The Costs of Owning Property

 

Investing in real estate can be an extremely profitable venture when done correctly. One of the most basic skills that must be learned in order to properly analyze potential investments is the ability to estimate the true expenses involved in owning the property. All too often, new investors look at their mortgage payment (principle, interest, taxes, insurance) along with the cost of monthly utilities when considering expenses and neglect repairs & maintenance, capital expenditures, property management, and vacancy. It’s essential to budget for these expenses as if they will be incurred on a monthly basis so that when they do come up you are able to comfortably afford them as they will come up in time. A property that truly cash flows will be able to pay for these expenses and still have income left over each month. So what are capital expenditures and why should you set aside money for them each month? And why budget for property management if you’re going to self-manage? These are important questions and their importance becomes clear when you take a long-term perspective. (All of the following percentages are assuming the rental property is a single family home or a residential (2-4 unit) multi family property.)

Capital Expenses

 

Capital expenses are the major expenses that come up rarely but are extremely costly such as a new roof, furnace, repairs to the foundation, etc. If you plan to own real estate in the long-run it’s essential that you budget for these expenses as these big-ticket items will need replaced on regular intervals. Generally speaking, you can plan for these expenses with some degree of accuracy as you know the approximate life of items like your roof or furnace but accidents happen and things break unexpectedly so you must plan for the unexpected if you want to be successful. You never know when a furnace will go out in the middle of winter and you will need $5,000 for an immediate replacement. For all of these reasons, it’s essential to allocate a percentage of your monthly income from the property to be put aside for capital expenditures. Determining the exact amount to budget each month depends on the specifics of the property. Was it built 100 years ago and are many of the major components of the house getting old? Then you will likely need to budget upwards of 8%-10% of your monthly income towards capital expenditures. On the other hand, if you buy a property and rehab it inside and out you will likely only need to budget 5%-7% for cap ex. Regardless, it’s essential to plan for these expenses as not doing so will likely lead to a very brief career in real estate investing.

Repairs & Maintenance

 

Repairs & maintenance are the smaller, more frequently occurring expenses such as painting after tenants leave or fixing simple leaks. These items are small but add up quickly and will come up frequently no matter what. When tenants leave there will always be small repairs to be made and even if tenants stay in the long-term there will always be things that break. You must budget an additional percentage of your monthly income for repairs & maintenance and even if you’re handy and intend to complete the work yourself you should still ensure that the income from your property covers this expense as you may not always want to do the work yourself. 5%-7% of your monthly rent should be budgeted for repairs and maintenance, closer to 5% for newer properties and 7% for older ones. This way you will be prepared when these costs come up and you don’t end up pouring your own money into the property.

Vacancy

 

Vacancy is another expense that comes in the form of lost rent. You can’t expect your property to be occupied 100% of the time so it’s key to plan for vacancy. If you own a single family rental it’s a safe bet that 1 month a year the property will be unoccupied on average which is about 8% of the time. If you own a small multi family property (say a four-plex) it’s generally safe to budget for slightly less of a vacancy expense (closer to 5%). Regardless, you must have some cash set aside to pay the mortgage when your property is unoccupied. Vacancy isn’t a tangible expense the way the others are so it’s often forgotten but when your rental is empty your mortgage payment is still due so you need to be prepared!

Property Management

 

Of all the aforementioned expenses, property management is the one most often neglected by new investors. Managing rental properties is not an easy job and will lead to terrible performance of your investment if not handled correctly so most new investors have no business managing their properties anyways (another blog on this soon). However, if you do have the knowledge/expertise to self-manage you should still budget for this expense as you never know what your situation will be in the future. You may not always have the time to self-manage so it’s important that the rents can cover this expense if need be. This is why it’s so essential to think through the long-term when purchasing real estate as your current situation may not be your situation in 5 years.If you own a single family rental you should expect 10% of your monthly income to go towards the cost of management. If you own a small multi family property it may be lower in the 7%-8% range. Many property managers tack on all kinds of hidden fees so it’s important to read through their contracts when you’re selecting a property manager but a good company will have a straightforward percentage cost with minimal to no fees.

Other Potential Expenses to Consider

 

Depending on the type of property, there may be other costs associated with ownership. Is the rental in an HOA with a quarterly fee? Do you have to pay someone to do the landscaping and snow removal? Did you remember to include the cost of garbage removal in your monthly utilities? Are you paying for bookkeeping software? These are all small items that are often missed and add up over time so it’s essential to think through all of the costs you will incur while owning the property. Plan for the long-termOne of the key takeaways from this article is planning for future uncertainty. Yes, you may want to manage your rentals now and you may not need a new roof for 5 years but if you don’t plan for both of these expenses now what happens when you can no longer self-manage or when you need $20,000 for a new roof? Perhaps 3 years pass with no turnover so you begin to think that you can just forget about vacancy expense. But what happens when your tenants leave in November and you aren’t able to rent out their unit for several months? In the long-run, everything regresses to the mean so if you get lucky and have abnormally low expenses in a certain area they will likely be made up for in the future. The point is, you must plan for all of the expenses involved owning property as if they occur every single month. This is the best way to ensure that your investment is profitable over time and that you do not end up losing your property when things go wrong!

Don’t Plan for Best Case Scenario

 

Do you really need to budget 8% for vacancy or up to 10% for capital expenditures? Perhaps not, but what happens when you do need that much capital set aside for these expenses? Would you rather take the risk of saving slightly more money each month than needed? Or risk losing your investment because you didn’t have the necessary funds set aside to support the property?  The point is that you need to plan for the worst and reduce your exposure to catastrophic loss (i.e. losing the property) first and foremost. Regardless of whether you’re investing in real estate or another vehicle for building wealth, the most successful investors are the best at mitigating risk and ensuring they don’t lose their capital when things go wrong. In real estate investing, this starts with planning for all of the potential expenses involved in owning property and running your numbers conservatively!

This blog was written by Dan Haberkost - dan.haberkost@gmail.com