Investing 100 Percent of My Income: May Edition

investing 100 percent of my incomeTime for the next edition of Investing 100 Percent of My Income, and I have just one question:

How is it June already?!

For those of you who are new readers: Will and I are a couple who have pledged to live on one income and invest the other. He gets a steady paycheck, while my income fluctuates because I’m self-employed. So we’ve decided that in 2012, we’ll live on his income and invest 100 percent of mine. (This makes financial planning a heckuva lot easier!)

By the end of last month’s update, I maxed out my Roth IRA, renovated a rental house with a 14.8 percent cap rate, and paid quarterly taxes.

That was the easy part. Those were no-brainer moves.

Now comes the hard part. It’s time to make strategic decisions about how to invest the rest of my income for the next 7 months of the year. Here are a few lessons I’ve gathered:
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Investing 100% of My Income: April Update

april investing reportIt’s the time of the month when I reveal my spending and investing habits for the past 30 days.

At the start of 2012, I pledged to invest 100 percent of my income into a combination of retirement accounts, real estate ventures and website-building activities. Will and I are living as a one-income household, spending his money and investing mine. Since I’m self-employed, it’s hard to predict exactly how much I’ll earn, but it’s reasonable to estimate that Will and I will bring in roughly the same amount this year, which means we’re investing 50 percent of our joint income.

You can read my January, February and March investing reports here.

So how did I do in April?

#1: I Maxed Out My Roth IRA!

I’m done, finished, finito with my 2012 Roth IRA contributions. Hooray! As you’ll recall, I fell just a few hundred dollars shy of maxing out my Roth by the end of February, and in March my budget got gobbled up by needing to pay for repairs on the 3-bedroom rental house that we bought for $21,000. I’ve been wanting to cross the Roth line-item off the list for more than two months, and I’m jazzed that I’m finally done!

#2: I Paid a Hefty, Hefty Tax Bill

Ah, the joys of self-employment: I get to write the government four checks a year.

My taxes aren’t withheld from my paycheck (because I don’t get a paycheck). Four times a year, I file “estimated quarterly taxes,” which consists of guessing how much I’ll owe and then sending the government a check for one-quarter of that.

After crunching the numbers, I discovered that every ounce of money-making effort I exerted during the month of April goes straight to the government. Gee, I hope they’re investing it soundly. :-)

Between taxes and capping off my Roth IRA, April’s income is spoken for.

Now Comes the Hard Part

Until now, this investing project has been simple. I make a hefty retirement contribution and continue working in the same manner in which I’ve always worked, without questioning the strategic growth or direction of my business.

This month, the hard part begins. If I’m serious about investing in my fledgling little businesses, then I need to carefully consider HOW my money is going to get spent. Should I concentrate on buying real estate or growing websites? Should I branch into podcasting and videos, or should I start upgrading my rental units? How will I have the time to grow these projects if I’m ALSO trading my time for money as a freelance writer?

I can’t just throw money at a business; I need to manage it carefully, making sure every penny is spent strategically. But that requires answering some tough questions.

This is an issue I didn’t have to deal with for the first four months of the year, when I was simply making retirement contributions and getting our rental house ready for move-in. I’ll face these questions head-on in May.

Perhaps this is an unexpected benefit, a blessing, of investing money in your business: it forces decision-making. It forces growth. It forces strategy.

In a strange way, perhaps investing forces you to hold yourself accountable. If I’m merely contributing my time, I might be tempted to sell myself short. But if I’m spending hard-earned money, I demand better results.

Thanks to Jimmy Benson for today’s photo.

Investing 100% of My Income: March Update

investing income into a rental houseIt’s time for the latest Investing 100 Percent of My Income update – where did my money go last month?

(Note for new readers: Will and I are a couple who have pledged to invest 100 percent of my 2012 income while living solely on his income. You can read about the pledge here.)

In January and February, I dumped every cent I earned into my Roth IRA and came really freakin’ close to maxing out my $5,000 contribution limit.

