjoying our new place.  (Yes, we thought of it in terms of “our”).  And that’s an unfortunate byproduct of personality defect number 2.  As much as we followed our newly established process for screening tenants, there was still some emotion associated with our selection.  In the end, things seem to have worked out OK.  And, we’re again faced with a new round of tenant screening.

We know every inch of our condo, having spent so much time renovating the place.  In our area, the renting process can be contracted out for roughly one month’s rent.  Each property can be managed (as a contract) for roughly 10% of the gross monthly rent.  Add both of those together, and our unit becomes significantly less profitable.  There’s the added uncertainty around a property manager: will they care about our property as much as we do? Will they present as good of a customer(tenant) interface as we will?  See personality defect#3 at work (Probably # 4 too)?  So, as much as we would like to have a better system in place, here’s what we we’re doing:

1. A pre-screening phone call.  We ask 7 questions of each person interested in seeing our unit.  The questions are:

  • Why are you moving?
  • When do you want to move in?
  • Are you OK with us conducting a background check as part of the application process?
  • Do you have residential and occupational references we can contact as part of the background check?
  • Is your income greater than 3x the monthly rent?
  • How many people/pets will be in the unit?
  • Have you ever been evicted?

2. Once we believe folks are good prospective tenants, we set up a time to show them the unit.  Note: I would love to transition this to an open house type of showing.

3. If they’re still interested, they fill out an application form and we proceed with background/reference/income checks.  To protect everyone involved, we’re using  TransUnion’s MySmartMove. We really like that our tenant’s personal information is protected: we don’t have to handle their data or worry about processing their application fees.  We get to see a quick summary of their current financial obligations, payment history, and a prospective tenant score.

 

    TransUnion’s Resident Score Range.

4. From there, we conduct rental history, employment, and income verification checks.  If everything checks out,

5. We review and sign the lease.  At last.

Whew!  What a process!  This being our first time screening tenants since the unit was finished, we had to invest a bit more effort to obtain interior photos, put up a detailed website, and prepare our listing on Zillow’s Rental Manager site.  We’ve spent 13.5 hours getting that all set up.  Hopefully, we’ll be able to re-use this for years to come.  In terms of screening tenants and showing the unit, we’ve spent 3.5 hours and showed the condo to 3 prospective tenants.  The third family submitted an application, and we’re processing it currently.  Keep your fingers crossed!

In a future post, I would like to revisit more of the non-recurring effort/ongoing maintenance effort and costs that we’ve experienced thus far.  From my homework in preparing to purchase this condo, I really struggled to find good data on these topics.

So, any ideas how we can systematize our rental property further and make it more of a passive income generating machine?

Would You Bet Your Life On It?

Look Out!

Look Out!

I’m betting that I won’t live to see my 55th birthday.

Ugh, that was a tough sentence to write.

But, in a way, it’s true: now that my wife and I have a little girl, we’re thinking about buying life insurance.

Which really makes me grouchy!

Why on earth would I dump money into something where I hope I never get paid back!?  Shouldn’t I just put money into an asset that may appreciate?  Won’t my family be better off just cashing out my investments once they’ve had a chance to grow?

Maybe.

Unfortunately, there’s a lot of buses out there, and you just never know if one has your name printed on the front of it.  And, that’s why we carry insurance: to protect us from low probability, high risk events.

  • The house burning to the ground.
  • Someone smashing into our beloved (parked) Scion xB.
  • A sudden stop to the journey we know as life.

Unless you’re already loaded, it’s tough to be completely self-insured (not us, by the way).  So, we’re back to buying life insurance.

More specifically, I’m looking to buy a 20 year term policy.  Let’s keep the math simple and say that we’ll buy a $500,000 policy (we don’t want her to grow up wanting).  I’m almost 35.  With a term policy, the bet that I’m making is that I will die sometime in the next 20 years.  If I do, my girls get $500,000 (assuming my path to the Big Dog Park in the sky met the predefined criteria).  Some really smart mathematicians have figured out the risk (or probability) of someone within my demographics suffering a similar fate.  Using some complex statistics and math, the insurance companies have figured out what premiums (small, routine payments) each person in the population would need to make in order to work out to a profitable business for them.  Their goal is to have more money coming in through premiums than money being paid out in claims.  For an insurance company the aggregate difference between the two is called the loss ratio.

