All posts in Real Estate

Why Your Fixed Real Estate Expenses Aren’t Fixed

by Darryl Kraemer on April 8, 2010 in Real Estate with 1 Comment

When you hear the word fixed expenses, you’d assume that means they are … fixed, right? Not so fast. Fixed expenses are never fixed, and when you are analyzing a property over 5, 10 or 20 years, you need to make sure you understand why they aren’t.

Introducing … INFLATION!

What is inflation you ask? According to Wikipedia, Inflation is:

…a rise in the general level of prices of goods and services in an economy over a period of time.

Which really means that as everything you need to buy gets more expensive over time, the money you have gets less valuable. What this means is that $100 today, won’t buy the same amount of goods in 5 years.

Why Is This Important For Real Estate Investors?

Glad you asked! In Real Estate, like other parts of life, you have expenses. These expenses could be heat, hydro, water, lawn maintenance, snow removal, repairs to the property, taxes, insurance, etc, etc, etc. These expenses aren’t going away, and because we have our friend inflation added to the mix, they are going to get more expensive every year.

What I see a lot of times is investors will forecast cash flows for the property out over 5 years, and happy add the 2% or so increase that we can legally apply to rents every year. Yipee — more revenue/rents coming in!

But they forget one very important thing. They don’t apply inflation to their “fixed” expenses. What happens is their cash flow in future years look better than they really will be. This leads to increase optimism, and if they buy on razor thin cash flows to start with, they will be disappointed in future years when the cash flow isn’t as high as they thought it would be.

Here’s an example, where you can see the expenses have increased $400 over 5 years based on a 2% inflation. If we look at the 20 year figure of $7353 per year, it is an increase of over $2400 per year!

fixed expenses with inflation

So What’s the TakeAway?

Make sure you apply at least a 2% increase to your fixed expenses when you are analyzing your properties. In the Investment Property Calculator that I’ve built, I made this an input so I can easily increase or decrease the percentage depending on what the economy is doing that year. It automatically increases the fixed expenses by this percent every year when it calculates the 20 year cash flow and returns.

We know that inflation is not fixed, but taking this into account when you look at the numbers for a property will help you make a more accurate prediction of what a property will do for you.

Good luck in your investing, and if you have any other tips that you use when looking at properties, please leave me a comment below!

Debt Reduction: The Forgotten Return in Real Estate Investing

by Darryl Kraemer on February 26, 2010 in Real Estate with 7 Comments

It is interesting how many times you are reading an article in a magazine or a newspaper, or when you are reading a book on Real Estate Investing, and the author focuses on one of two ways to get a return on your investment:

  1. Cash Flow (the life blood of any real estate investment) OR
  2. Appreciation (the speculation in real estate investment)

I want to talk about the third, sometime forgotten return in real estate investing, and that is:

Debt Reduction on your mortgage (thank you Mr. or Mrs. Tenant!)

Debt reduction is a key factor to take into account when you are analyzing the total return for a potential real estate investment you are looking at. You can thank your tenants for this return, as they are the ones who create it the moment they begin paying their rent.

When you pay your mortgage every month, the payment consists of two pieces: Principle and Interest, sometimes referred to as P+I. Interest is what you pay the bank, mortgage company or private lender in return for the risk they take on by lending you the money to buy the house. Principle is the part of your monthly payment that actually reduces the amount outstanding on your mortgage every month.

Let’s look at an example:

Mortgage Amount: $100,000
Interest Rate: 5%
Amortization: 25 years
Term: 5 years
Compounded: Semi-Annually
Payment Frequency: Monthly

Based on these inputs, your monthly mortgage payment would be $582 per month. Of that $582, part of it pays the interest and part pays the principle. How much you ask? It breaks down like this for the first month:

  • Interest: $412
  • Principle: $169

Now, you may be saying that $169 is not that much, but remember, you aren’t paying it down. Your tenant is! Every month. They are reducing the amount of the mortgage outstanding just by the act of paying their rent.

A year later, the break down looks like this:

  • Interest: $404
  • Principle: $178

The amount of principle in every payment has gone up! As you (your tenant) chips away at the mortgage amount outstanding, the interest portion of each monthly payment is reduced because there is less of a mortgage balance to pay interest on.

Let’s look at a table from my investment property calculator that shows the break down of cash flow, debt reduction, and appreciation every year so you can see your total return on a potential investment.

After 5 years, when the mortgage term is up and it is time to renew, even with a 0% appreciation in your property value, you can refinance back to 80% LTV, pulling over $11K out of your property to use as a down payment on another. This is in addition to the over $10K in cash flow your property generated, even with a 5% vacancy allowance.