(Last month I discussed how on an “accrual” basis I earned more, but on a “cash” basis I’m a couple hundred dollars shy of hitting the $5,000 mark. If you don’t know what those terms mean, you can find out here.)

My plan for the month of March was to finish maxing out my 2012 Roth IRA contribution. I’d “snowball” this savings goal, cross it off the list, and move on to the next item at hand.

But something unexpected happened: I bought a second rental home. I hadn’t planned on buying another house at that moment, but I spotted a deal that was too good to refuse. Will and I had been saving to eventually buy a second home, so we were prepared to pounce on it.

The house needs a ton of repairs. So every cent (and more) that I earned last month went into fixing up the place.

Here’s the breakdown:

  • Garage door – $576.73, including installation plus removal/disposal of old door
  • Carpet – $1240, including installation plus removal/disposal of old carpet

Labor Only:

  • Tearing down and rebuilding a 10×12 deck – $375
  • Painting the house interior – $900
  • Laying vinyl flooring in kitchen/bath – $200
  • Repairing laundry valves – $200
  • Patching drywall holes and painting garage – $200
  • Installing countertops in kitchen and bath – $150
  • Patching drywall throughout house – $100
  • Removing and re-hanging interior doors – $100
  • Sanding and painting kitchen cabinets and bath vanities – $250
  • Replace fascia and rotted roof decking – $370

Total: $4,661.73, mostly for labor. The only material included in this figure is the carpet and the new garage door.

In addition, we also bought materials such as paint, primer, caulk, drywall compound, vinyl flooring, decking, cement, roof shingles, screws, nails, and LOTS of wood. I haven’t processed the exact figures – you should see how thick my stack of receipts is! — but I believe this figure comes to roughly $2,000 – $3,000. I’ll post a more precise update once I spend a few hours inputting everything into a giant spreadsheet.

There are still more repairs needed: I need to replace the gutters and water heater, tune up the HVAC, take a few huge loads to the dump (or rent a dumpster), paint the fascia and termite-proof the house.

In short: I need to pour every cent into this house to get it rent-ready. Everything else is on hold.

Why Not Do It Yourself?

Our first rental building – the triplex in terrible condition – taught me that doing-it-yourself costs time. It’s dollar-cheap but time-expensive.

Here’s where we get into a quandary: on one hand, I believe in being frugal with time, not money. On the other hand, it’s tough to part with hard-earned cash.

Our happy medium solution is to do the most expensive things ourselves, like electrical work and plumbing, and to outsource the most time-consuming tasks, like paint and drywall.

(Update 2013: Now we outsource everything, because our time is more valuable than it was in 2012. Our businesses have grown, and that demands delegation.)

As I’ve discovered, collecting quotes from contractors and comparison-shopping for materials like vinyl and carpet eats up about 10 hours per week. Driving to the house to check on the progress eats another 2-5 hours per week.

Of course, that doesn’t compare to the time-cost of doing the actual work ourselves, which could eat away 60 hours a week if we were serious about finishing it quickly so that it can go on the rental market.

Opportunity Cost

The good news is that we bought this house in cash, so I don’t have the stress of needing to make mortgage payments while we repair the house.

The bad news? Lack of a mortgage is a double-edged sword. Without that stress, I’m less motivated to work quickly. I find myself putting off calling contractors for “just one more day,” until those days add up to a week.

Logically, I know that every month this house isn’t rented is costing me hundreds in the form of “opportunity cost,” or lost income potential. But humans are hardwired to be more motivated by losing actual money (money we’ve gone through the trouble of earning) than theoretical money (opportunity cost).

Setting deadlines helps: my goal is to get this house rented by May 1. Creating a reward for myself also helps: as soon as this place is rented, I’m rewarding myself with a flight to Austin, Texas to visit one of my good friends. That gives me the motivation to continue managing this project.

There’s No Such Thing As Paid Vacation. (But There’s Something Even Better!)

