All Forum Posts by: Tim J

There is no rule. No standard. No average. Every area is different.

Talk to investors, property managers and owners that know the rental market in your area and see what their true operating costs are. It could vary from 25% to over 100% (yes, there are properties that have a NEGATIVE cashflow even if cost of money is zero). Talk to as many locals as you can that manage property similar to the one you are looking to purchase, get an average of their expense, compare to your property and you'll get a very rough number to start with. Don't bother using a formula unless it's one that locals in your area can agree with.

And take everything a realtor tells you with a grain of salt.

My goodness! $90,000 for a house? How big is the lot? How big is the home? Where is this?

Rents haven't been keeping up with prices here in Hawaii either. But the rents have gone up a lot. I would say rents are up about 50% in the last 6 years (whereas property values are up about 100%). But before that, rents were flat for about 8 years. So we may be in for a long period of flat rents. That's what I suspect at least.

My tax returns over the last few years show negative income because of depreciation on my RE investments and losses incurred from an engineering company I own. That's what I meant. I have plenty of cash reserves, just not ideal income numbers. And yes, this is a commercial office condo unit.

Well, it is clear that we agree to disagree. You can continue to use your nationwide average as a guide when determining whether a property is a good investment in a certain city and state. I will continue to use an average specific to the locale I am investing in.

You mention that I didn't include all the expenses in my example. Yes, I understand that I may have left certain operating expenses out. But the scenario was meant to show you how the numbers are dramatically different in different parts of the US and using an average in local markets is completely useless. If I was to include all these additional expenses you say I left out, could you tell me how this would refute the point I'm trying to make? Please plug all of your numbers into the equation and see what happens. Nothing. The reality is that one property still has a much higher operating expense in percentage of gross rents than the other.

It is not that simple. That's my point. Let me make it clear that I'm not disagreeing with the fact that you will never know what your total expenses are on any given property. But what you're saying is that because it's impossible to even get close to the actual figures, the 45-50% rule should put you in a safe zone. Again, the illustration on my previous point outlines how this is not safe.

This doesn't have to be the last word; my eight years of experience in the real estate investment/rental industry pales in comparison to what many others on this board have. I have learned new things, disagreed and agreed with others. This is what the internet is all about - sharing opinions. And it's a wonderful thing.

I agree that having a portfolio of several rental properties in several different areas/markets is key in that is spreads your risk, similar to having a diversified stock portfolio.

But to try to adhere to the statistical average of 45-50%, you are really doing nothing if you're a first time buyer looking at your first investment property (there are many like this on this forum). Sure, if you own many properties in many markets, using the 45-50% rule can apply. But if I'm a newbie and looking for advice on a first possible investment property and everyone tells me "45-50% or you'll be in trouble", is just plain misleading.

Let's try to break this down and see how this works:

Property #1 (estimated figures for property I've seen available for sale)
3 bedroom, 2 bath 2,000 sq ft home in Texas
Value $120,000
Rent - $1,000
5% Vacancy - $50
Property tax (1.5% of annual value) - $150
Maintenance/upkeep - $230 (10 cents sq ft + appliance replacement) budget)
Insurance - $90 (quote from Allstate)
Property management (10%) - $100

[b]Total monthly operating costs - $710
Net operating monthly income - $290 (71% of gross rents going to operating expense)[/b]

Property #2 (actual figures on the average property in Hawaii)
3 bedroom, 2 bath, 1,400 sq ft home in Honolulu, HI
Value $600,000
Rent - $2,500
5% Vacancy - $125
Property tax (.35% of annual value) - $175
Maintenance/upkeep - $245 (15 cents sq ft + appliance replacement) budget)
Insurance - $130 (quote from Allstate)
Property management (8%) - $200

[b]Total monthly operating costs - $875
Net operating monthly income - $1,625 (35% of gross rents going to operating expense)[/b]

Using the 50% rule, you've over-budgeted on property #2, but you're WAY short on property #1. Sure, my estimates may be off. But not enough to refute my argument.

Interestingly, the CAP rate on property # 2 is actually a little better than property #1. If you were a newbie and someone said you can buy a property for $120,000 and rent if for $1,000/mo, that sounds like an OK deal. But tell the same person they can rent a $600,000 property for only $2,500. Horrible deal, right? As you can see from above, this can be very misleading.

