The other day, I was visiting with Kim about buying a home. In the conversation, I realized I’d never shared with her what we had discovered about the relationship between personal cash flow and home value, which allows the household to maintain both cash flow and asset margin. So here we go.

Cash Flow

Personal cash flow comes in many forms. Cash flow can be salary, or earned income, dividends, interest, distributions from retirement plans or pensions, business income or royalties and rents, among others. Income is a tax definition, such that income is whatever the IRS says it is. So, for our purposes, we will simply refer to personal cash flow, and define it as before-tax cash flow.

Home Value

For these purposes, we will think in terms of original purchase price. However, we have found it a valuable exercise to review these ratios annually, if for nothing more than the sake of awareness.

Ratios

We have worked with households for more than thirty years. Some of the individuals in the households own or have owned companies, others have worked on the corporate side, or in a government or academic role. Some have inherited substantial assets. Regardless of the source of the assets and cash flow, we have found some consistent ratios between available cash flow, and the value of the primary residence, which allows the household to maintain both cash flow and asset margin.

What do we recommend? We suggest a home market value of no more than three times annual cash flow. For example, if annual cash flow is $200,000, an ideal home value is no more than $600,000. If annual cash flow is $1 million, an ideal home value is no more than $3 million.

But…

What if I sold a company, or won the lottery, or exercised a big block of stock options, or received a significant inheritance, such that I could pay cash for whatever size and price home I wanted? You can certainly do that. Every asset of which we are aware has two cost components. One is acquisition cost. The other is operations and maintenance cost.

Maintenance

Again, after studying and watching this for a long time, our observations. Long term, we advise clients to allocate 3% to 5% of a home’s value annually, toward operations, maintenance, renovation, and upkeep. A new home may not require quite this outlay. Over time though, these are good general ratios. If you are your own handyman, it’s prudent to allocate $25,000 to $30,000 annually for long-term maintenance of a $1 million home. And if you outsource, probably closer to $50,000.

So, though a one-time cash event could certainly enable an acquisition, the ongoing maintenance, renovation, taxes, and insurance are supported by cash flow, and such costs are best taken into account.

Mortgage

For the mortgage, if you have one, the sweet spot is to keep the original mortgage at no more than two times annual cash flow.

Feel free to reply to this email if you would like us to look at your annual cash flow to home value/mortgage ratio.