As a real estate investor, cash flow is the fuel that drives our businesses. Whatever means you use to purchase properties, it still doesn’t address the number one problem that causes businesses (real estate or other) to go out of business: lack of positive cash flow. Businesses depend on positive cash flow to keep functioning and paying their bills, vendors, and principals. In addition to the day to predictable day expenses that businesses incur, there are also those unexpected things that can pop up from time to time.
For rentals, there are things like furnaces, hot water heaters, plumbing, and other items that can break down, and tend to do so just when you least expect it! Another scenario is that you go a month or two without a tenant. Thus you have no rental income to pay the mortgage and other expenses for that period.
For fix and flips, sometimes you will find that there are some issues that were either missed or not readily apparent with the inspections, such as mold, foundation issues and the like. It is also possible that the project will take longer or cost more than you initially thought. Whatever the situation, you may need to dig into your business “pockets” and pull out some cash.
It’s no secret that it’s a smart idea to keep some money in reserve in your business to deal with these unexpected problems. The question is: How much money should one keep in reserve to be able to handle common issues and other than something catastrophic occurring and be able to sleep at night?
A generally accepted rule is to have between 3 to 6 months of operating capital in reserve. Unfortunately, many beginning, and often even experienced investors don’t have this kind of money put aside. It is vitally important to try as part of your goal setting, to build up this reserve as quickly as you can. We will talk later in this article about some strategies you might use if you do run low and don’t have the cash readily available. The secret is to have the money lined up before you need it!
Let’s first talk about some factors to consider when trying to pinpoint a sufficient reserve fund to keep your business running smoothly:
- What Are Your Current Expenses? Add them up. Be sure to include your monthly, quarterly and annual expenses and include a buffer.
- Future Cash Needs? Let’s face it, prices never seem to go down, so be sure to anticipate additional fees and costs for future needs.
- What Stage is Your Business Currently At? Businesses starting up may require more of a cash infusion than an established business that has a good handle on their current expenses and also has positive cash flow coming in from current and future endeavors. If you are in an expansion phase, this may also require having more cash on hand.
- How long will it take to get more cash if you need it? Do you have reserve lines available or other means of quickly obtaining more cash?
Depending on your real estate business strategies, the requirements vary a bit so let’s look at both rental and fix and flip cash needs
- It is generally not a great idea to purchase rental properties that produce negative cash flow, especially for the beginning investor. Unless you have a way to help pay the upside-down costs, it can be a problem. In some rapidly appreciating markets, it can make sense, but you need to know what you are doing and have a plan to make up the loss and maintain your current business while holding the property.
- It is inadvisable to buy a rental without some “emergency fund” in place or at least access to a line of credit or partner to help cover unexpected costs. It is not a matter of “if”- it is a matter of “when”.
- For conventional financing or a refinance, banks may require that you have up to 6 months of cash reserves for payments, operating costs, etc.
- When you are planning out your cash flow projections, remember you have additional costs other than the mortgage. Things such as accounting, marketing, vacancy, and other costs fall into this category. As a general rule, single-family homes will require about 25% of the gross rents as other holding expenses. Multi-family units will require more of a percentage. Smaller multi-family units less than four units make take up to 30% or more. Larger apartment units can require 50% or more of the gross rents. These are generalizations; it’s always smart to look at each property and figure the exact expenses, so you have a more accurate number.
- The more units you have, the more cash reserve you will need but normally you will need less per unit.
Other Factors to Consider for Rentals:
- The age and condition of the property. Older properties normally take more upkeep.
- The class of the property and what type of area it is located in.
- Type of tenant (lower-income residents and single people tend to move more often, causing higher vacancies)
- Terms of your loan. Is it a fixed rate or variable?
- Be sure to figure in any HOA fees and assessments.
For Fix and Flips
- Always figure on six months of holding time, even if you anticipate the holding time to be as little as three months. Here’s why:
– Buyers can back out of the deal or may not qualify for the loan.- You may run into additional problems with the property not evident with the initial inspection.- Flips often take longer and cost more than originally planned.
- If you are doing numerous flips simultaneously, you need MORE cash reserves or quick access to cash, so you don’t run out of funds and thus delay the completion date of any of the projects.
What to Do if You Run Low on Cash
- Sell or refinance current assets.
- Tap into your equity line of credit. If you don’t have enough equity in one property, sometimes you can cross-collateralize the equity in another.
- Obtain and utilize a personal line of credit. Although pricey, credit cards can also work for this if you have no other means available.
- Take a loan from your 401k or a loan from the cash value of an insurance policy.
- Get a loan from an acquaintance, friend or relative.
- Although rare, sometimes one can get a private money loan if the deal looks secure enough for the private lender to take a second lien position.
A Few Final Tips
Make sure you keep constant track of your cash flow! If you have to tap into a line of credit or borrow the money, make sure you have a plan in place to pay it back! Also, it’s a good idea to pay the expenses that affect your credit first.
Always stay in touch and be honest with your creditors and vendors. If you run into a cash crunch, it is likely not the first time they have seen this situation and may have some good ideas and suggestions to help you out. It is possible that they may provide an extension. It is always advisable to have this situation handled in advance so that you know if the lender will provide an extension, what it will cost you additional and what the added impact will be on the terms of your loan.
Remember, even the most experienced of investors will run into a “hiccup” with their cash flow occasionally. It’s part of doing business! However, those that anticipate and plan for it will be those that will be the survivors. With a little preplanning and lining up cash beforehand, you will be prepared for most situations.
Here’s to your success!