You know that guy with a megaphone, standing atop of a makeshift platform, preaching at the crowd? You’ve read about that guy. You’ve seen him in the movies. Do you know that guy?
Well, I am that guy—or at least that’s the way I feel. And what I am yelling into that megaphone goes something like this:
Fool, listen to me. Yes, I am talking to you! You cannot underwrite operating expenses on income property as a percentage of revenue. All of those expenses are dollars, not percentages!
Yep, I called you a fool. I don’t know everything, but I do know lots. I did just raise $3.5M in equity and $7+M in debt in three weeks to close on this 98-unit.
I am here to teach you the truth about how this works, and since BiggerPockets doesn’t pay my salary, I don’t care much for your sensibilities.
Related: 12 “Hidden” Real Estate Expenses That Blindside Investors
I see stupid, I call stupid. And using percentages to underwrite OpEx is definitely stupid.
Hopefully, you’ll change your mind after you read this article!
A Very Simple Example
Let’s say two tenants break a window in two of your units. The cost of replacing one window in each unit is $350. Unit One rents for $575/month, while Unit Two rents for $950.
Annual GPR for Unit One is $6,900. The cost of a new window in Unit One represents 5% of GPR:
$350 / $6,900 = 5%
Annual GPR for Unit Two is $11,400. In this case, the cost of replacing one window represents 3.1% of GPR:
$350 / $11,400 = 3.1%
Now tell me: How in the hell can you represent the cost of replacing a window in your underwriting as a percentage in these two units with any degree of accuracy? If you try, you’ll either be wildly underpricing or overpricing one of these units.
You can, however, very easily represent this cost as a dollar amount, because that’s what it is—a dollar amount.
And this is the same for most of the line-items on the OpEx.
OpEx in Income Property
In one way or the other, the following operating expenses should be accounted for in the underwriting for income property:
- Property Taxes
- R & M
- Contract Services
- Pay Roll
- Management Fees
Let’s consider these expenses and try to understand whether they are best viewed as dollar expenses or percentages.
- Property Taxes: Clearly a dollar amount having absolutely nothing to do with income.
- Insurance(s): Same.
- Utilities: Same.
- R & M: Same. Stuff costs what it costs. Nothing at all to do with income.
- Administrative: Same. Internet, printer, copier, software, etc. All $$$.
- Contract Services: Landscaper and pool guy work for dollars, not percentages.
- Marketing: Same.
- Pay Roll: Same
- Management Fees: OK. This one is a percentage.
You see, only the management fee is truly calculated as a percentage of the income (effective not GPR, but that’s too much in the woods for this article). The rest of the expenses really and truly are dollars!
Now, it’s obviously true that we could back into the percentages (just the way I did in our window replacement example), but the starting point is always to price each cost as a dollar amount.
To Sum Up
My friends, in order to achieve any degree of accuracy in your underwriting, you must place a dollar amount to monthly and annual costs. Now, some of you may say (and actually have said): But Brandon uses percentages in his webinars.
Related: How to Estimate Future CapEx Expenses on a Rental Property
Understand—for the purposes of his webinars, Brandon has to make the assumption that 99 percent of his audience are total newbies who know nothing. Percentages are much easier to comprehend for a newbie. That doesn’t make use of percentages any more valid.
I am making an assumption that you are a bit more advanced than Brandon’s audience on a webinar, and are therefore able to have a realistic conversation!
Costs are dollar amounts, not percentages!
Weigh in with a comment!