I’m Here on My Soapbox Yelling: “Hey, Fool—Expenses Are NOT Percentages!”

by | BiggerPockets.com

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:

  1. Property Taxes
  2. Insurance(s)
  3. Utilities
  4. R & M
  5. Administrative
  6. Contract Services
  7. Marketing
  8. Pay Roll
  9. Management Fees

Let’s consider these expenses and try to understand whether they are best viewed as dollar expenses or percentages.

  1. Property Taxes: Clearly a dollar amount having absolutely nothing to do with income.
  2. Insurance(s): Same.
  3. Utilities: Same.
  4. R & M: Same. Stuff costs what it costs. Nothing at all to do with income.
  5. Administrative: Same. Internet, printer, copier, software, etc. All $$$.
  6. Contract Services: Landscaper and pool guy work for dollars, not percentages.
  7. Marketing: Same.
  8. Pay Roll: Same
  9. 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!

Got it?

Weigh in with a comment!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben the author of the Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

30 Comments

  1. Cindy Larsen

    Ben,

    Your articles usually have a friendlier tone. Seems like you are not having a great day. Sorry about that, but most of us here on BP try pretty hard NOT to be fools.

    Your point is well taken though. Of course, costs are actual $ costs. However, since at least some of the costs are unknowns, when you are trying to analyze a property for cash flow (while deciding whether to buy it) using a percentage of rents is a LOT better than failing to account for those unknown costs altogether. Also, building up reserves for things like maintenance and repairs, and capex, by setting asside a specified percentage of the rents makes sense to me.

    So, if you can get real numbers for some of your maintenance and repair costs, great. I did my best to do that when determining what percentage to put into the BP Rental Property Calculator. I added up all the real costs for maintenance and repairs I could think of, estimated the ones I couldn’t find data for, looked at that total number as a percentage of rents, and then added percentage point or two to cover whatever I missed. I did the same for capex. And after buying each property, I set aside those percentages of the rents to cover those costs, both the predictable ones, and the unknowns. When I fix a unit up, and then raise the rents, I keep that same percentage of the new rents as my new reserve amount.

    Why do I do that? As a small investor, with 2-4 unit multifamlies, it is difficult to predict maintenance, repairs, capex and vacancy. I think you mentioned this difficulty in a recent article. So I am being cautious, and building up the reserves for each property to the point where, I hope, they will cover the unknown events that will inevitably happen. Hopefully, my pecentages are big enough to handle the ups and downs of those real life, real $ events. Until my crystal ball starts working, those percentages are the best I can do.

    What else do you suggest, to accoun for those real $ costs,
    for those of us in the small multifamily space?
    And please don’t answer that by saying I should have bought
    large multfamily, just because the costs are more predictable.
    There are good reasons for buying small multifamily.

    Cindy

    • Ben Leybovich

      Cindy – whoever suggested not accounting for costs? Account for costs, but use dollars instead of percentages. A cost is free-floating. When you use a percentage, you are pegging the cost to another number – that’s about as wrong of an approach as there could be 🙂

      • Cindy Larsen

        Ben,

        My point was that there are costs that are difficult or impossible to predict and that means assigning them dollar figures ahead of time doesn’t work.

        Will you need to replace the roof when it is 25 years old, or 30? Did you fail to account for damage caused by moss growing on the roof in Washington, because you live in California, and that doesn’t happen where you live?
        Will you have to evict a tenant? How often, and how much will it cost?
        Did you remember to account for the repair and maintenance of the asphalt driveways on the property? Is that every year, or once every 3 years?
        What will the real cost be of the work neded to deal with autum leaves on the ground, in the gutters and on the roofs?
        Did you account for a tree dying because of bark beatles, and falling over? How much will it cost to remove?
        How about the yellow jackets your tenant just reported under the eves?
        What money will be wasted on incompetent contractors? Even if you don’t end up paying twice for same work, there is an impact on your vacancy rate. How much?
        How long will the appliances that came with the property last, and what will be the cost for replacing them? Will that be all in the first year, or spread out over 3 years?

        What is the cost for things you didn’t know to account for?
        Perhaps, after many years of managing the same set of rentals, I will be able to account for all the costs, in dollar figures, ahead of time. I hope so. At least most of them.

        But, I am still learning. I need a way to account for both known and unknown costs for maintenance, repairs, capex, and vacancies that results in my having enough money to pay those costs. I want those costs covered by money that is generated by the property, Not out of my other income. With percentages, I have a better chance of building up reserves that will do this.

        Also, when deciding whether to buy a property, inputting your best educated guess on the percentages into the BP calculator to account for these costs gives you a much better idea of what your cash flow is likely to be than not doing that.

