All Forum Posts by: Tim J

Here in Hawaii, it is impossible to find a property that meets the "1% rule". In fact, after expenses, you're lucky to find a property that receives 0.5% in annual net rent. True 4% cap rates are the norm here, 5% rates are around but not common. 6% rates are extremely rare (or the property will require major rehab to achieve) and 7% is impossible to find. If I could handle the cold, I would move to a state with better prospects. My understanding is that it's impossible to find a property that meets the 1% rule in metro or higher end areas.

Thanks for the response. I've talked to several seasoned, long-term RE investors here in Hawaii and this is what I've been told are the total operating costs -

5% vacancy
5% repairs/maintenance
8% management
utilities
lease fees (if applicable)
maintenance fees (if applicable)
property tax
excise tax
hurricane/hazard/fire/liability insurance

Since I am taking care of the management, I can eliminate the 8% mgmt fee. I prefer to manage myself not because I will save money, but because I prefer to screen my own tenants and take care of tenant issues myself rather than have someone else do it. Getting ideal tenants into your properties will probably reduce 90% of potential headaches down the line. And I don't know any property managers that screen as well as owners would. Property managers also aren't as price/quality conscious when it comes to doing repairs/maintenance. I'm pretty well rounded in this department (I practically built my own home), unlike many property managers that don't even know how to change a light bulb.

I find it amazing that a property can yield expenses that are 67% of gross income, let alone even close to 50%. Here in Hawaii, where rents are much higher than the national average (we're actually highest in the country according to many surveys/studies), it's difficult that repairs and other associated costs could take that big a chunk out of the high cost of the rent. Our rents are high here because cost of living is very high, and real estate prices are very high when compared to the mainland. So an overwhelming majority of costs associated with a rental are mortgages which luckily do not move with inflation (granted you have a fixed program). Also, we live in a temperate climate so we face less maintenance issues than in states with seasons (e.g. we have roofing systems that easily last 30-40 years; generally no HVAC systems, heating, freezing issues, etc). That's the benefit of having an average temperature that's +/- 10 degrees all year round. Our main concern here is termites and an occasional visit by the Thermidor alleviates that problem. Our rent yield per square foot is probably 2-3 times the national average. For example, my property rents out for about $2.70/sq ft (small 560 sq ft two bedroom duplexes). Studios often rent for $3.50 sq ft+ here. Costs to maintain, repair and remodel are relatively constant based on sq footage. So if you have a property that yields only $.75 sq ft and another that yields $2.70 sq ft, the latter property will obviously have a much lower operating cost based on a percentage of gross rents. A good chunk of that $.75 yield will go to repairs/maintenance. Whereas you have a lot of cushion on the property yielding $2.70/sq ft.

Here is a good example -

Home #1 - 2,000 sq ft home rents for $1,500 ($.75/sq ft)
Home #2 - 1,100 sq ft duplex (two units) rents for $3,000/mo ($2.72/sq ft)

5% of gross rental for repair/maintenance on house #1 seems low - 3.75 cents/sq ft. Whereas we have dedicated 13.6 cents/sq ft on house #2. Is $75/mo enough to maintain a 2,000 sq ft home? Probably not. But is $150/mo enough to maintain a 1,100 sq ft duplex? Probably. So house #1 would require more than 5% of gross rents to cover the maintenance cost. Perhaps even 10% may not be sufficient. So my point is that a larger home with lower yield per sq ft rent will require a higher percentage of gross rents going to maintenance/repairs than a smaller home. This can be dramatic when you get into areas that yield very low rents per sq ft. Hawaii and other states that command high rents per sq foot should naturally have the lowest % of gross rents going to maintenance.

Another reason why our operating cost may be low is our very low property tax rate - 0.4% of assessed value annual. Insurance is also affordable at $168/mo for hurricane/fire/hazard and liability for the entire property (3 duplexes, 6 individual units). I've seen insurance rates of over $500/mo in Florida, for HURRICANE COVERAGE ONLY on a single family home.

Also, if you purchase a 50 year old property with deferred maintenance issues, unless you completely rehab the place, you will likely be faced with some pretty high maintenance costs going forward. If you purchase a property and REBUILD it completely, you essentially have deferred a majority of major maintenance problems for many years. This will undoubtedly reduce your maintenance costs. For example, my property is completely rebuilt - new roof, walls, flooring (subfloor too), structural supports, windows, appliances, plumbing (all copper), electrical, bathrooms, cabinets, etc. Basically the whole place minus the skeleton is brand new. The yard is extremely low maintenance (just river rock and a few palms). So how I should calculate 40-50% gross rentals for operating costs are beyond me.

The residential vacancy rate historically in Hawaii is 2.1%. It's 1.7% right now. Hawaii doesn't suffer from out-migration like in the mainland because, well, because we're an island in the middle of the Pacific. It's not easy to move. And because we don't have an economy that depends on any one (or two) industry, the likelihood of out-migration is very low. So if historical rates are anything to go by, I am overestimating the vacancy rate. I have nearly $6,000/year for maintenance and this should be sufficient being that everything is brand new. My first modest repair issues should likely surface in about 5 years, at which point I should have a nice chunk saved up from the "maintenance fund". Until then, appliances may fail but outside of that, I don't see what major items could fail (unless the tenant is responsible in which case the $$ wouldn't come from my pocket).

Regarding depreciation, my understanding on the commercial vs. residential is that any property that's zoned and operated as residential property can be depreciated at the 27.5 year rate. Any property that is zoned and operated as commercial property must be depreciated at the 39 year rate. The property is located on residentially zoned land, and used as residential property. I also pay the residential property tax (there are separate commercial use and residential use taxes). So I don't understand why you're telling me I need to depreciate at the 39 year rate.