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theres no such thing as paid vacationToday is my first day back at work after a one-week “unpaid” vacation. I’ll earn less this month than I did in the previous few months, since I only worked three-fourths of the time.

This is because I trade my time for money. I have a huge limitation on how much I can earn.

Everything I do these days – including my pledge to invest 100 percent of my income – is intended to cut the relationship between time and money. I’ll have “real” wealth the day I can unplug for one year without suffering a hit to my income. Wealth is measured in time, not dollars.

Some people believe that they already have stints in which they get paid to do nothing. They refer to this as “paid vacation.”

I’ve written before about my belief that paid vacation is a myth, but its such an important concept that its worth devoting a post to.

There’s No Such Thing As Paid Vacation

Casey searches for a job with paid vacation.

“Can you imagine?,” she says. “Laying on the beach and getting paid for it?”

She finds a job as a marketing assistant. Her new gig pays $50,000 per year, plus three weeks of paid vacation, health insurance and a three percent retirement match.

Casey is elated. During her first year on the job, she jets off to Aruba, visits friends in West Hollywood and goes skiing at Whistler. As she cruises down the slopes, she thinks, “Wow. I’m getting paid for this.”

Except … she’s not.
real paid vacation comes when you can unplug for a year
Casey’s boss, Shannon, launched the marketing company 10 years prior. For the first few years, he worked round-the-clock with only meager pay to show for it.

Shannon watched in jealousy as his friends enjoyed their steady flow of paychecks, paid vacations and company-sponsored happy hours. At times, he contemplated quitting. But he continued to build his business.

After two years, he was ready to hire his first employee. A year later, he hired a second person. Today, a decade into the company, Shannon has eight employees.

Casey became employee number eight. Shannon estimated that her efforts would help the company’s revenue grow by an additional $100,000.

So Shannon made an agreement with Casey: I’ll pay you for 49 weeks worth of effort per year. I’ll pay $53,300 in total — $50,000 in the form of paychecks, $1,500 in the form of a three percent retirement match, and $1,800 worth of health insurance, which has a fair market value equal to a $150 monthly premium.

In other words, I’ll give you $1,087 for every week you work for me. ($53,300 divided by 49). I estimate that my investment will add $2,000 per week in value to this company, so I’m happy to give you half.

For the sake of simplicity, Casey, I’ll space those payments out in regular two-week intervals. It makes the bookkeeping a heckuva lot easier.

And hey, Casey, if you take time off at the end of the year, then I’m paying you in installments for work you’ve already done.

Shannon Gets Real Paid Vacation

With eight trained and talented employees, a well-organized system and strong client relationships, Shannon isn’t worried about the day-to-day management of his company anymore.

He jets off to Aruba, West Hollywood and Whistler, just as Casey did. Shannon’s company turns a strong profit, even while he’s away.

Each of his employees create an additional $1,000 per week of net earnings, so Shannon collects $8,000 every week that he’s on vacation. He can do this, in perpetuity, forever, barring any sort of catastrophe. When he returns, his company is running even more smoothly than it was before he left.

Shannon gets a true paid vacation. Everyone else just gets paid in installments.

Is This House a Good Investment?

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income propertyForget fancy-pants calculus.

The most important math is the stuff you learned in fourth grade.

How do you know if an income property (rental property) is a good investment?

Start with The One Percent Rule: Does the monthly rent equal one percent of the purchase price or more?

Purchase Price: $100,000

$100,000 x 0.01 = $1,000

Is the monthly rent greater than, or less than, $1,000? If the monthly rent is greater than $1,000, this property merits further consideration. Otherwise, ignore the property and move on.

In other words: for every $100,000 in price, I look for $1,000 in rental income. If a house costs $225,000 – as mine does – it needs to rent for $2,250 per month or more.

One percent is the bare minimum level of return I’d accept.

