Estimating expenses too conservatively?

[Brad Cogswell]

Hey all,

Wanted to get your opinion here. I'm investing in California, and have been looking at a number of duplexes. After gross rent, I'm deducting an immediate 30% off the top for variable expenses - Vacancy at 5%, Repairs at 5%, Capex at 10%, and Property Management at 10%. Am I being too conservative where I will make it too difficult to find a deal at all based on those assumptions?

In the example below, I'm left with $323 in monthly cash flow with a cap rate of 7.7% and CoC return of 9.1%, which doesn't seem high enough for me to pull the trigger. Below is the pro-forma to take a look. Thanks!

[John Jacobus]

@Brad Cogswell As a rule of thumb, I use 50% of gross rents as a starting estimate of total operating expenses (line 21 in your model).  This is popularly known as "the 50% rule" and is helpful to quickly weed out uneconomic deals but insufficient for a detailed underwriting of a deal.

I recommend that you start with the 50% rule and then adjust it upwards depending on the age of the property, class of the neighborhood and tenants, and amount of deferred maintenance.  If your deal doesn't work using the 50% rule, move on to the next.  If it's close, dig in further to qualify your assumptions and adjust your analysis as needed.  The value in the 50% rule is that it helps focus your time and energy.

Your current total operating expenses (line 21) should be ~$200/month higher to get to the 50% rule.  Add to this where you detect issues with deferred maintenance, tenant turnover, vacancy, and owner paid utilities.

I recommend a few good resources for honing your deal analysis chops:

1. Is This a Deal? By Ben Leybovich

2. The ABC's of Real Estate Investing by Ken McElroy

3. Wheelbarrow Profits by Jake Stenziano & Gino Barbaro