The moral: While the fool argues about things he does not know nor understand, the ass knows full well that he is right, but still argues with the fool.<\/p>\n
Now, those of you who know me well are well-aware that I am never the fool. Indeed, I know lots of stuff — that\u2019s the good news. The bad news, if you choose to look at it this way, is represented with the following syllogism:<\/p>\n
Major Premise:<\/strong> When two men argue, one is always a fool, while the other is an ass.<\/p>\n Minor Premise:<\/strong> Ben Leybovich knows lots of stuff, but always argues; therefore…<\/p>\n Conclusion:<\/strong> Ben Leybovich must be an ass!<\/p>\n To this I say, what the hell\u2026 somebody\u2019s got to do it. I might as well take the bullet. Basically, as I see it, so long as I teach you something, I figure I have the green light to be an ass all day long (and twice on Tuesdays, when my articles come out)!<\/p>\n Well, that was my intro, y\u2019all. Thoughts? I\u2019m pretty pleased with myself, actually. And what\u2019s been said thus far is nothing in comparison to what\u2019s coming\u2026<\/p>\n Last week a good friend of mine, Serge S., called me. I don\u2019t mean to say that this in and of itself is anything special, cause Serge and I talk three times most days. Twice per day Serge calls to tell me to quit being a judgmental ass, and one time per day he calls to tell me that I am right and to ask for my opinion. Haha!<\/p>\n So help me God if I am lying, y\u2019all\u2026<\/p>\n The following is a transcript of conversation #3 from about a week ago:<\/p>\n Serge:<\/strong> You keep telling them to quit buying $30,000 pigs, and you get a lot of support in the comments section from people that have been around for a while, but the newbies keep arguing. Why don\u2019t you just write an article and show them the accrual of CapEx, and how they will spend all of the cash flow that they think they have\u2026<\/em><\/p>\n Me: <\/strong>Dude \u2013 they already think I\u2019m an ass. I know I am right. You know I am right. Who cares what they think \u2013 like I got time. If they want to buy pigs, let \u2018em buy pigs. It\u2019s called school of hard knocks\u2026<\/em><\/p>\n Serge: <\/strong>Dude \u2013 I\u2019ll create the spreadsheet so you don\u2019t have to. All you need to do is just write an article around it. People should know the reality of these numbers!<\/em><\/p>\n Me: <\/strong>Fine, but we\u2019ll get 200 comments on this one. You better help with the responses\u2026<\/em><\/p>\n Serge: <\/strong>OK \u2013 I will.<\/em><\/p>\n And so, ladies and gents \u2013 put aside your feelings and intuition. In this article, Serge and I will show you the numbers behind the statement of truth:\u00a0Don\u2019t buy $30,000 pigs in Ohio (or anywhere) \u2013 You\u2019ll lose money! <\/em>This is unbiased truth that your turnkey provider will not tell you.<\/p>\n One way is something we refer to as pro forma. This is akin to a snapshot in time, whereby you put the numbers on the page and assume that these will be the numbers going forward, and nothing will ever change.<\/p>\n The other way of analyzing property is to understand that just because something looks today the way that it does, doesn\u2019t mean that tomorrow it will look the same. There are many items we can discuss under this heading; however, the one that Serge and I want to focus on today is CapEx \u2013 capital expenditures which pay for replacement of aging components of the physical property.<\/p>\n You\u2019ve heard the word depreciation <\/em>tossed around a lot, I am sure. The context in which it is used most often is as it relates to paper write-offs against income from income property; depreciation is thought of as a tax break the IRS gives us.<\/p>\n Related:<\/strong> Newbies Take Note: Why You Shouldn\u2019t Buy Houses for $30,000<\/a><\/em><\/p>\n Important to realize is that the reason the IRS gives us this shelter is because they, unlike many investors, understand that property actually does get older and depreciates, which means that over time we, as owners, have to step up and upgrade items which have depreciated beyond useful life.<\/p>\n The presumption the IRS makes, which is logical and reasonable, though missed by most investors, is that property owners are setting money aside to be deployed in the future to cover the items on CapEx list. For this reason and to encourage us to be responsible owners, the IRS allows us to depreciate and save on taxes today (and hopefully save that friggin\u2019 money!).<\/p>\n Yes indeed, stuff really does get older and needs replaced. And eventually, the shell of the structure itself is so old and with so many functional deficiencies relative to modern consumer\u2019s expectations (functional obsolescence) that it becomes painful to put money into components because having spent sufficient money to bring the thing up to par, your investment of capital is greater than the market valuation of the house — financial obsolescence!<\/p>\n This constitutes the end of the road for a property, and this defines a PIG! Why else do you think the marketplace has decided that a house is only worth $30,000\u2026? C\u2019mon — it\u2019s a 1,100 sq. ft. 3\/1 SFR, which at today\u2019s prices carries replacement value of at least $110,000, and yet the marketplace has decided it\u2019s only worth $30,000 — good luck with that math!<\/p>\n “That doesn\u2019t matter…”<\/strong><\/p>\n This is what you say. It doesn\u2019t matter because you are buying for (these are the buzzwords) cash flow<\/em>, and at such a low basis, you\u2019ll just make money hand over fist every month\u2026<\/p>\n Well, let\u2019s look at that:<\/p>\n The following is a chart Serge put together and I added to:<\/p>\n As you can see, in the first column we list the depreciating items; I am sure we missed a bunch, but this is a good start.<\/p>\n In column 2, we indicate the number of years in the useful life of an item. This comes from our personal experience of owning lots of units for a decade. HUD and IRS have their charts, but in looking at those, it becomes clear that their numbers are just stabs in the dark. We feel that our numbers are much more \u201ctrue\u201d to what happens in reality.