        • Ben Leybovich

          Cindy and my point is that the entirety of underwriting is in itself predicting expenses. It’s difficult but not impossible. It’s been studied, categorized, and compiled for ages. Nothing magical at all about how much it costs to run buildings. Just have to buy the right kind of an asset 🙂

    • Vaden Haynes

      Hi Cindy!

      There are really good reasons for buying small multifamily. Congrats on yours.

      Two suggestions for estimating reserves;

      Talk to a commercial multifamily appraiser or take a first level course, when you can, from the Appraisal Institute. Or just buy a used textbook from the course. They teach how to estimate lifespan of long term/short term items. Like the roof, boilers, hot water heaters, etc. And how to then calculate the amount of money to be set in reserve in each year of the remaining life of the asset.

      Have your accountant do it for you AND explain to you how he did it. This is one of the reasons it is good to have one on your team.

      Best regards,

      Vaden Haynes

      • Cindy Larsen

        Thanks Vaden,

        Good suggestion. I haven’t taken a formal course, but I have researched a lot of the easily identifiable expenses like roofs, appliances, hot wather heaters, landscaping, painting, etc.

        The issue is identifying and allowing for expenses that I did NOT think of: like a tree falling down, missing the house and the fence (yay), but still, presenting me with the unexpected cost of having it chopped up and taken away. Or the cost of an invasion of hornets under the eves. Or the cost of emergency toilet plumbing. Or finding out that you have bought a property and one of the inherited leases is a section 8 tenant who doesn’t feel responsible for making sure his rent is paid. Of course, I read the lease before I bought the property, but it gave no indication of section 8, nor did the former owner or the tenant mention it. I found out when the rent was late. I ended up giving the tenant notice and wasting a lot of time dealing with the Tacoma housing authority, but I did get my rent in the end, did a minor remodel on the unit and rerentedmit for 25% higher rent. I did incur a month of lost rent from vacancy, but will recoup,that over time.

        I’m still learning about all the things that can go wrong, and as I identify them, I account for them or put preventative measures in place. But as you said, it is ESTIMATING reserves. My approach is, after I identify and estimate all the costs I can think of, I look at that amount as a percentage of the rents, then choose a higher percentange of the rents as the reserve amount: Just in case the unexpcted happens. if that causes me to build up my reserves slightly higher than needed, I can always reallocate the extra cash later. It seems to me that bigger than needed reserves is better than not enough reserves.

        Thanks for agreeing that small multifamily can be a good investment. Ben seems to think it is stupid to invest in small multifamily, but I don’t agree.
        I don’t like the risk associated with remote investments, and could not find positive cash flow in the large multifamilies locally. And the larger multifamilies had higher interst rates than small multifamily properties.

        The smaller multifamily properties are cash flowing for me, as I get the units upgraded and rerented. Of the units I have turned over, I have increased rents by an average of almost 30%, with much higher quality tenants now in place. I analyzed all my investments using the BP Rental Property Calculator, and input previous rents, with expenses expressed as percentages of those rents. With increased rents, and those same percentages as reserves, I expect the cash flow to be very good as soon as I finish upgrading all of my units. My best scenario so far was a duplex both unit that had rents of $1075+$75 water sewer trash.
        They are now renting for an average of $1359 + $125 water sewer trash. And on top of that, another $105pet rent ($35/pet, three dogs in the two units)

        According to the BP calculator there was positive cash flow at the old rents. After upgrading and rerenting it is obviously much better cash flow.
        So, as soon as I replicate that across all of my units, I will be able to prove that small multifamily can be a great investment, regardless of Bens opinion.

        Cindy

  2. Ken Virzi

    My first two properties were a condo in LA that rents for $2200 and a duplex in Cleveland that rents for $1125 total. Percentages don’t work when you have one property that rents for $1,000 and another that rents for $500. If you based a set of expenses on a rental amount what amount did you do so on?

    Let’s take a roof. Divide that total cost by the number of months and get your cost. Let’s say the monthly cost for a roof (assuming long term buy and hold strategy) works out to be $15. For the $1000 rental that is 1.5% whereas for the $500 rental it is 3%. Extrapolate that out to other expenses that can quantified and the gap grows. Let’s say $9 for a water heater let’s say $11 for a furnace, adding another $20 monthly. Now we are at $35 a month. 3.5% on the $1,000 house and 7% on the $500. So when looking at just the three most basic CapEX items if you added 2 percentage points on the first one to be safe you’d still be way off since 5.5% is well short of 7%. Assuming this applies to other items as well as maintenance. Now we are looking at 10% minimum for the $1000 house. However to get to the same dollar amount the $500 house would need to set aside 20%. If you used the 50% rule on the first house to cover all expense etc, you’d possibly have to use 100% on the house that gets half the rent.

