So, I did one of my scopes on Periscope this week. I do those now because I saw Brandon do a few and thought they were cool. I also saw Cardone do a few from his Rolls and figured that while doing my scopes from my Tesla isn’t quite as sexy (or perhaps more so depending on who you talk to), my personality makes up for it.
So, on that scope I was talking to them about utility bill-backs, and Brandon, who was good to jump on, said I should write a post for BP.
This will be short and sweet ’cause I am busy. But I promise you will learn something today, so pay attention!
Here are some of the things you’ve heard here on BP:
- It’s a good idea to buy multifamily — you heard this from a certain adorable nomad-looking, bearded dude by the name of Brandon.
- If you’re going to buy multifamily, it’s a good idea to buy below intrinsic value (which means value add) — you heard this from me.
- One of the techniques of value add in multifamily is utility bill-back — you heard this from Brandon, Serge, me, and everyone else.
All of the above is true; however, all of the above require finesse. Let’s discuss utility bill-back!
Download Your FREE Tenant Screening Guide!
Hey there! Screening tenants can be a tricky business, and this critical step can be the difference between profits and disaster. To help you with your real estate investing journey, feel free to download BiggerPockets’ complimentary Tenant Screening Guide and get the information you need to find great tenants.
Concept of DTI
DTI stands for Debt to Income Ratio. Debt to Income Ratio, in its purest form, describes the relationship of one’s income to one’s debt. You’ve likely heard of this term if you’ve ever applied for debt.
This article is not about the DTI, but I need you to comprehend the concept. The idea that someone can only reasonably spend a percentage of their income to pay for things in their life is an important concept that often gets lost in this conversation around value add.
Let’s say you have a 24-unit building, where you the landlord have to pay for the water and sewer, and those two utilities combine to about $2,400/month. The 2-bedroom units in this building rent for $425. The rent is low, which is a reflection of the economic realities in Podunk, USA where you live.
One day, after listening to Podcast 14 with Ben Leybovich, in which he talks about passing the cost of water to the tenants, you sit down and strongly consider charging each one of your tenants $50/month for water and sewer. No, this wouldn’t underwrite all of your cost, but it would help! So, here’s what you need to consider:
RTI stands for Rent to Income. I just literally invented this term as I am writing this. I mean, Brandon invents terminology all the time, and he always sounds cold when he does (BRRRR), as he should — it’s cold and dreary in Podunk. (Brandon — applause please.)
Anyhow, Rent to Income is a play on words of Debt to Income and is meant to underscore the reality that what people can spend on living expenses is a function of how much they earn. And if you push them higher than this margin, bad things start to happen — more on that in a minute.
Well, your rents (in Podunk) are $425/month. Why not $1,300/month? Because there are 3 factories and a hospital in Podunk, and that’s the extent of the economic base. That, plus McDonalds, plus Starbucks. And in this setting, $1,300/month is what most people bring home on a monthly basis, which explains why the market for your 2-bedroom units is only $425. You know — 3 times the rent. Common sense!
What About Bill-Back?
So $425 rent represents 33% of $1,300 take-home pay. Add to that electric, which the tenants are already paying for, and your tenants are already spending 50% of their monthly income on rent-related costs. And now you want to add another $50 on those costs — because you can.
Tell me — what happens to people when you push them too far? People break, right? Maybe not right away; perhaps they try the best they can to make it work. But eventually they break, and what happens then?
Physical and Economic Vacancy
People move out, forcing you to spend money on turning the unit. Or what’s more likely, they simply default — stop paying rent — forcing you to absorb months of no rent, pay eviction costs, and still have to turn the unit. Are you seeing the picture?
More Income or Less Cost?
That is the question. Understanding that destabilizing the tenant base will cost money, what you have to figure out is whether the additional bill-back revenue will create larger spreads than the potential losses. It’s a numbers game and a judgement call.
This is a discussion of the economic environment you operate in. How much people can spend on life is a function of how much they earn. And while a water bill-back something you can do, the question is should you?
Investors: Do you bill back utilities to your tenants? Why or why not?
Let me know your thoughts with a comment.