02 Apr Real Estate Financial Planning Tips You Should Know
Having your finances in order should be the priority of every adult, but more so if you are embarking on the financial adventure of real estate investing. Real estate investing can be lucrative. It’s an excellent way to generate personal wealth and to create a financial legacy for your family. Once much of the foundational work is done, it is mainly passive income, so it’s perfect for retirement. But first, you have to begin. By financial planning, you will know what you have, what you’re doing with it, and where you’re going. You’ll be able to act purposefully and avoid the mistakes that come with aimless spending. Financial planning takes time, research, and discipline. But the rewards can last a lifetime.
Create a Roadmap
Every journey starts with a plan. What exactly is it you want to accomplish? Personal financial planning has to take into account more than just building up savings. Here are a few of the other things to consider as you create your roadmap:
- Managing money as an individual or a couple
- Understanding and minimizing your taxes
- Thinking like an entrepreneur to build your investment portfolio like a business
- Mitigating the risks associated with real estate investing
- Life events like marriage, kids, career changes, and elderly parents
- Protecting the people you love
- Diversify investments for big life events like kids in college and retirement
- Plan for the unexpected events
To get financial planning right, you should consider your personal and financial circumstances and your future plans. Be prepared to monitor and measure your progress closely and adapt your actions as needed.
Create a strategy to build and maintain business cash reserves
Building and maintaining business cash reserves is imperative for real estate investing. It isn’t enough to have the funds to purchase your investment property, but you’ll need money on hand for all the things you can anticipate and for all the things that you can’t. This isn’t something you do once, but it’s an ongoing activity – something you’ll have to think about and work toward constantly.
Here are a few of the things you may need funds for:
- Maintenance and repairs for your property
- Sustain you during vacancies or non-payment of rent
- Down payment for next investment property
Keep in mind that these reserves are different from other money you may be trying to accumulate. These can’t be tied up in funds. They have to remain liquid in a savings account that allows you easy access.
Develop a retirement projection and update it annually
Do real thinking about what your retirement needs will be. Be generous with yourself and consider as many factors as possible. We recommend that you run a retirement projection every year to reassess your progress and adjust as necessary.
There are many tools available to help you create a comprehensive retirement plan, including financial planning software, spreadsheets, and other DIY tools. Do whatever works for you.
You may need to do extensive research and educate yourself on these matters, but it will be well worth the effort. This is a step that most people skip, but we can readily see the unfortunate results.
Create a plan for risk management
There is a cool term for risk management – it’s like boosting your financial immune system. Risk management is about predicting and evaluating all the possible financial risks you may be exposed to and then mitigating that risk.
Here are three critical areas for consideration:
- Make sure you are covered by the appropriate insurance policies. It’s essential to protect your finances by protecting your family and property in case of emergency or death.
- Choose a legal structure. Will you incorporate it as a business?
- Use financial ratios as guidelines for your real estate business—ratios like cap rate, rent return, vacancy rate, and a good debt-to-income ratio.
Although the world is full of uncertainty, you don’t have to be at its mercy. It is possible to manage your risk and come out ahead more times than not.
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Even if you’re just starting out with your first property, knowledge of your state and federal laws may save you money in taxes. A certified accountant or Enrolled Agent will be able to advise you better on specifics.
Here are a few ways you can minimize taxes:
- Contribute to a tax-deferred retirement account. As a tax-payer who earns income, you can contribute to a regular IRA (individual retirement account). If you make a certain amount of money, you can contribute to a tax-free Roth IRA. If your real estate business is profitable, consider setting up a Roth 401(k), a solo 401 (k), or pre-tax SEP plan. This will enable you to contribute additionally for a greater retirement fund later.
- Depreciate properties on your income taxes. Although this will minimize your income taxes, you may have to pay more in capital gains taxes when you sell the property at the appreciated value. Since this move could save or cost you, talk it over with your financial advisor.
- If you’re selling a property but planning to continue in the real estate game, look into a 1031 like-kind exchange. If you sell one property but purchase another of a similar kind, you won’t have to recognize a gain or loss. Discuss this further with your financial advisor.
What’s your target debt-to-income ratio
Some investors use debt leverage as an investment strategy, and for experienced investors, it might work well. But the wiser move is not to over-leverage yourself. It’s possible to borrow at times of economic and real estate market up-turns, only to suffer crippling debt when a down-turn follows. Keep a balanced outlook.
One way to prevent over-leverage is to set a target debt-to-income ratio. The ratio is your total monthly debt divided by your total monthly income. To do an accurate calculation, your debt should include your personal and rental property mortgages and all other loan payments, credit card payments, etc. Your income includes, of course, your salary and rental income, but also your pension, social security, interest and dividends, and any other regular income.
Your ratio should be low if your net worth and risk tolerance are also low. Likewise, you can have a high debt-to-income ratio if your net worth and risk tolerance are also high. Ideally, 35% or lower should be your target ratio.
Develop sources for fixed and flexible income
Your rental income is considered a fixed income source, so is your pay from work. But in addition to these, you will want to create flexible income sources as well. These will help sustain you into retirement. The rule of thumb is that fixed income sources take care of fixed expenses, like your mortgage, and flexible income sources take care of flexible expenses.
Here’s the difference:
- Fixed income sources are your rental income, pay, annuities, social security, pension, etc. These should cover your fixed expenses like housing, food, utilities, and transportation.
- Flexible income sources could include IRAs or Roth IRAs, 401(k)s, or any work-related pension plan. This kind of income should be spent on flexible expenses like a family vacation, a new vehicle, a new appliance for the home, or an unexpected medical expense.
What about exit strategies?
We can’t predict the future, so have an exit strategy for each property you own. Property is illiquid, which just means you can’t cash it in in a hurry. It takes time to sell a property and get the cash from it. Additionally, even if you aren’t earning any rent, you still have to pay out in mortgage payments, maintenance, insurance, water, garbage, and so on.
When you purchase, determine when and how you will exit the investment:
- What is success? How much rent and what appreciated value will feel like success to you?
- How long will you lose money before you decide to sell?
- How will things change over time, like in your retirement?
Know these things going into the investment, and you won’t have to stress later.
Develop a personal budget and a business budget
A budget is a spending plan, and you should have separate budgets for your personal finances and your real estate business. Having an accurate accounting of what comes in each month and what goes out will let you know when you’re ready for another property or when a property is losing you money. Of course, one budget informs the other, but having two is beneficial.
Annually, do a budget versus actual to ensure your budget is realistic.
Have an estate plan
What happens to all of this when you die? I know, not your favorite topic, but estate planning will make it an easier time for your loved ones. Here are three categories of things to be sorted:
- Titlings and beneficiaries – ensure that as you continue to purchase new properties and life circumstances change, you are updating these as well.
- Those five all-important documents – a will, a guardianship provision (for minor children), living trust (possibly), a living will (healthcare directive), and durable powers of attorney.
- Your digital life – this includes your personal and business social media, websites, email addresses, and online log-ins.
Real estate investing is exciting and profitable, but only if you take the time to do it right. Financial planning is a big part of fully benefiting from your property investment and enriching your life now and for the future.
Do you have questions? We have answers. Visit Nestrs today.