PSA: Taxes Are the Biggest Cashflow Killer (With Examples)

We don’t have TV service in the main house. We do have one in the casita for our guests — but not in the main house. We do, however, enjoy some Netflix at home. In the evening, once the kids are down for the night, Patrisha and I spend about 45 minutes watching something funny or interesting.

Lately we’ve been on a documentary kick. The last one we watched was about the great American band the Eagles. The documentary is called History of the Eagles.

There were many takeaways for me, but one thing in specific caught my interest. Toward the end of the movie, when all of the narrative’s Ts are being crossed Is are being dotted, Don Henley reminds us of a line in “Hey Hey My My” by Neil Young: “It’s better to burn out than it is to rust”

As I heard these words, I thought I knew where he was going. But then Don Henley comes back with this: “…but, I don’t see rust as a bad thing. I have an old 1962 John Deer tractor that’s covered with rust, but it runs like a top. You know, the inner workings are just fine.”

Does anyone else find this interesting? This intro doesn’t specifically have to do with the subject matter I’ll be touching on in the following paragraphs. It’s just that I, seemingly unlike so many people on BP, see real estate as a part of life — but not life itself. I hope you’d forgive my transgression in saying something of value not just in your real estate endeavors but in your life as a whole.

And now, let’s teach you something about real estate.

The Basics

On your way to figuring out how much to pay for an income-producing property, the first order of business is to figure out the net operating income (NOI). The application of this NOI varies from one investor to the next, but in one way or another, we all start there.

Now, it’s important to understand that while we do look at the trailing data, what’s most important to us is not how the building has performed in the past, but how we think it’s going to perform in the future. And with this in mind, we are forced to make certain assumptions about both the income and the operating expenses. It is when making these future-looking assumptions that I see people running into trouble.

The Biggest Killer of Cashflow

There is one item in specific which seems to represent the biggest pitfall for people, and it is property taxes. I am going to tell you about five of the properties I came in contact with over the past 30 days. Two we put offers in on, and two others we did in-depth underwriting on, trying to compete. These properties ranged from 52 units to 174. In addition, one of the clients I consulted was underwriting a 20-unit property.

All of these were on-market properties. In all cases we had access to both the trailing financials and the offering memorandum (OM).

The Offering Memorandum

You know what they say about contractors: If they show up, they are in the top 10 percent. Sad but true. The bar is very low. Well, as it relates to broker underwriting, the bar is similarly low: If an underwriter makes an attempt to look honest, they are in the top 10 percent.

Brokers are in a tight spot, and I respect that. They have to paint the best possible picture. They have to make a pig look like a milk cow that produces chocolate milk. Let that sink in. Those who are better educated manage to do this while maintaining some sort of semblance of appearance of propriety. Most don’t even bother with that.

As it relates to the underwriting of property taxes, if a broker acknowledges the reality that your tax bill will go up post close, that’s about as much as can be expected. But hardly anyone is honest about this, for obvious reasons.

In the case of the five properties I mentioned above (the four that we underwrote for ourselves and the one I helped a client with), some of the offering memorandums flat out made no attempt to underwrite future taxes, while others made feeble attempts at being “honest.”

Here’s what we were comfortable underwriting having researched applicable information:

52-unit: current $43,000; projected $68,000

152-unit: current $57,000; projected $100,000

163-unit: current $122,000; projected $175,000

174-unit: current $162,000; projected $308,000

And the 20-unit I consulted on: current $6,500 – $31,000

Conclusion

uirtye numbers above were arrived at after detailed conversations with localities. These are guesses, but they are educated guesses. Could our estimates be high? Sure. But I don’t find the thought of calling my partners, who brought $5 million to the deal, to tell them that I underestimated the taxes appealing. I underwrite as per municipal guidelines.

None of the offering memorandums offered guidance anywhere near real numbers.

Be careful out there, boys and girls!

What about you?

Have property taxes affected your deals in the past? Share your experiences below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.