Let's say you decide to buy your first real estate investment.
After crunching all the numbers and doing all the research, you're convinced that this property is a good investment.
How much money do you need - should you put 10%, 20%, or more down? Common wisdom says put down 20%.
The idea being that the more money you have in the property the lower your expenses are and the better you can withstand shocks.
It's true.
The more money you put down the easier it is to be cash flow positive.
Your risk is reduced because you're taking on less leverage (Mortgage to Equity Ratio).
But your profits will also be lower because it requires more capital.
Let's say that you make your decision, put down 20%, and start collecting rent.
You have the foresight to put money away for a rainy day.
But, again, how much should you set aside? Two month's expenses, three, maybe more? Here is where most beginner investors stumble.
Setting aside a fixed sum of money, however large, will never be enough.
I hear the groan "but how can that be? Surely if I have 3 months expenses, and I'm earning a profit, I'll be fine.
" If you keep your reserves rigid and remove all the profits, you will go bust.
It's inevitable.
In finance theory, if you maintain a fixed initial capital, take risks, and remove all profits your risk of ruin will climb to 100%.
(Risk of Ruin is a formula for estimating the probability of losing a given amount of capital when taking a repeating risk.
) When people judge the likelihood of needing the money they often overlook that it's not a onetime event.
Sooner or later even a small risk, if taken enough times, will happen more than once.
For example, you buy a townhouse.
You estimate that in any given month, an unexpected event (like a major repair) has a 5% chance of occurring.
If it does, it will use up your entire reserve.
Now here's the rub.
Because these events are mutually exclusive, they add up over time.
Taking this gamble repeatedly for 12 months grows your risk of ruin to over 45%.
Repeat for three years, and it's almost certain you'll run out of money.
(Google 'Binomial Distribution' if you're interested in the math).
Here's how you can avoid this pitfall.
Don't take all the profit out.
Leave some behind to counter the effect.
With each interval the risk goes up and is in turn balanced by the growing account.
As a rule of thumb, set aside 5% of gross income each month.
So when the losses happen you'll have enough to survive.
In real estate investing, having enough money to stay in the game is critical.
Many failed investments could have been avoided by following this simple rule.
Let your reserves grow and you can make money and avoid running out of cash.