What aren't the numbers telling me?

Question

I'm spent a considerable amount of time here and at other sites/books researching and learn about REI. (I have a single townhome rental, that I got 10 yrs ago while in school, LONG before I knew any of what I know). I built a spreadsheet that runs the numbers (built before I became a pro member here, but the output numbers line up) and have been searching in the northern San Diego area area I will be moving shortly, that said I am still have some trouble figuring out some expense figures. Based on the research I've done I've been using 5% vac, 7% repair, 7% capex of monthly income (these are below the traditional 10%, to account for the high purchase prices in SD). I've been toying if 5% vice 7% is more realistic. That all said, what prompted this post was a property I looked at and unequivocally rejected was just sold in about 2 weeks and I am wondering what I could have missed. I doubt there are mind-readers here, so I realize we can't know certain factors pertaining to the buyer, but rather I was hoping some ppl would look at the listing and the numbers as I see them and see what I might have missed in my analysis. My end goal is to fine turn my analytical abilities. Below is a link to the property

House

Justin R. · Answer

@Sean Stu Some of your numbers are off.  I'll share how I do this.

Here's my annual budget for a triplex property, purchased last year at a similar price point, but within the City of SD limits:

Not sure I want to paste the full proforma publicly, but the relevant points...

• The budgeted maintenance number is 5% of value.  That has historically been high.
• Taxes are 1.1% of purchase basis.
• I self-manage, so that $50 monthly is just incremental costs on top of other properties I deal with.  If you're not going to do that work, this number is obviously higher.

To calculate the NOI and Free Cash Flow:

Actual vacancy for me across all properties over the past 10 years is a tad less than 2%, but I still budget 3.5%.  I don't do a reserve study for properties with few units - that's why it's using a round $200/door for CapEx.

From there, it's just a matter of how much capital you've got stuck in the property - if you've got $100k stuck in the property, you've got a 7% CoC return (and a total annual ROI of ~14% when backing out principal payments).  If you're inclined to underwrite for appreciation to match inflation at, say, 2% annually, that potential ROI jumps up to ~28% annually.  To really nail your numbers, though, you'll convert these into IRR.

Now, when comparing two investments, one can look at the IRR.  Easy.  But, each investment carries with it some level of hassle (assuming both are of equal risk) - high risk investments give me headaches (that's a hassle).  So, I consider a bunch of metrics:

• Property Characteristics Factor: Newer construction is less hassle than older.  Better areas of town are less hassle than worse ones.  Submetered utilities are less hassle than master metered.  Properties with garages are less hassle than ones without.  Properties where tenants stay longer are less hassle than ones that don't.  Properties closer to me are less hassle than ones further away.  Properties near single family neighborhoods are less hassle than ones in denser neighborhoods.  Properties in higher per capita income areas are less hassle than lower.
• Tenants: A return of X% when I have 3 tenants is less hassle than a return of X% when I have 10 tenants.
• Capital: A return of X% on a large amount of capital is less hassle than a return of X% on a small amount of capital.
• Appreciation: Properties that are likely to appreciate over time are less hassle than ones that are unlikely.

For my base case, I use a specific triplex property I've owned for a while.  Here's what I used for this one:

• Property Characteristic Factor: 1.3
• Tenants: 1.0
• Capital: 1.1
• Appreciation: 1.0

Then, it's just modeling that to figure out how attractive that 14% annual ROI is relative to other real estate investments.  Point being, a 14% return is neither good nor bad ... it only makes sense to compare two investment opportunities or strategies and try to normalize their returns.  There's a personal preference factor in there that plays into it.

And, hope it's obvious, but this is all specific to small MFRs ... different game if you're dealing with commercial space are large MFR communities.

That said, I don't think I could ever personally justify the duplex you referenced to hold in my B&H portfolio.  :-)  As @Cody L said, whoever bought that definitely isn't doing using the metrics above.

Sarah D. · Answer

@Sean Stu  I'm going to echo @Cody L. Even if you find a property that cash flows, it typically does so with a hefty (20%+) down payment only.  That's not to say it it's bad to buy here, but you do have to be picky about what you buy.

However, there are greater reasons to invest in SD real estate for a house hack:

-Appreciation over cash flow (a gamble, but a fairly safe one over the long term)

-reduction of living expenses.  Chances are that duplex will be cheaper for you to live in than a SFH

-short term/vacation rentals.  Lots of people use this to cash flow their house hacks.

-hands on experience for your next purchase

There are also value add properties that come up.  Look for the places that need work, with below market rents, and are too expensive or overwhelming for the typical first time house hacker/investor and too small for the experienced investor.  Best of luck in your search!