Back to my bet against the insurance company’s…  I received a quote from an insurance company for monthly premiums.  They quoted roughly $20/mo for the first 5 years, and $25/mo for the remaining 15.  In exchange, were I to meet an untimely demise within the 20 year period, the insurance company would pay out the benefit value of $500,000 to my family.  And that’s the bet we’re each making.  The insurance company is betting I’ll outlive my policy so they don’t have to pay up.  I’m making sure my family is covered in the unlikely (I hope!) event of an early ascension (or a bus ride to someplace warm).

So, what are the odds in this particular bet?  In my mind, the insurance company knows the odds of an individual passing, and they set the premiums accordingly.  So I’ll assume that the:

 Payout x Probability Of Dying can be no more than the Cumulative Premiums.

What I think that means is that:

The Probability of Dying <= Cumulative Premiums / Payout

I said I was going to keep it simple.  That’s all the math I’m going to throw at you for this post!

What are the odds? In whose favor are they?

What are the odds? In whose favor are they?

The less than condition is there to cover profit, overhead, etc. that the insurance company factors in to their math (and I don’t have access to that stuff).  Let’s look at the “best” case where I’ve spent the least and receive the payout: tomorrow.  I’ve paid my first month’s premium, and wham!  Fortunately for me that works out to a 0.004% or smaller chance of occurring.  But it could happen, and that’s exactly why I want to “invest” in life insurance.  Our investments haven’t had enough time to grow to cover the costs of raising our daughter, paying for college, etc.  It’s tough to find a $500,000 return for on an investment of $20 anywhere else (25,000:1).

Now fast forward to the last month of the 20 year term.  I’ve successfully dodged buses, riots, airplane crashes, and all other manner of unexpected hazards.  I’ve paid in $5,700 in cumulative premiums (without adjusting for inflation).  Then a slip in the shower and wham!  That < 1.14% chance of death somewhere within the 20 year term worked out in my favor … I guess.  My family still gets the payout, but it cost me the full premium amount.  That’s still almost an 88:1 return.

Let’s look at the most likely case: everyone lives happily ever after.  This is the one that keeps insurance companies in business.  It’s also the one that feels like a warm blanket.  My girls were covered for some of the most vulnerable years of our lives.  I slept better knowing that they would be taken care of in case of unlikely events.  And that’s well worth $5,700 spread out over twenty years to me.

 

I should mention that in no way should you use any of this to make any life insurance decisions of your own!  Do you homework.  That said, what do you think?  Are the odds worth the expense?  How much insurance do you carry?  What type(s)?

Return On Invested Capital 

There’s an investment class I’ve deliberately not spent much time discussing yet: real estate.  In light of Brexit and some increased volatility in the stock markets, I think the time is right to start talking real estate.

I don’t mean your home.  I don’t mean that piece of swampland Aunt Bessie left you in Central Florida either.  I mean rental properties.

Ask some people you know if they’ve ever looked into the rental property business.  You might be surprised at how many folks have already taken the plunge.  I know the more folks I’ve asked, the more surprised I’ve been at how many people and who owns one or rental properties.  I think there are a couple of reasons for this:

  1. Almost passive income
  2. Sustainable side hustle
  3. Return on Invested Capital

Almost Passive Income 

Most folks work for their paychecks.  We trade our priceless time for an hourly wage.  Passive income lets us change the game by avoiding this traditional approach to creating income.  I first started reading about passive income as a concept in Rich Dad, Poor Dad (Affiliate link).  To this day, it remains one of my all-time favorite personal finance books.  Passive income has the ability to help each of us achieve our financial freedom earlier.  Passive income lets us get to that “Freedom Uttained” point faster.

Think about it like this: let’s say I have an annual salary of $100k.  And, I spend about 2000 hours a year to get that salary.  That works out to $50/hr.  Not too bad, right!?

I Love Cubicles..