All newbie investors should find out the average operating expense for their particular area/market. Then use that average as something to work off of when looking at individual properties. Do not use a NATIONAL average when looking at local markets. You could either pass up some good deals or get hosed.

I'm located in Honolulu, Hawaii and own a fee simple commercial office space in a small (17-unit), prime location building right outside of Waikiki The property is currently free and clear - no liens. I haven't had it appraised, but conservatively, I would estimate the value to be about $330,000. My goal is to borrow at least 60% of the appraised value. If I could go higher on the LTV, I would. But I prefer to keep the rate and terms as low as possible and sacrifice on the LTV. My tax returns are not good (typical real estate investor), but my assets are strong and my FICO is in the mid-700s. Can anyone help?

Well, this $20,000 expense can occur in any state, any city, any town - not just LA. Yes, certain states are more landlord-friendly, and others are more tenant-friendly. I happen to be living in a tenant-friendly state - Hawaii. But to factor worst case scenarios into the budget which include evictions is not smart in my opinion. If you have to deal with an ugly eviction, you're just going to take a loss. That's one of the risks of investing in real estate. You can't plug this into your operating figures. I would gander that rentals that target the more affluent have lower default/eviction rates than rentals that target the average joe. These so called "socialist" states generally offer a better picking of properties that target the more affluent renter. That's why it's hard to find a good investment property in these areas - those residing there are either wealthy enough or savvy enough to purchase their properties instead of rent. Note of course that these are HUGE generalizations that I'm making.

And accounting for a possible future vacancy of 30%, or any vacancy figure for that matter, is impossible. For example, if you bought in a small city where 90% of the population works at a nearby Toyota assembly factory, using your logic, you better factor in some really worst case scenarios just in case the factory shut down, because your vacancy will go from whatever it was when you bought to 100% - overnight. You have to research the area, the city, the demographics. What kind of people work there? In what fields? Education level, incomes. How diverse is the employment in the area? How stable are individual industries, and how long have they had presence in the area. VERY IMPORTANT FACTORS. This will determine your risk, NOT the operating expense. You just simply don't plug these numbers in because there is nothing to work off of. You are basing things on chance, and not historical information. Please tell me how you can plug these numbers into the equation? It's impossible. You set a vacancy rate and work with that. If you come out on top, you made some gravy. You underestimate and you take a hit and come in below your expectations.

I think that about 90% of all expenses can be quite accurate (property mgmt fees, mortgage, property taxes, insurance, maintenance/repairs). Mortgage, of course, is fixed. Taxes and insurance generally move up at the rate of inflation so this can be calculated fairly safely.

Regarding maintenance, I add up the cost on all the appliances and divide by 96 (8 years = 96 months) to give me my monthly cost. For example, $3,000 worth of appliances would incur a $31/mo repair/replacement budget. I would then take the total square footage of the house and multiply by 15 cents. This would give me a relatively safe monthly repair/maintenance budget for the home itself (roof, windows, walls, flooring, plumbing, electrical, etc). For example, a 2,000 sq ft home would incur a repair maintenance budget of $300/mo. This figure can vary in different states (higher in high-labor and construction materials markets and lower in low-labor and construction materials market). And of course, if you have a simple tract home vs a fancy custom high-end home, this could bring the number up or down. My figure is just an average. Age is also a huge factor, but using a base multiplier can put you in safe zone when it comes to the uncertainty that repairs and maintenance costs offers. If you have a condo, I would take whatever the figure is for the home and divide by 3. For example, 15 cents a sq/ft for a house would be 5 cents sq ft per month for a condo. This does not include appliances.