<\/p>\n Important to note as well is that these useful life numbers will vary a bit with location and climate. For instance, in CA or parts of AZ, an asphalt roof may need replaced every 10 years because of the extreme heat, while in the Midwest, the same roof might last 23 years. The same is true of the HVAC. However, property taxes and insurance costs in AZ are a fraction of what they are in OH, so things even out over the course hold.<\/p>\n In column 3 we show the yearly accrual for each line item — and at the bottom cumulatively. This is the amount you have to set aside in anticipation of having to replace each at the end of useful life.<\/p>\n And in the last column, we show the monthly breakdown.<\/p>\n This initial table presumes SFR, and it presumes a B Class asset, which attracts B Class tenants. Let\u2019s not beat around the bush — life of equipment is shortened the harder it is used, and C, and especially D Class tenants, will likely be taking less care than B and A Class. In another chart we make adjustments to reflect this.<\/p>\n Additionally, in apartment setting everything can be either less or more expensive, and we make those adjustments as well below. More on that in a bit\u2026<\/p>\n And finally, this table presumes you start out with brand new equipment, and accrual of replacement costs is based on a full lifespan of this equipment. This is important to note, as it really does not matter if you\u2019re doing a \u201ctenant proof\u201d remodel. Obviously, if appliances can be expected to last 8 years and you\u2019re starting off with a 5 year-old appliance package, then you would need to accrue replacement reserves at a much higher rate so that you\u2019re ready to deploy in 3 years, and this can really add up quickly. Furthermore, if you are inheriting 20-year-old appliances, then it\u2019s likely wise to have the full replacement cost on hand from day one!<\/p>\n This logic applies to all of the items on the list.<\/p>\n As you can see, the reasonable expectation of replacement costs seems to be about $257\/door per month in a B Class Single Family. This means that if you are going to be a reasonable owner, you would need to set aside this amount of money every month so that you are prepared for the eventuality of replacing items as needed. And while this dollar amount can be argued all day, most reasonable, experienced SFR operators will concede that the number will be most certainly be over $200 a month.<\/p>\n Keep in mind that this is not your maintenance and repair budget; this is CapEx, and is (or should be) a totally separate line item in your underwriting of expenses.<\/p>\n Well, let\u2019s just create a pro forma for a typical older house in a so-so market in Ohio; a place like my hometown of Lima, or Toledo, or Dayton, or Cleveland, or Cincinnati, or Columbus, or any place. Let\u2019s presume an all cash purchase, and let\u2019s just say that you are local and are going to self-manage.<\/p>\n With just those costs, presuming a cash purchase and no management expense, pro forma indicates cash flow of $360\/month, or $4,320\/annum. This, on an annualized basis, looks pretty good at 14.4% CCR.<\/p>\n Now let\u2019s subtract the CapEx replacement costs:<\/p>\n What you are left with is $103\/month of CF, which on an annualized basis constitutes a 4.12% CCR against the purchase of $30,000. Not so good!<\/p>\n But we are not done, because if you are not local, your pro forma looks like this:<\/p>\n And now your real CF after you set money for replacements is a whopping $33\/month \u2013 1.3% CCR.<\/p>\n And this is presuming you are starting off with brand spanking new equipment and can benefit from full life to accrue replacement cost. You know this isn\u2019t realistic. Why? Because it costs more to replace all of this equipment upfront than what you paid for the house!<\/p>\n You\u2019ve bought a pig that\u2019s going to bleed you to death. If you are at least local and can do the work yourself, then what you\u2019ve bought is a job, but there is a reasonable chance that you can build some CF. If you are from CA and you are buying turnkey, meaning that you can\u2019t do the work at cost and you have to pay for management, even presuming B Class tenant base, you cannot make money at $700\/month rents \u2013 period.\u00a0 It\u2019s just math, y’all.<\/p>\n One final point on this: We are not even including the cost of the initial rehab, the cost of the retail rehab when you’re ready to sell, the legal costs of the inevitable evictions, and the consistent turnover. Neither are we including lease-up pay to your property manager, which they most certainly will charge you. It\u2019s normal practice. I tell you, it\u2019s the pits — the management fee of 10% never costs 10%; at least 12%, guys. I know, I\u2019ve seen the numbers. \ud83d\ude42<\/p>\n Now, what you need to realize is that there are no miracles in this business. In Ohio, a $30,000 SFR is by definition at best a C Class. The market says so; otherwise, you\u2019d be paying $70,000. And with this being the case, you can expect to have to turn it more often, to have turns cost more, and to have to replace equipment sooner than the above table indicates!<\/p>\n That being said, the table below adjusts CapEx up by 15% for C Class and 25% for D Class. You do that cash flow math:<\/p>\nExtended Intro<\/h2>\n
![\"credit-report-loan\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2016\/12\/credit-report-loan.jpg\" "\\"\\"")
<\/p>\nThere Are Two Ways to Look at Numbers<\/h2>\n
About Depreciation<\/h2>\n
Depreciating Items and Annual Accrual<\/h2>\n
![\"CapEx_Aricle_TABLE_1\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/03\/CapEx_Aricle_TABLE_1.png\" "\\"\\"")
<\/a><\/p>\nWhat Does This Mean?<\/h2>\n
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![\"landlord-lessons\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/02\/landlord-lessons.jpg\" "\\"\\"")
<\/p>\nC Class<\/h2>\n
![\"CapEx_Article_TABLE_2\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/03\/CapEx_Article_TABLE_2.png\" "\\"\\"")
<\/a><\/p>\n