I should even tolerate grey cubicle hell for a while at $50/hr.  But, I can’t.  I want more.  And, I suspect most other people do too.  I’ll dive into the details of my experiences with rental property in future posts.  But, for now, let’s say I net about $500 a month from a rental property (net = rent – all expenses/reserve contributions).  And, I spend an additional 5 hours a month managing my rental property.  That sounds pretty doable.  Apparently, Americans spent more than 5 hours a day watching TV in 2015 according to the Bureau of Labor Statistics.  You know where I’m going with this: the simple math says, I just made $100/hr.  Each month (on average).  Until I sell the property.

Turn off the TV and go make your own life better!!!

And that is the beauty of the rental property business.  You still have to trade some time for cash.  But what you get in return is a seedling.  Your first money tree sprout that may eventually blossom into the life you want to live.

Sustainable Side Hustle

Let’s say my wife and I spent almost 500 hours researching, screening, visiting, negotiating, reviewing contracts, rehabbing, and finally renting out our first rental property.  (It was our first, and I’m pretty risk averse!)  Now we spend about 5 hrs a month managing it.  Some months it’s more.  Some months it’s less.  But, we manage it outside of our day jobs.  And, the checks keep coming in.  To be sure, we don’t plan for 100% occupancy.  In fact, we’re coming up on our next lease renewal, and we will likely have some down-time while we make a couple of improvements and complete some maintenance items.  But overall, we’ve found a way to take some of our surplus cash flow and turn it into gold.  Now, someone else pays our mortgage on the rental property.  Their rent covers the routine maintenance costs and fills out a savings account for bigger items.  All we have to do is wait…

Return on Invested Capital

And that brings us to the actual topic I wanted to dive into.  You see, we didn’t pay cash for the full value of our rental property.  We have a mortgage.  So, let’s do a little math with simplified numbers:

We’ll buy a $100,000 property at market value.  In the first situation, we’ll put down 25% because this is an investment property, and the bank wants a little more skin in the game (or they charge a higher interest rate).  The bank offers us a 4.5% rate resulting in ~$500 per month in principal and interest payments.

In the second situation, we’ll buy the same property with a suitcase full of cash.

Is this the best way to buy a rental property?

Our rent is the same for the property: $1500/mo.  Our costs for taxes, maintenance allocations, utilities, etc. are the same regardless of how we bought the property. Again, keeping things simple, we’ll estimate that at $500/mo. Also, for the sake of simplicity, I’m ignoring closing costs,any renovations, and a few other items that are roughly comparable regardless of how the property was financed.

Is it better to buy with leverage or all cash?

Is it better to buy with leverage or all cash?With

With our loan, we put down $25,000.  Each year, we would bring in a theoretical $6000 of profit for this property.  That’s a whopping (hypothetical) 24% return on the investment we made.  Compare that to buying the property with $100,000 in cash.  We bring in $12,000 profit.  Even though the total dollar amount is higher, we’re only making 12% on our $100,000 investment. Not too shabby, but now we’re out of cash.

In theory, we could use the $75,000 we didn’t spend in the first scenario to buy three more properties!  Using leverage, our new situation looks like this:

Full Leverage ROIC

Living dangerously? Or, spreading the risk?

 

Now, we’re making that same 24% on our money.  And, we’re clearing $2000 a month.  Freedom Uttained point, here we come!  Of course, we had to take out $300,000 in loans to get there.  There’s now a higher chance that we cannot pay all 4 of our mortgages if all our properties are vacant.  But, what are the chances that all four properties are vacant at the same time?  Probably smaller than the chance that the single one is vacant in the case of our all cash purchase!  We just spread out our risk, boosted our returns, and launched ourselves on the path to real estate mogul.

In my mind, this illustrates why real estate is such a neat asset class.  You can buy a full property with 20-25% down.  Doing that with stocks seems way riskier.  If you hold the property long enough, your tenants completely pay off your mortgage for you.  Now, your net returns go through the roof.  Leverage lets us either get into the game a lot earlier or use the cash we didn’t deploy by borrowing to further increase our holdings.  Either way, what we do with our limited resources matters.  And Return on Invested Capital is one way of looking at investments to help us decide where to allocate our limited resources and reach financial freedom that much sooner.