I'm curious to hear how other people account for phantom repairs when looking at a deal to purchasing a rental property. By this I mean the depreciated value of having an older roof, furnace, etc. in a house you are looking to purchase. I call it a phantom repair because these items are still perfectly functional at the moment so there's no current repair to be done, but you'll probably have to replace them sooner than if they were newer.
For example, say you are looking at two SFH that are identical in every way. The only difference is that one has a brand new furnace and the other has a furnace that is 15 years old but works just fine.
Generally when doing deal analysis it seems people will account for estimated rehab to make a unit rentable, and they will estimate an amount for monthly or yearly maintenance and capital expenditures either as a percentage of rent or some estimated dollar amount. Using this method both houses would look the same on paper even though the one with the new furnace is obviously better.
Here’s my thoughts on ways to account for these.
1. Ignore it. It seems many people do. I suppose this kind of makes sense if you’re planning to own the property for a long time because even though you’d have to replace the items sooner, after replacing them you then wouldn't have to replace them for a longer period of time. So it would at least mostly wash out in the long run.
2. Count it as part of the rehab cost to get the unit rentable. If the furnace is 15 years old and you expect a furnace to last 20 years, then include the cost of 75% of a furnace in your rehab costs even though you won’t actually be spending it now.
3. Use a discounted cash flow model. This would take the future timing of the expense into account. Or on a similar note, do the same method as number 2 but discount the 75% cost by 5 years. I don’t think most people get this sophisticated in their deal analysis though.
4. Increase the estimated capital expense/maintenance expenses. Of course then the question is, by how much? Some arbitrary amount? To pay for the cost of a new furnace in 5 years? By that logic if it was older than its life expectancy you have to raise it enough to pay for a whole furnace every month or year which obviously doesn’t make sense.
So, do you account for this when you’re looking at a deal, and if so, how?
You are either putting way too much thought into this or not enough. If you intend to hold the property for a long-time everything is going to break and many things will do so multiple times. The simplistic solution is to assign a certain percentage of your monthly rent to repairs. 8% is a fairly common number although I've seen more conservative estimates. Some months will be nearly zero, others (such as the one when that furnace does give out) will be much higher. Over enough time, it will wash out.
If this isn't satisfactory, try this exercise... Think about everything that you will have to replace over a 30-year time period and the number of repairs that might be necessary. Using your furnace as an example, let's say it costs $2000 and you have to replace it 1.5 times. Additionally, let's assume you will have 2 service calls of $500. Over the 30-year period of ownership, this item will cost you $4000/360 = $11.11 per month. Now go through EVERYTHING in the house including the roof, mechanicals, flooring, paint, cabinets, lights, etc. Add up all of the monthly costs, and you will have your repair reserve funds.
I like the second method as it is not dependent on fluctuations in house location or rents. (Two identical houses will have the same needs/costs over the long run regardless of whether the rental rates differ). The second thing I like is that you gain insights about your properties and your business. If you assume that you paint once every 5 years and it costs $1500 each time, the monthly allocation for paint is $25. That's more than twice the cost of a furnace! Also, if one particular property is running well-above these costs, it is a good idea to check out why. Is it just the end of life for big ticket items, or is there an underlying problem? Conversely, if a house is well-below, you may consider selling (or getting a home warranty) before the big ticket items start failing.
@Adam Moehn I'm no expert, but generally use your method #2. If I can have major mechanicals replacement costs accounted for in a purchase price that allows the numbers to work, I go for it. Buying at a discount, while not saving you cash on repairs up front, can provide a little cushion between all-in costs and sale price when you sell the property in the event your major mechanical replacement cost was higher then expected.
@Adam Moehn or ... Number 5, treat it like a rehab for flipping. Anything at 3/4 of it's expected life is replaced as part of the rehab. It may seem wasteful, but price labor costs on an as-available basis vs. that inevitable middle of the night emergency mid-winter. Or the cost of the interior damage when your roof leaks. Since it is part of your cost of purchase (factored in) it just means you need to be a little more picky about properties and purchase prices. It essentially puts the cost on the seller rather than you.
Right now I ignore it unless it is obvious that it will need repair in the near future. I budget $1,000 per year for a single family residence and $.67 per foot per year for capital reserves.
I like the idea of listing items and their useful life. Too lazy right now to implement.
Thanks for the ideas.
We had purchased an SFR rental about 8 years ago, with a very old but working furnace. Life expectancy according to our contractor could be another year or 5 years. Since we were rehabbing the house anyway, and didn't want one of those "middle of the night, middle of winter" calls, we replaced it for about $2000. We were then able to market the rental as having a brand new, efficient gas furnace that was under warranty. Tenants have been very happy with the low gas bills.
Thanks for your answers. Looks like a mix of ignore it, count it in rehab, and just replace anything old.
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