    The calculators are a driving sales factor and I get it, but I do see how they could really set someone up for failure who is evaluating a turnkey deal in a Midwest market.

  3. John Barnette

    Absolutely true. Percentages only as a very loose guide to start. And I think only helpful when comparing to similar properties in a similar market with similar revenue. Good luck with that one.

    However that being said, I do own a number of similar 50s ranch houses in a similar area and can do fairly reasonable rough calculations on places I come across Same type of underwriting. But you are playing a game of averages with several levels of deviation.

    With experience comes knowledge of true costs and reasonable expectation of “surprise” costs in addition. That broken window for instance. They tend to average out over multiple years.

    Ben how do you feel about allocating and basically forcing yourself to spend a percentage of revenue on preventative maintenance. Sometimes when I have a nice run of a few months without any extroardinary expenses in my portfolio I feel I should splurge and hire someone to clean some gutters or flush hot water heaters or something along those lines. Tackle some lingering someday items.

    Good work. Miss Ohio? I was back.in Columbus after being gone for 25 years. Wow all grown up and quite nice. At least in the summer.

    John

    • Ben Leybovich

      John – do not miss Ohio even a little bit! Columbus is fantastic, but it is likely the only place that is. and as nice as it is, s grown up as it is, when my folks come to visit in Phoenix they always equate Columbus to a village – still a small town 🙂

      Yes on the preventative, but have to be very careful on that.

      Experience and knowledge are hard to come by on BiggerPockets. Every time I try to share some, they just want to argue. Thanks!

  4. Ken Virzi

    Well volume is key because if you start collecting enough rent after expenses then capex and larger surprises as well as small ones can be taken care of easier. If you are collecting $8k on your twenty properties you could replace every roof each month for the next twenty months and still collect $3k each month. So volume is great!

  5. Ron K.

    So Ben and all, do we say that in a given market, I’m better off with 15 units at $1,200 rather than 30 units at $600, since I have half the stoves, A/Cs, etc. Or, do we say that expenses on a higher income unit are more, since they are higher end or larger? and then, the expenses actually do relate to income?

    • Ben Leybovich

      hahah not at all. It’s just that you are asking questions answers to which are a bit difficult with the confines of this comment sections. No, it’s not merely a function of a number of units. It’s a function of efficiency, which is a synthesis of many things.

      What I am saying to you is that if I were given an option to buy a 15-unit with $1,200 or a 30-unit with $600, I would choose option 3. I concede that one of the provided options is better in some ways than the other, but on balance I want nothing to do with either…

      • Donald S.

        So you’re synopsis is, if you can’t afford to get into 100+ units, or don’t have the acumen yet to raise the funds for a 100+ unit, you should just sit on the side lines and learn/save until you can?
        So people like Brandon, David Green, Coach Carson, etc…have it all wrong. “The Stack” as Brandon terms it is a fools errand and the fact that he is successful while starting with single’s and 2-4’s is a coincidence?
        I’m confused by this article. Usually your articles follow the 1) here’s your misconception, 2) here’s why you’re wrong, 3) here’s what you should/could do to be right. But this one seems to just stop at 2 the you’re wrong stage.

        • Ben Leybovich

          No, my synopsis is: you can listen to me to discover what works and what doesn’t, or you can go discover it for yourself like Brandon and I did. Now find bigger deals to do because they work better, and Brandon puts money in them 🙂

          The thing is, David, it’s not wrong to go to school. If you insist on paying for it with mistakes, I won’t tell you that you are wrong. I am telling you it’s wrong to invest this way, but I am not saying it’s wrong to do it so you learn. And if you are like me, you’ll have to go through it, and that’s Okay, just put it in perspective and call it what it is – your schooling.

  6. Tina Huffman

    First of all, why don’t I have a link to reply the thread instead of dropping to the bottom?! :-/

    Second of all, Ben, I’d love to hear exactly from you what works and doesn’t, but there hasn’t been much elaboration due to commentary confines. Sounds like fodder for your next post.

    Tell me how far off I am: Larger deals offer economies of scale etc that smaller units counts don’t, so it may be better to join a good syndication as a passive investor if necessary, than go it alone w smaller units. W/out putting words in your mouth, if this is your premise, I’d certainly listen to the why of it. It would be a lot less hassle after all. Tough to quantify though, because the schooling does have value, even if it isn’t apparent on paper. If Brandon et al had only passively invested, they wouldn’t be where they are today, right?

    Still though, I’d thought before of creating a model with hypotheticals of serially joining and reinvesting syndication funds vrs long term buy and holds over say 20 years.

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