Note: Whenever I say “purchase price,” I’m referring to total acquisition cost — which includes property price, closing costs, and any upfront repairs to get the unit rent-ready. It wouldn’t make sense to just count the “sticker price” of the home, because you might buy a $10,000 home that needs $80,000 in upfront repairs. Run calculations based on total acquisition price.

Just FYI, there are some investors who believe that One Percent is too lenient. These investors shoot for the “2 Percent Rule,” which means they collect $2,000 per month in gross rent for every $100,000 of house. However, I don’t (necessarily) advocate for those types of properties, since those tend to exist in high-risk neighborhoods. Keep in mind, there’s usually a tradeoff between risk and reward.

Midtown, Atlanta is a stable neighborhood with high rental demand. Tenants are likely to be college-educated, and many will hold graduate degrees. Tenants are likely to have perfect credit. Many are saving for their own home.

The tenant risk is lower, so your returns will also be lower. One percent is probably the best you’ll find in an area like this. (I got lucky.)

Hypothetical Town, in contrast, is an area with a high crime rate. Tenants are likely to have bad credit and bankruptcies. The tenant risk is higher, so your returns should also be higher. I’d demand at least 2 percent in a place like this.

The Cap Rate

If a house passes the One Percent Test, I look at a measure called the capitalization rate.

The capitalization rate, or “cap rate,” measures the return on the property value. Cap rate equals annual net operating income divided by the acquisition price.

“Uh, what?” – Don’t worry, that sounds like gibberish to me, too (and I wrote it!) Let’s walk through an example.

  • Rent = $1,200 per month
  • Insurance, Taxes, Water, Trash, Repairs, etc. = $700 per month
  • “Net operating income” (also known as “NOI”) = $1,200 – $700 = $500 per month.

Multiply by 12 to find your Annual NOI: $500 * 12 = $6,000
does this property produce good income ?
To find the cap rate, divide $6,000 (Annual NOI) by the total acquisition price of the house. Let’s assume your house cost $200,000.

$6,000 / $200,000 = 0.03

Multiply your answer by 100 to convert it into a percentage. The $6,000 in cash flow you’re receiving translates to a 3 percent return on your property value.

Meh. Yawn.

I’m not excited about that.

Let’s change one variable: Let’s assume you bought the house for only $100,000.

$6,000/$100,000 = 0.06, or 6 percent.

Much better! At that rate, it will take you 16 years to “pocket” the price of the house (100/6).

(Notice that if you bought the house for $200,000 and rented it for $1,200 per month, it wouldn’t meet the One Percent Rule. But if you bought it for $100,000 and rented it for $1,200 per month, it totally hits the One Percent Rule.)

**Important Note: Notice that we’re calculating “net operating income,” not “net revenue.” This sounds like an inconsequential distinction, but it carries one important implication: We subtract operating expenses, but not debt servicing or equity-building expenses.

What does that mean? Mortgages consist of four parts: Principal, Interest, Taxes and Insurance. These are collectively called PITI. When you calculate NOI, you subtract the cost of TI (taxes and insurance), because they’re part of your operating overhead. You don’t subtract the cost of PI (principal and interest), because these build equity and service debt, respectively. They’re not an operating expense.

“Okay, I understand not subtracting for principal repayments. But why wouldn’t you subtract the interest?”

We’re trying to evaluate the asset itself — the property — not the attractiveness of the loan. Let’s exaggerate this for the sake of illustration: ALL properties will look terrible with a 99% interest rate, and MANY properties will look awesome with a 0% interest rate. That doesn’t necessarily make those properties inherently good or bad rental candidates. We want to remove the financing arrangement from clouding our judgment about the property itself.

In other words: First, evaluate the property. If you like it, THEN find good financing. Don’t mix the two.

Cash-on-Cash Return

Finally, I scope out my cash-on-cash return: An equation that shows how far my cash will carry me.

The formula for this is annual NOI divided by down payment.
is this income property a good investment?
Using the same example as above:

I buy a house for $100,000. I put 20 percent down, or $20,000. The annual NOI is $3,000.

