What motivates a person to do the things he does? The person is either moving towards something pleasurable or trying to avoid pain. My real estate career took off after I decided I had enough with my former business. I was moving away from the pain of that experience, and I was filled with emotion and motivation towards my new venture.
In life, as in real estate, there are real costs and there are hidden costs. For example, a hidden cost of pursuing my new endeavor was entering into unchartered territory. Although it was exciting and uplifting, it created a sense of anxiety and uncertainty in my life (hidden cost). The toll it was about to take on my family as I transitioned to a new career was also a hidden cost. Ultimately, I had already decided that the benefits far outweighed the hidden costs, and I made my mind up rather quickly to push ahead.
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Real & Hidden Costs in Real Estate
This article is going to differentiate between “real” and “hidden” costs in real estate. First, I would like to define the normal operating costs in real estate, what a capital improvement is, and finally dive into the hidden costs.
An operating expense in real estate is any cost that is required to keep the property performing. Here is a list of typical operating expenses:
- Pest Control
- Utilities (garbage, water, electric, gas, phone)
- Repairs and maintenance
- Taxes (property, payroll, other)
- Management fees
- Office expenses
Operating expenses are vital to calculate because they affect the Net Operating Income (NOI) of the property. If you would like to learn how to calculate value on a multifamily property, click here. All of these operating expenses have a true value. You know how much landscaping costs when you receive the invoice in the mail.
Capital expenditures, on the other hand, are expenditures that improve the useful life for more than one year. The main difference between the two: Repairs maintain the property, and capital expenditures increase the life of the property. Let me give you a few examples of a capital expenditure:
- Driveway replacement (not a repair)
- Hot water heater
- A/C Units
It is important to note that capital expenditures fall below the NOI and do not affect the value of the property.
Here is a list of hidden costs in real estate, followed by an explanation of how these hidden costs are real and detrimental to the business:
- Terrible employees
- Apartment turnover
- Capital expenditures
- Fighting the expense creep
- Avoiding repairs
6 Hidden Real Estate Costs That Blindside Multifamily Investors
There are different levels of terrible employees, from lazy to incompetent to downright criminal. We experienced the cost of a terrible employee firsthand. When we purchased our second property, we were still newbies and becoming acquainted with building a team and managing the employees. We “inherited” a resident manager with the purchase, and looking back, we should have noticed the huge red flags.
At first, things seemed OK. Once we began to implement our systems and implement new rules, the pushback began. He was uninterested in following any of our changes, and we were met with constant excuses. We finally decided to part ways, but unfortunately, the story did not end there. How did this employee cost us?
We had to evict the resident manager from the unit he was occupying, which cost us legal fees and lost revenue. His laziness and incompetence surely cost us additional revenue losses. Once he was replaced, revenue exploded around 30% within six months. We ended up going to court and spending thousands of dollars on legal fees. I would compare this type of employee to a professional tenant. This guy knew every rule and regulation when it came to employment, and we got schooled.
Related: Investors: Think It’s OK to Skimp on CapEx? Here’s Why That Could Cost You BIG.
But the true hidden cost was the time we lost and all the negative energy that was expended dealing with this situation. It’s simple to tally up how much he cost us economically, but far more difficult to put a price on our time and our emotional well being. My recommendation in this situation is to cut out the “cancer” as quick as possible and move on.
The number one goal for offering amenities to tenants is to offer value and to establish a level of service. If you think amenities do not help in securing quality tenants or market rents, then think again. There is a reason why most C properties do not contain a pool or a fitness center. These amenities will cost the tenant and the operator more money.
We only select amenities that match the tenant base. In our most recent acquisition, the property’s tenant base fit into the B class, so we decided to renovate the clubhouse, remodel the pool, install a fitness center, and build a dog park. This expansion of amenities was due to the fact that our competition offered these services, and we felt we needed these amenities to compete.
There are numerous hidden costs with amenities. Insurance rates will be higher, along with the cost to run the amenities. Maintenance will need to spend precious time throughout the week to maintain the amenities. If your amenity does not allow you to either attract tenants or generate some type of revenue, think twice about allocating funds for your amenities.
Apartment turnover hits you two ways: lost revenue and the expense to get the unit rent ready. The hidden cost is the amount of time it takes the unit back “online.” If you are renting an apartment for $600 per month, the rent is $20 per day. If the apartment takes two weeks to turn, you’ve just lost $300, not to mention the $800 you just blew fixing up the unit.
Oops! There goes another A/C unit. Watch out, the roof is caving in. These are real life examples of a day in the life of an apartment owner. These hidden costs seem to come out of nowhere. All successful owners set up and fund a capital expenditure account to guard themselves against these unforeseen costs. We estimate $250 per unit per year for capital expenditures. The age and the condition of the property will affect the amount of money you establish as a baseline for your capital expenditures.
On our first deal, our septic fields failed soon after we took over. Fortunately, we had a bit of money saved from the closing to help with the repair. We were fortunate that no other hidden repairs popped up.
Fighting the Expense Creep
If you’ve been in business for a while, you know exactly what I am referring to. The landscaping bill was $400 six months ago, and you open up the envelope to a $450 bill. Why?!?! My partner Jake refers to this as “the expense creep.” Vendors become comfortable with an account and decide it’s time to tack on a few extra bucks.
The only way to counter expense creep is to maintain accurate records and review the expenses quarterly (we review them monthly). The solution is to confront the vendor immediately and demand a reason. If his answer is not to your liking, it’s time to shop for another vendor. Can you imagine if every vendor employed the expense creep? We’re talking serious hidden costs!
This final hidden cost is what I refer to as the “death spiral.” Our portfolio is full of properties that were neglected by their owners. What happens when repairs are shunned? The tenant base starts to deteriorate, the rental rates drop, and even worse, the value of the property plummets. Remember, NOI drives the value of multifamily real estate. Once you begin to collect less rent, NOI drops and the value drops. The death spiral has begun, and Jake and Gino are going to purchase your property at a discount.
I always declare real estate is all about the numbers, but reflecting back on what I just wrote, I can clearly see how misguided that statement is. There are numerous hidden costs when running a property. Please take all of these costs into consideration when purchasing a property, and factor them into your analysis.
I would be grateful if you could leave me other hidden costs you have encountered while investing in real estate. Always trying to cut expenses!
Let me know your suggestions with a comment!