Growth is the goal you have almost absolute control over. You get to decide if you want your business to make $10-thousand, $100-thousand, or more each year. You get to decide if you want to grow your business, shrink it, or shutter it.
That’s one decision I’ve never heard discussed in a business text or class. Everyone assumes growth is good, or at least necessary for survival, but that’s only true to a certain extent. Growth is only good when you need to grow or want to. I’ve seen many entrepreneurs get into trouble by growing their companies too fast and outstripping their resources.
One the other hand……if your income is based on a small number of rental properties, you probably need to grow your business. It’s very hard to produce enough income to support yourself and your ongoing repairs and maintenance budget (not to mention your operating reserves) with only a few rentals.
Leverage is business-speak for debt, for using debt, also know as other people’s money (OPM). The good thing about OPM is that it enables you to control more assets than you could on your own and, hopefully, grow your profits accordingly. The bad thing is that OPM can be as addictive as the drug it sound like, opium.
When a company’s debt gets out of hand, it’s not unlike when an individual gets too dependent on credit cards. Sooner or later, the debt load exceeds the ability to maintain it. In business speak, this is called a “cash flow problem.” The debt may be all good debt. There may be plenty of equity to justify it, but when the cash doesn’t come in to make the payments, it gets scary fast.
The cash flow problem may stem from any number of causes. A house or two may take longer to sell than planned. A rental may stay vacant for a couple of months. Or you might find an opportunity that is simply too good to pass up but eats into your cash reserves.
The Necessity of Debt
On the other hand, leverage is about the only way to grow a real estate company, especially since most of them are privately held and can’t raise cash through stock offerings. SEC securities regulations designed to protect unsophisticated investors see to that. The cost of complying with SEC regulations can exceed the value of a small company.
But debt….let’s assume JK Properties owns one $150-thousand house they use as a rental that generates $500/month in cash flow. Without a significant cash infusion (winning the lottery or finding out you really are heir to that prince), it would take nearly 25 years to generate enough income from that one property to buy another one without leverage. It would only take around six years to buy another income property with leverage.
Both of those estimates assume no capital expenditures or inflation. Everyone who has ever owned a rental knows those are faulty assumptions. Things are going to break, and the house will not remain 100% occupied forever. And, obviously, you can’t use the income from one rental to cover its own repair and vacancy risks. You need a rental portfolio to cover those risks. You are required to grow your portfolio, at least to some degree. After all, you also want to use some of that rental income for your own purposes, right?
But how do you grow that portfolio?
Relying on rentals to grow your business is not simply sustainable, or, at least, on a timeline most people are able to work with. Rentals are a good way to grow wealth, not the business. And even then, you need more that a few to be sustainable. You need another source of income, too.
Renovations generate chunks of income, assuming the renovated houses sell. That income can be used to acquire rentals. You can grow even faster, if you renovate your rentals to increase the equity and cash flow they generate.
I believe the only way to achieve a sustainable rental portfolio without tying up all of your personal income is through renovation. Our goal is to keep one out of every three or four renovations as a rental. That way we grow our portfolio and build wealth at the same time.Hermann says please like and share!