$3,000 / $20,000 = 0.15, or 15 percent! Holy moly!

This illustrates why real estate is so powerful: it’s probably the safest way to leverage your dollars.

Let me be clear: Real estate is still risky. But leveraging your money for other investments – like buying stocks “on margin” (with borrowed money) – is much riskier.

Gigantic Freakin’ Disclaimer:
The cash-on-cash return needs to be taken with a grain of salt. (Actually, take it with a whole damn salt shaker.) This equation rewards people who take out the biggest possible mortgage. (This shrinks the denominator, which makes the formula spit out a higher number.) Frankly, that gives this the potential to be a dangerous equation. You don’t want to get led into thinking that more leverage is always the better option.

The bigger your mortgage, the bigger your risk. Be cautious about using the cash-on-cash formula.

Here’s a safe way to use this formula: Try using this equation ONLY to compare the performance of properties you’d buy in cash. That way, you’re looking at “pure cash return,” absent of leverage risk.

If you can’t literally buy a property in cash, run the numbers through this equation anyway. You’ll at least gain an understanding of what type of return this property will create once the mortgage is paid in full. In other words, you’ll develop stronger knowledge about the strength of the property itself — absent any financing considerations.

Final Thoughts

Of all these formulas, the One Percent Rule is the easiest and most intuitive.

Cap rate is the most comprehensive.

Cash-on-cash is a nice finishing touch.

Use them all. Your success (or failure) as a real estate investor happens before you buy.

Note: This article was updated in February 2015 to clarify FAQ’s around this topic.

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Thanks to Jeremy Levine Design and Images of Money for today’s photos.

Three Mantras for Small Biz Owners

Remember this when starting your business ...

I took part in a pretty dynamic, thought-provoking Twitter chat tonight in which a lot of small business owners shared ideas about how to take the leap to starting your own business.

I want to share 3 of the best quotes from that chat, and accompany them with a sentence or two about how you can apply that advice to your own small business (whether it’s an actual “business” that sells a product, or a side gig like tutoring, for which you still have to promote your service, manage your time, demand payment from clients, etc.).

These 3 brilliant snippets of wisdom were all said by @caroljsroth, author of The Entrepreneur Equation,

If a few people aren’t laughing, you’re not dreaming big enough.

SO TRUE!!!! Now can I make a confession? I am embarrassed to call myself a blogger — because I don’t make a living from it yet. I feel like an imposter. (Who calls themselves an “aspiring blogger,” anyway?) I’m afraid that if someone asks what I do and I reply, “I write,” they’ll laugh.

But you know what? My dream is for this blog to become big. HUGE. My dream is to start an entire Afford Anything movement. I want 1,000,000 readers to this blog. I want 200,000 email subscribers. I want this to spawn books, magazine articles, a television show. I want nothing short of a cultural phenomenon.

Are you laughing? Good. That means I’m daring to dream big. And so should you.

Be willing to take a couple steps backwards to make a huge leap forward.

Again, this is entirely true. The biggest barrier to risk-taking is comfort. If you’ve got a comfortable life, with a comfy job, comfy income, comfy home, comfy shoes, you’re at risk of not taking risks.

USA Today recently reported that the Great Recession and layoffs spawned record numbers of people to start businesses. Why? Because with 10 percent unemployment, and an even greater percent of underemployment and low wages, people stopped feeling comfortable. And that’s when the real fun began.

Your time is valuable — if you don’t think so, no one will.

Small business owners who sell a service — such as freelance writing — often charge extremely low rates, which they justify by telling themselves that they’re in a business with very little overhead. After all, a freelance writer just needs a laptop and an internet connection, right? And some incidental office supplies?

What that freelance writer isn’t considering is his or her time — hours of her life which she’ll never get back. Hours which could have been devoted to doing something else, whether it was pursuing more highly-paid work or relaxing and enjoying life.

Our lives are short and our time is valuable — so value it.