After last week’s three-part series on investing in real estate, several readers posed fantastic and hard-hitting questions. I started answering these in the ‘comments’ section but then realized that these answers deserve their own post.
So welcome to another installment of “Answering the Readers Questions: Real Estate Edition.” Just wait ’til you hear what my time is worth!
Question 1: What’s Your Time Worth?
One reader asks:
“With a positive cash flow of $1,100 and the time you both spend working on the home, it hardly seems like a positive cash flow. In a prior post, “What Does This Woman Earn?” you calculated her salary based on commute time, preparing for (work), etc.
It seems you should do yourself a favor and make sure you calculate the true cost of your rentals with time and materials included and then ask yourself your ruthless question: “What is the true cost of this rental?”
I loved this series because in every step you looked beyond the obvious, you didn’t take no for an answer, made a great purchase price, worked hard with the bank. But you disappointed with your bias cost accounting for the rental.
How about you repost those numbers a little more honestly, time and materials include and lost income becuase you worked on a rental property instead of you self employment or other income producing activities.”
I love this question. Everyone should ask themselves this question: What’s my time worth? Am I paying myself what I deserve?
In my case, the answer is a whopping yes.
I don’t like to over-emphasize the “resale” value of the home. I don’t want to join the parade of people who are obsessed with housing prices.
But to put a value on the time I invest working on the house, I have to look at the market value of the home before and after I fix it.
As I mentioned in the first installment of the real estate series, a standard single-family home in my neighborhood costs about $600,000. Multi-unit properties are about $100,000 cheaper, priced at a cool half-million dollars.
So we faced a choice: Should we buy a mint-condition home for $500,000, or should we buy a fixer-upper for $225,000 that requires us to invest about 15-20 hours per week for 3 years?
(Actually, it wasn’t much of a choice – we don’t qualify for a $500,000 loan. But that’s beside the point.)
Let’s say we spend 17.5 hours a week, 50 weeks a year, for 3 years, repairing the house. That’s 2,625 hours.
In addition to that time, we also spend $40,000 in materials:
Kitchen Remodel = $15,000 ($5,000 per kitchen x 3 kitchens)
Bathroom Remodel = $4,000 ($1,000 per bath x 4 baths)
Landscaping = $3,000 (small city yard)
Foundation Repairs = $8,000
Paint and Siding = $3,000
Carpet = $2,000
Doors, Windows and Insulation = $5,000
After subtracting for the materials cost, each hour of our DIY home repair work is worth $70 per hour.
Of course, I’m ignoring the extra debt interest we’d pay if we had a higher mortgage. If you count the interest, we’d roughly double the value of our time to $140 per hour.
But let’s stick with the simple estimate: let’s take the conservative, at-face-value estimate that our time is worth $70 an hour when compared to buying a ready-to-go rental building.
Now, let’s assume the worst. Let’s imagine that I made some huge calculation error when I estimated how much we’d spend on the cost of materials. Let’s say we spend DOUBLE what I predicted we would — $80,000 on the price of materials.
Even after laying out $80,000 on materials, our “return on time” is $55 per hour. I’d say that’s pretty darn good.
There’s always the question of opportunity cost — what else could you be doing with your time? I don’t know about you, but I think $55 to $70 per hour to work from home is a fantastic opportunity.
Question 2: What About the 50% Rule?
Another reader asks:
How did you come up with the $3100/yr in maintenance? I would expect much higher on such a large and old house. You’re probably familiar with the commonly used “50% rule” which states you should prepare for total operating costs to be 50% of your rents. If that’s the case, you’re severely underfunded. Perhaps it’s less of an issue because you guys are doing the work yourself, and I would guess using high quality material.
There are dozens of “rules of thumb” to predict how much you’ll spend on a rental property, and I disregard all of them.
The 50% Rule states that your operating costs – such as property tax, insurance, repairs, maintenance, water and trash service – will equal half of your rental income. Anything that’s left over either goes to the bank – to repay your mortgage – or goes to your pocket.
It’s a popular rule, and it’s one that I completely ignore.
The 50% Rule is based on a variable – the rent – that has absolutely zero relationship to your operating costs. Regardless of what I charge for rent, the rest of my bills — water, trash, insurance and taxes — remain the same.
As a landlord you realize the arbitrary nature of rent. Here’s how rent pricing works: You pick a number out of thin air, advertise it as ‘rent’ and see if anyone bites.
If no one wants the space, you lower the rent. If people flood your Inbox, you take down the ad, raise the price, and re-post the ad.
I’m oversimplifying. I toured about two dozen rental units in my neighborhood to get an idea of what the competition charges – so the number I set as the rent wasn’t completely out of “thin air.” But ultimately the difference between charging $700 or $800 per month boils down to my confidence.
Let’s imagine I’m ultra-confident. Let’s say Cameron Diaz is shooting a movie scene in the house next door, turning this block into Atlanta’s “hot new spot.” (This actually happened a couple weeks ago. It increased the ‘desirability’ of my street without costing me a penny.) Or let’s say that an abandoned old building down the street morphs into a new shopping development (this is also true – it’s happening as we speak).
Now that I’m feeling more confident, I raise the rent $100 on each of the two single-bedroom units and $200 on the three-bedroom unit. That’s an increase of $4,800 a year.
According to the 50% Rule, my predicted “operating costs” should jump by half of that, or by $2,400 a year. But that doesn’t make sense. There’s no relationship between rent and costs.
To put it simply: You charge what the free market allows you to charge. You spend what you’re forced to spend. The two are not related.
That’s why I refuse to sign a contract with any Realtor who gives me a line such as: “Well, I don’t know what the average water bill is, but if it’s high you can just raise the rent to make up for it.”
