I used to say that not everything is as it seems in real estate. I don’t say that anymore because it simply doesn’t do justice to the truth as I know it. What I say now is, “Nothing is as it seems.”
As it relates to income-producing real estate, neither the income nor the expenses are what you think they are going to be, which in and of itself is the only constant. I know, that sounds weird—welcome to real estate!
The Secret to Success
The secret to achieving success in this sport is first coming to terms with the above reality—the only dynamic you can count on is that nothing is as it seems. Once you accept this, the path to success is a function of developing an ability to see that which is not obvious. Basically, it goes like this—now that I know that nothing is what it seems, how do I figure out the real truth?!
The Flow of Money
The flow of money in income property is at first glance obvious. You have income, and you have expenses. The income includes rents and fees, and the expenses include, well, you know what they include—you’ll find all of them in the BP Calculator.
What you may not know, however, is that there are forces at play that silently impact both the income and the expenses, which can dramatically impact our bottom line. These forces of evil are typically referred to as economic losses.
Related: How to Estimate Future CapEx Expenses on a Rental Property
One subset of these economic losses are all of the costs that are the result of tenant turnover. For example:
Loss to Lease
Let’s say you are renting a unit for $1,000. The tenant signs the lease for one year, and things go well. When renewal time comes, you send the tenant a notice that their rent will be increasing from $1,000 to $1,040. The next day, the tenant walks into your office and says that they are not comfortable paying more than $1,000, and if her rent goes up, she will need to look for another place to live.
Now you have a dilemma. You think that you can rent the unit for $1,040. But on the other hand, you realize that it’ll take a month to turnover and re-rent the unit. You’ll also need to clean the carpets, replace some blinds, and perhaps do some painting. So, it ain’t like re-renting this unit will cost nothing. The question is, will it cost more than keeping the tenant’s rent at $1,000?
And the answer is, in most cases, yes! In this case, lost month of rent is $1,040. Plus repairs, let’s say all in, you lose $1,500 on the turnover. On the other hand, not raising rents by $40/month will only cost $480 for the year.
Which loss is better—$1,500 or $480? Think on that for a minute.
You Lose Either Way!
Yep, you sure do. Why? Because even if you chose the lesser of the two evils, it’s still costing you money (be it less money). After all, if the market for the unit is $1,040 but you keep your tenant at $1,000, you’ve signed up for a loss of $480 on your bottom line—say hello to LTL (loss to lease). And if you are going to be intellectually honest, you are going to show a 4% loss to LTL somewhere in your pro forma. This is why when I see people throw around 5%-10% vacancy, I just laugh!
The moral of this story, in a roundabout kind of way, is that while not always, in many cases it is cheaper to keep a paying tenant in place, but doing so costs money. The lost revenue is but one aspect of this. You may also paint an accent wall or replace a few blinds for them. Happy and paying tenants, producing stable cash flow for us, is worth the effort and cost!
Very few costs in real estate are obvious. I read on the forums this week some dude say something like, “It’s all about the numbers; plug the numbers into a spreadsheet, and if they work, they work.”
Yeah—but you’ve got to know which numbers to plug into that spreadsheet.
Investors: How do you approach this dilemma (risking tenant turnover due to raised rent)? Do you agree with this assessment?
Leave your thoughts below, and let’s discuss.