Wednesday, February 27, 2013

Financial Planning On An Irregular Income

Are you in a career that is feast or famine? Most self-employed folks and those who work on commission face the challenges of an irregular income. I’m familiar with this financial roller coaster since I have been self-employed for all but about 2 years since 1999.

1.) Base your lifestyle on the “famine” times instead of your “feast” times. When you’re starting out, most of your extra resources need to go towards building a reserve. Living out of your cash register or business checking account is an easy way to go broke. You must have a Personal Reserve and a Business Reserve. Your Personal Reserve should be at least 3 months of your “personal” expenses, maybe more depending on your unique situation. How much of Business Reserve do you need? At all times, you should have enough to levelize your income for the next 12 months.

Business Reserve Example: Your monthly obligations are $4,000. You project your income over the next 12 months to be as follows: Jan, Feb, March - $2,000 each month ; April, May, June - $6,000 each month ; July, Aug, Sept, - $3,000 each month ; Oct, Nov, Dec - $5,000 each month. You would need at least $9,000 in Business Reserves. Use the “Reserve” in months where you are short, and replenish it in the good months.

2.) When you bring home a fat paycheck, DON’T go on a spending spree. Give yourself a small bonus as a reward, enjoy a modest celebration, and save the rest.

3.) As your career progresses, average out your yearly income over the past 2 or 3 years, and pay yourself regular monthly paycheck. Base it on real numbers NOT anticipated income that also allows you to continue to reinvest back into your business and set aside money for taxes.

4.) This should probably be #1 but I hate taxes, and I know you do too! Set aside what you will need to pay Uncle Sam off the top of EVERY check. Don’t fall into the trap of relying on that next big paycheck to take care of your income taxes. Designate a separate account to set aside money for taxes based on your effective tax rate assuming you are NOT paying quarterly tax estimates.

5.) Eventually you’ll be in a position to start investing outside of your business, and diversification is crucial. You must reinvest back into your business to keep it viable, but you must also diversify away from your core business. If you are in a real estate related industry for example, your first investment should NOT be real estate. Unless, of course you want to risk losing all your investments along with your business in the next major economic downturn. You CANNOT out smart systemic risk. Believe me I tried and I lost thousands of dollars in the 2008 collapse. Systematic risk can be mitigated only by being hedged. To diversify away from you core business, start with asset classes that are as unrelated to your core business as possible.
6.) Determine what, if any, formal entity is right for your business. For some people it’s OK to always file a schedule C. For others an LLC, S-corp, or C-corp is best. All depends on your business, amount of income, federal and local taxes, and of course liability. Not setting up the right entity can be costly to unravel. A business attorney along with your Financial Planner can help you decide.

7.) Last but certainly not least is you must have all the proper insurance coverage’s based on your situation. Auto and Home. Health Insurance, Business Insurance, Disability Insurance, Life Insurance. I know business owners and self-employed are usually risk takers because I am one. But don’t be a bonehead! Risk Management is the foundation of your financial plan.

Friday, February 22, 2013

Calculating the ROR on Real Estate

Cash on Cash Return On Investment Method

The cash on cash return on investment is the Annual Before Tax Cash Flow divided by your initial cash investment. The formula looks like this:

Cash on Cash Return on Investment  =  Annual Cash Flow / Initial Cash Investment

Annual Before Tax Cash Flow: calculated by subtracting your annual mortgage payment from your net operating income (NOI). The net operating income is simply the total income from the property minus the total expenses.

Example: $150,000 purchase price for an income property requiring a 20% down payment of $30,000. Annual Before Tax Cash Flow is $3,000 per year.

Cash on Cash ROI  =  $3,000 / $30,000  =  10%

The cash on cash ROI is a good measure of a property’s first year financial performance. However, it does not include the additional benefits achieved through real estate such as the amortization of the mortgage and any future appreciation. The total return on investment addresses that.

Total Return on Investment Method

The total return on investment provides a better and more complete measure of a property’s financial performance. That is because it factors in amortization and appreciation gained over time.
Total ROI  =  (Annual Before Tax Cash Flow + Net Sales Proceeds – Initial Cash Investment) / Initial Cash Investment

In order to calculate the total return on investment, one must project the net sales proceeds from the future sale of the property.

Let’s take our example above and assume we have 30 year mortgage with a 7% interest rate and we plan to sell it in five years with an average annual appreciation rate of 4% per year. After five years our $150,000 property would be worth $182,498, and our mortgage balance would be $111,665. Let’s also assume that our selling expenses total 5% of the sales price, or $9,125.

Using the figures above, our net sales proceeds from the sale of the property in year five would be $61,708 ($182,498 – $111,665 – $9,125). Additionally, our before tax cash flow after five years would total $15,000 assuming no annual increase in rents or cash flow. Formula looks like this:

Total Return on Investment  =  ($15,000 + $61,708 – $30,000) / $30,000  =  156%

To say it another way… You earned a profit a 56% on your initial investment after your initial investment was returned. But I would recommend looking at your profit as an annual percentage so you can compare it to other investments like stocks and mutual funds. The annual rate of return on this 5 year investment was 9.26% per year. So another investment would have to earn you at least 9.26% per year over the same 5 year period assuming the same risk level.

Note that some investors calculate their total return on investment using their after-tax cash flow instead of the before tax cash flow. However, it does not provide a good measure to compare one investment to another since tax liabilities will vary between individual investors.

The total return on investment can be a little shortsighted when used in isolation. This is because total return on investment does not measure of the property’s financial performance as it relates to its equity. For this we must calculate the property’s return on equity (ROE) which I will save for another day.

This is just some of the basics, and can be a little overwhelming especially for beginner investors. That is precisely why you need a CFP, knowledgeable Real Estate Agent, and Tax Expert on your team.