I put the following tirade together to show my friend how real estate beats the market (equities, stocks). The scenario below is the actual property I purchased last year. Please let me know if I'm off on my assumptions.

I purchased a 6-unit multifamily property for $1.5 million with 10% cash down ($150,000 cash including closing costs). I now have a fixed mortgage for 30 years, at 6%. My monthly mortgage is $8,100 and my rental income is $9,500. To be fair, I should deduct 5% for vacancy AND 5% for future renovation/maintenance/upkeep – bringing the income to $8,575/mo. Then I must deduct all property taxes, water/sewer fees and liability/hazard/fire/flood/hurricane insurance. My net income is now $7,875/mo. After paying the $8,100/mo mortgage I now have a negative $225/mo cash flow.

Now the tax benefits… Let’s say I am a wash on income and expenses. But I can still depreciate the building; in this case the building is worth $600,000. Over 27.5 years this comes to $21,800/year. I can then reduce my taxable income by $21,800/year. In the 30% tax bracket, that’s $6,540 in taxes I save every year. Or $545/mo, which wipes out the $225/mo negative and puts me in positive after-tax cash flow territory ($320/mo positive). Sure rents can drop. But as long as the rents are not inflated (like how they were in SF during the internet boom years), they generally increase at 2-4% year without a whole lot of up or downswings.

So now you see how the property has become sustainable on its own. You see that I have allocated enough to cover the expenses including maintenance and upkeep, and insurance to make sure the asset is protected (can’t insure a stock, can you?), and still cover the mortgage.
But now let’s talk about the gravy. Considering a 30 year mortgage, you are contributing every month to the equity in your property at a rate of 2.34%. That’s on top of any real appreciation on your property. That means that from the first year to the 30th year, you are annually adding 2.34% compounded to your investment. How does this work? Well if you take the outstanding mortgage of $1,350,000 from the first day (and you own none of that), it would take exactly 30 years to pay it off. But you’ve just made $1,350,000 – buy just paying your mortgage down. This 2.34% is in addition to the appreciation in home value.. If the “normal” long term real property appreciation rate is 5%, and you are paying down a 30 year mortgage (and do not have an after-tax negative cash flow) your real rate of appreciation is 5% + 2.34% = 7.34%. Not bad? Well, it gets better.

Let’s consider that $320/mo in positive cash flow and put that in an investment – whatever that may be. And let’s say that returns 8% (the standard that I see everyone use). Well, $3840/year, every year invested in an account yields $125,000 in 15 years and $508,000 in 30 years.

OK, but how will inflation affect your bottom line. Well inflation is your friend in real estate. YOUR BIG FRIEND. Inflation increases the cost of everything, including maintenance, upkeep, insurance, taxes, sewer fees, etc. But this usually represents a small portion of your monthly costs when taking into account the mortgage (which is fixed for the life of the loan). But inflation increases RENT. So if we consider a modest 3% inflation rate, your rental income will increase by $3,420/year in the second year, $3,522 in the third year, $3,628 in the fourth year and $3,738 in the 5th year so forth and so on. So as you can see, the increase starts off at about $3,400 and compounds at 3% on that amount every year. So now you have $3,400 MORE to invest every year after the first year (the $3,400 actually grows by 3% every year but I’m not sure how to compound the difference) In 15 years that’s another $110,000 and in 30 years $450,000 at 8% yield. But to be fair, you have to consider increases in other non-fixed costs. In this case, we are talking about $780/year at 4% (insurance, property taxes and sewer fees always seems to outpace the general rate of inflation). So we can subtract $40,000 from the $450,000 yielding $410,000.

So now lets recap what happens in 30 years… So you realize only 4% appreciation in your real estate value. Your $150,000 cash down has given you in 30 years –

$3,365,000 (4% annual appreciation)

$1,500,000 (2.34% annual “appreciation OR principal paid down on loan, however you want to look at it)

$508,000 (after-tax cash flow invested annually into 8% annual yield account, whatever that is)

$410,000 (increase in rents minus increase in variable operating costs invested annually into 8% annual yield account, whatever that is)

Total gain - $5,783,000 or 12.9% compounded annual yield on the $150,000 investment.

And these are based on conservative numbers – 3% annual rental increase, 4% annual increase in operating costs, and 4% annual home appreciation. Add just 1% to the annual home appreciation (the long term industry standard of 5%), and your total gain is $7,400,000. Conversely, if annual appreciation is well below the standard – 3%, your total gain is $4,558,000. But this is still a respectable 12% annual gain. Not bad huh? Of course, there are a TON of variables that can come into play. And I am managing the property myself (just finding tenants and collecting rent checks, I have a property manager take care of issues on site) so there is work involved. Maybe your tax benefits will be better, or worse. Maybe you’ll have bad tenants that don’t pay rent and have a higher vacancy rate than 5%. But you may also have great tenants that pay rent and a low vacancy rate of 2%. You may realize 7% appreciation or 2% appreciation over the 30 years. The above scenario provides an average look, if not a conservative one on real estate investing. If you want to make money in 2-5 years, stay away from real estate. Corrections can last 10 years or more. While unlikely, your property could lose 30% of its value in 2-5 years. But like any long term investment, you have to be able to ride the rollercoaster. And if you want a “set it and forget it” investment, steer clear of real estate. You will be a very stressed out, unhappy individual, any way the market goes. If you can stick it out for the long term, nothing beats real estate. Nothing even comes close.