Financial planning for real estate investors is anything but a passive activity. The income (for most investors) might be considered passive in the eyes of the IRS, but it’s active within a financial plan. Real estate offers investors benefits such as cash flow, equity, appreciation, and tax efficiency. These benefits can be optimized when planned and managed appropriately.
Implementing a financial plan for rental properties will help you stay organized, make better decisions, optimize tax, and manage risk. If you want to get the most out of your real estate investments, let’s break down the basic elements of a real estate financial plan.
Whether you’re a real estate investor or aspire to be, you’ll want to define the role of real estate in your financial plan. Often, people come to our firm after watching videos on social media. In two minutes, these videos explain how easy it is to make money in real estate (or any other lucrative investment). I want to stress there is no easy road to wealth or financial independence. Real estate is a business. The power of real estate investing isn’t the fact that it’s real estate; instead, the power is in the business that you operate. It’ll likely be a subpar investment if you’re not willing to run a business or put effort into analyzing, making decisions, monitoring, and managing properties.
The common question is, “But what if I get a property management company to do everything for me?” Property management is only delegating part of the business operations. As the owner of the property, you’re making decisions. A property management company can take tasks off your plate, but it’ll come at a cost—a decision to be made.
The bottom line is that you must want to operate a business if you own real estate. It will require your time, attention, and brain power.
A cash reserve is a simple way to manage risks on your property. It allows operations to run smoothly if an emergency, unexpected expense, or vacancy happens. Much like a personal cash reserve, the goal is not to earn a return on this money. Instead, it’s to have a return on stability.
A cash reserve can help:
The amount of cash held in reserves will vary by property, but an excellent place to start is to have the money to cover 3-5 months of operating capital. Building up a cash reserve might take some time, but mark it as a high priority. If you use cash reserves for any reason, replenish them through cash flow as soon as possible.
A simple but essential step is to separate personal and business finances. Do not commingle funds. Separate transaction history will make life easier when managing operations, tracking investments, staying organized for tax time, maximizing tax deductions, and managing cash flow. You cannot run a profitable and efficient business without organization.
Separate accounts and credit cards (get the points!) will keep expenses and income siloed from personal finances. If you own multiple properties, you may consider a bank account for each to keep organized records.
Cash flow is the foundation of a financial plan. You need to know what you expect in cash inflows and outflows. Tracking and estimating expenses will help create a budget for your property. Using this info, you can further create a cash flow projection that’ll assist in making proactive decisions and better understanding your rental real estate investment(s).
A good exercise is to create an annual budget and cash flow projection. Then each month, compare the actuals to your projected numbers. This will help fine-tune estimated expenses, revenue, and how much to keep in cash reserves. In addition, a cash flow plan will assist in finding areas of opportunity, overspending, or where to increase profits.
Here are some common expenses when creating a budget and cash flow projection.
A properly constructed budget and cash flow projection for your rental real estate are essential to the success of the investment.
Unlike investments in the stock market, much of the power of real estate investing is from control. You get to make decisions that directly impact the investment. When investing in stocks or private companies, you’re diversifying the control factor into companies you aren’t making decisions for.
When constructing an investment portfolio that includes real estate, one thing to remember is that it’s illiquid. This means it can’t be turned into cash quickly like stocks or money in a bank. So, depending on your strategy, it might make sense to have liquid investments to balance the illiquidity on your balance sheet. This will ultimately increase flexibility and diversification as your assets grow.
Another factor is leverage. Leverage is a powerful benefit to real estate investing. It can magnify returns to the upside. Unfortunately, it can also magnify returns to the downside. Monitor and track the amount of leverage you’re taking. Don’t become overleveraged where there is potential to become a forced property seller during market downturns.
Consider creating an investment strategy statement that lists all investments, the timeline you intend to hold them, and the reason/goal for the investments. This will keep investments aligned with your goals. It’ll even help you create an exit plan for any properties you intend to sell.
Tax planning is a must when you own rental real estate. This is a much different process from tax preparation. Tax preparation is entering historical info on your tax return. Tax planning is positioning forward-looking strategies to minimize your tax bill over a lifetime.
Being a business owner has some of the best tax benefits in America. Taxes are important but don’t make decisions based on taxes first. You’ll be disappointed if you buy or own rental properties only for tax efficiencies. On the other hand, if rental real estate investing fits your financial plan and helps you reach goals, then the tax benefits can accelerate the path to financial independence.
The right tax strategy will depend on your situation and goals, but here are some common tax strategies.
Tax strategies can be a real estate investor’s best friend to compound tax-efficient wealth. However, it’s important to plan around your goals first and then make decisions for taxes. Don’t limit your flexibility and increase complexity only to save on tax. And I can’t stress enough to work with a financial and tax professional to help determine what strategies make sense for your situation.
Avoiding and minimizing significant financial risks is crucial to real estate investing. Risk can be reduced or transferred through proper coverage and liability protection. When implementing a risk management plan for your real estate business, there are many things to consider.
This is only a short list of methods to manage risk. There are other insurance policies and structures to consider for your rental properties. Here is a list of the most common. Again, working with your legal, financial, and tax team is important to determine the best for you.
As you can see, financial planning for real estate investors is multi-dimensional. Investors seek higher returns from real estate because of additional responsibilities, time, and risks. Without a financial plan, you leave yourself open to these risks, wasted time, and an investment that might not perform well. If you need guidance on implementing a real estate investment plan within your personal financial plan, we are here to help.
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