Cody L. · Answer

Oh this is an easy one:  You ran the numbers, and correctly realized it wouldn't cash flow.  But now your confused why it sold in 2 weeks if the numbers suck.

Easy:  People don't buy in San Diego for cash flow.

Justin R. · Answer

Sorry, should add specifically that your insurance should be closer to about $900/yr and your property taxes should be 1.1% of your purchase price.

Which... makes the free cash flow even worse than it already is.  :)

Justin R. · Answer

@Sean Stu Yes to what Dan said.

In practice, you ignore depreciation until you deal with tax issues.  Just know that it'll shelter any income from the property for the first ~10 years-ish.

The property values are high here, but the property taxes are not variable... which is a good thing since they're the largest single property expense.  That doesn't help short term B&H people, but it's gold for investors who are patient in the long run.

In your proforma, base your property taxes on the purchase price.

Dan H. · Answer

@Sean Stu The property tax in Cal is based solely as a percentage of value sold plus the Prop 13 controlled appreciation after sale.  the percentage has a bit of variation based on things such as including the trash in the property tax or any local bonds such as for schools but 1.1% is a good estimate but 1.2% is a safe estimate.

The depreciation is based on structural value.  The depreciation would count against profits but if there is no rehab on the property or other large cap expense the depreciation in San Diego actually places most properties in the red from a tax perspective.  Depending on your income level or being a real estate profession (which has a high criteria for investors) this depreciation is either written off or banked against future profits.  If you want exact info I suggest an CPA or EA provide better details (I have a tax man).

By the way I would not reduce your maintenance too much lower than 7%.  My handyman costs me ~4% of my rents but then there are the contractors (mostly plumbing) that is sporadic but add up.  Where this becomes fuzzy is some of the plumbing is cap expense and some is maintenance.  Ditto the electrician.

Good luck

Sean Stu · Answer

@Dan Heuschele @Justin R. et al

Thanks for the insight. Again analyse is priority #1 and I appreciate the experienced eyes.

Thanks for confirming I am prob over estimating maintenance.  10% was the starting point as it seems to be used in every blog, reading etc, even on BP. I starting lower from 10% for the very reason you 2 mentioned- % rental income falsely inflates costs in high $ areas like SD relative to property characteristics. (I'd like to think I'm learning ;) )

I was using 1.1% for taxes but was calculating based on redfin, etc listing from prior tax basis. This might be an embarrassing rookie questions, but is the tax basis based on the last purchase price? (I understand there's a land and structure component) but in my sheet you see I have a box labeled tax value b/c I looking at the reported tax data the tax structure value was not was the purchase price was and often much lower (1/2). Should the 1.1% be based off my offering purchase amount (minus some land component)?

Also the the original point- while units will very, and a general rule would using a % (50& maybe) of the tax basis provide a better approx for repair/capex. I realize Justin you used a fixed number as you have the experience/data to support that. But for rookies.

Again- I have made some fine tuning on my analysis already and I sincerely appreciate the inputs everyone has given.

Dan H. · Answer

@Justin R. implied this but basing cap expense as a percentage of rent is not very realistic.  Cap expense is more a function of property characteristics like number of bathrooms, size (footage), number of bedrooms as well as the tenants (number of properties tenants and do they treat the property as though they own it).

A 3/2 that rents for $1800 in east San Diego probably should use higher cap expense than the 3/2 that rents in North Park for $2900 because the tenants are likely to cause more wear n tear.

For my cap expense I only use the unit characteristics and assume tenants are going to cause significantly more wear n tear than if I was living in the unit.  So I would use same cap expense for the 3/2 regardless of rent amount.

My cap expense estimate would be higher than 7% of rents you projected for that property but I use high cap expense estimates.  This month I am getting estimates for replacing 150' fence and surprised at how high the quotes have been.  So I am asking my handyman to give a quote realizing it may take him 3 weeks to do the job.

Anyone in San Diego have a recommendation for someone putting a fence in at reasonable cost?

The rent and cost numbers used suggest this is not in a blue collar area.  Blue collar areas in San Diego have better cash flow numbers but 2/1 rent for average size at ~$1500.

Good luck

Christine Kankowski · Answer

You said you turned down the property, but are second guessing yourself because the property sold quickly.   There is low inventory in San Diego right now.  Someone may be buying for long term appreciation and not current cash flow.

One thing to consider would be going about 30 miles north to temecula.  Newer places, Half of the price, great tenants, good schools, Low vacancy, crime and unemployment.

Jeff B. · Answer

Firstly, lenders typically use 8-12% for vacancy, but with 2yrs rent rolls, I was able to prove actual vacancy was 2% - - be tenacious.

What aren't the numbers telling me?

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