I guess the point that I'm trying to make is that people shouldn't be scared off by a property if the annual rent isn't DOUBLE what their total expenses are. I've learned that most of the "gurus" (members with high volume postings) on this website like to tout the 50% rule, which can scare the heck out of many potential long term real estate investors. Where, outside of poorly appreciating markets and/or bad neighborhoods, can you actually find this type of property??? It is absolute fact that you could be much more profitable in the short and long term on a property with 20% of gross rents going to operating expense, than on a property with 50% of gross rents going to operating expense. There is no rule, period. All costs can be accurately determined to an extent. You just have to take your time and do your research. Don't be scared away by a "crappy" gross rental income to operating expense ratio - RUN ALL THE NUMBERS. It may not be that crappy after all. And then after you run the numbers, realize that you might lose money if your property goes unrented above your vacancy rate, and/or you get a bad apple that destroys your home and decides to never leave and live rent free. That's the big risk you take in real estate. I had a response where I was told that I was going to be $3,000/mo negative on a property I thought I was going to be break even on. I thought long and hard to try to figure out where the $36,000/year was going to. Apparently the member thought my home was in a small town where 90% of the people worked at one car factory, and was anticipating a factory closure very soon. Must have been it.

I completely disagree with the 50% rule as being accurate. It is FAR from accurate. Some properties may have operating expense which is far greater as a percentage of rents. For example, if you rent a large 2,000 sq ft house for $1,000/mo in Texas, you will incur operating expense which could easily EXCEED $500/mo. The long term maintenance/upkeep alone could be $300/mo for a large home, if not more. Then you have to add 10% property management, hazard/liability/hurricane insurance, 5% vacancy, any utilities, property taxes, etc. You're sure to be over $500/mo once all the fees are calculated.

You could also rent the same size home in Los Angeles for $3,000/mo and the total operating expense would be much lower than 50%. Since the rent is higher, chances are you can bargain with a property manager and drop the fees to 5-8% vs the 10% minimum they would require on a lower rent home (LA home would yield $150/mo income for the property manager at 5% and only $100/mo income for the manager of the Texas home but same amount of work). Property taxes and insurance would probably be higher because of the higher property value, but the scale is not linear. Even vacancy of 5% is not a good number to plug. Historically, some areas rent with 10% year round vacancy, others only 2%. Check the historical numbers. The operating expense on the LA home could be considerably lower than even 30% of gross rents. And the Texas home would be short with 50% of gross rents going to operating expense.

I wouldn't use the 50% rule ever, or ANY rule for that matter. Each property is different and you have to break down every expense applicable to the specific property, line by line. That's the only way to get an accurate figure. One exception where it's hard to find a historical number or current fixed cost is on maintenance/upkeep. It would be good to plug a number there but I'm having a hard time figuring that one out on my current properties.

I'm in a bit of a quandary at the moment. I purchased a property in pretty bad shape for about $1 million last year and spent about $500,000 on what ended up being a MAJOR rehab project. The city assessed the value of the property when I bought it at $1 million, but only $100,000 was assessed to the building, and $900,000 to the land.

So now my CPA tells me that the IRS goes by the city assessed values to determine the PERCENTAGE of land vs building value. So if you purchased at $1,000,000, and now the property is worth $1,500,000, the IRS will allow 10% of that $1,500,000 to be depreciated ($150,000), while the rest cannot since it goes to land value. Am I the only one that thinks this is ridiculous? The city and county of Honolulu is notorious for unfair land/building ratio valuations.

My view is that I should ignore my CPA, and go with the REPLACEMENT VALUE the insurance company assessed on the building. The insurance company put the replacement value of the building at $660,000.

Or, should I take the initial purchase price, somehow subtract a fair value for the building BEFORE the rehab (let's say $200,000), and then add the labor and material that went into the project (approx $500,000) giving me a building value of $700,000 to depreciate?

Then there is the appraisal (not sure if this can be used for depreciation because the appraiser never splits land and building values), which came out at $2,140,000. But how do I allocate the building value out of that?

As you can see, I have no idea how to determine my new basis going forward. I just completely disagree with my CPA that I should use the "ratio" the city and county uses to determine the building value.

Thanks in advance for any advice and help!

I'm a little confused about how the depreciation works on items that don't last 27.5 years, such as flooring, appliances, cabinets, etc. I know that you can apply accelerated depreciation (5 years) on certain items, but how do I know which items qualify to be depreciated at the higher rate?

And is depreciation on items such as appliances recaptured? I understand why the IRS recaptures depreciation on things such as the building itself (which is essentially never just tossed in the garbage), but if you use an air conditioner and toss it in 5 years, should I have to pay a recapture tax on the depreciated amount being that it's now at the landfill? Thanks in advance for any help.