Hogwash. The free market sets the rent, and the market doesn’t care what my water bill is.
To go back to the beginning of the question – how did I arrive at $3,100 as a maintenance cost? A few ways:
#1: I take the cost of items that deteriorate over time – a dishwasher, a roof, the water heater, the insulation in the attic – and “spread” that cost, or “amortize” it, to estimate how much I’d pay per year. For example: bathtubs need to be replaced every 12-15 years, so the bathtub’s price per year is X divided by 13 or 14.
#2: I also assume about 5 percent of the rental price as the cost of hiring a property manager – since managers do, in fact, often tie their costs to the rental price. (It’s an incentive for them to increase the rent).
#3: I’m not counting upfront one-time expenses that are a result of buying a fixer-upper. Maintenance costs will recur forever. Upfront repair costs are in a separate category. For reasons I outlined in Question #1, above, upfront repair costs are part of my buying/selling calculation.
Paula,
That’s sweat equity at it’s finest. I’m hoping my housing investment will pay off.
You’re definitely right about the market setting the rent price. Real estate agents call it “comparables.” It’s only worth what someone is willing to pay no matter how much your expenses are.
The worst case is if you ask too high of rent price, you run the risk of the property going empty, thus loosing out on cash flow.
$70.00 per hour? Maybe. My quick take of your numbers show a definite negative cash flow that you choose to call paying yourselves rent. It’s not paying rent it’s negative cash-flow that you are covering. If by chance you had to move due to family health issues job changes you would still have a negative cash flow plus would have to pay to live some where else.
Income
3 bedroom $550.00 x 2 = 1,100
2 bedroom $700.00
1 bedroom $750.00
Monthly income $2550
Annual income 30,600
Expenses
Insurance 250
Water 250
Mortgage 1138
Taxes ? 400
PMI ?
Materials ? 1/3 of the 40,000 planned spending over three years 13,330 per year
Annual expenses 51,786 not including your time
Don’t get me wrong, it’s important to pursue your dreams, it’s just that your blog is all about being honest and not looking through rose colored glasses. If you take off the glasses and do an honest accounting and it is still what you want go, go for it!
Trash ? 1200 (per month or year?)
Total annual income
@Homefree — You’re forgetting one very important point. If we moved out of this room, someone else would move into it, paying us $550 per month for the privilege. Do you really think we’d let the room sit vacant? That’s $6,600 per year.
It’s only fair that we pay rent to ourselves, because we’re taking the spot of another tenant who would pay this same rent to us.
Further, “annual expenses” do not include one-time, non-recurring fees like repair materials. That’s not an annual expense, that’s a one-time expense. To call it anything else is erroneous.
And our $13,000 a year repair budget comes the rent on our bedroom — $6,600 a year — plus our excess positive cash flow of $6,000 a year. (Remember that in “normal-case-scenario” years our cash flow is $6,000, which we reinvest back in the house. The $1,100 is a worst-case-scenario estimate that assumes massive vacancies.)
You seem to be under the impression that cash flow is only cash flow if you spend it on a flat-screen TV or a trip to Italy. I prefer to reinvest my cash flow back into my business. It’s certainly a far superior option to taking out a loan for double the cost. That’s not rose-colored glasses, that’s good investing.
Trash, to answer that portion of your question, is $1200 per year, or $100 per month.
Paula, It is very tough to put a price on one’s time. I try to do it, but my time teaching college students “Investments” is worth a lot more than the time I spend doing the dishes:)
Homefree, As a professional real estate investor who has rehabbed and rented a number of homes, I can tell you that upgrades to a property are not part of the cash flow equation. Sure, you might be putting some money into the house, but that is a longer-term, strategic investment rather than a simple ongoing cost.
None of my rehabber friends would consider money spent on upgrading a place in the cashflow model. If that were the case, there are no houses that could be upgraded with a positive or neutral cashflow according to how you see things.
Rather, you have to look at the investment value of the money you are putting in as an investment. If adding $5000 to a kitchen will boost the rental value by $100 a month, then you are looking at a 4 year payback on that investment- that’s pretty good. (roughly 24% cash on cash ROI – I’ll take that any day of the week, and I guarantee I won’t go broke doing so).
Granted, some renovations are more “valuable” than others, so the trick is to find the ones that will increase the value of your property and simultaneously increase the rental value and attractiveness of a place.
My top picks are:
1. Paint
2. Bathrooms
3. Kitchens
4. Decorative Moldings (like crown, base, etc.)
All of these things are pretty cheap to do and add a good “wow” factor that will impress a potential tenant.
@REInvest — Wow, well said! That was much more eloquent than I could ever say it!
As the owner of several rentals, I completely agree! It is all about ROI and cap rate that makes a huge influencing factor when it comes to rentals.
Paula,
I liked the way you calculated your hourly rate! Impressive.
By the way, isn’t there a small error in the calculations? If you went for a $225,000 house instead of $500,000, you saved $275,000 there. Subtracting $40,000 leaves you with $235,000, which when divided by 2625 gives you $89.5, not $70. That’s an increment of 27.8%
Cheers,
Mark
@Mark — You’re totally right!! I goofed; I subtracted $40,000 from $225K instead of $275K. WOW! I “earn” even more than I thought!!
Great catch — this is the best news I’ve heard all day!! 
I like the approach to your mathematics. The way you’ve worked it out, even if you estimate poorly suggests positive cashflow.
I suppose the ultimate metric is your bank balance. While the calculations suggest you’ll make money, you seem to be earning more than you spend and therefore what you are doing must work.