Best way to estimate operating expenses on a rental?

Question

I am looking very closely at my first deal on a duplex (owner occupied for 1 year). I have been looking at several duplexes and am trying to make sure I have all my numbers in a row.

What is the best way to ACCURATELY estimate the operating expenses for a property? I have used the 50% rule, but I want to get more specific as I am considering pulling the trigger on this deal and I want to make sure I am not underestimating or overestimating expenses.

Obviously, taxes, insurance, utilities, and vacancy expenses are relatively easy to estimate.

I will be also managing this duplex myself--should I still factor in the average 5% to 10% for management fees when looking at cashflow or because I am managing this myself should I LEAVE OUT management fees?

Maintenance, repairs, legal costs, and CapEx are more difficult to estimate however. What is the best way to go about estimating those types expenses?

Also, what am I leaving out/forgetting in what I mentioned above? I am doing my final deal analysis and want to make sure I have everything accounted for.

Here are all the "expenses" I am aware of that I need to find exact figures for:

Monthly Insurance
PMI Insurance
Mortgage Insurance
Landlord Insurance
Hazard Insurance

Monthly Property Taxes

Monthly HOA Fees (If Applicable)

Monthly Management
Management Allowance 8% of Gross Rents

Monthly Utilities (If Owner Paid)
Electric
Water
Gas
Garbage Pickup

Other Costs (Averaged Monthly)
Vacancy (7% of Gross Rents)
Advertising
Snow Removal
Landscaping
Maintenance
Office Supplies
Legal Fees
Evictions & Court Costs

Capital Expenses (Averaged Monthy)
Roofing
Furnace
A/C
Windows
Siding

Again my questions are:
1) How do I accurately estimate my maintenance & repair costs?
2) What is the best way to estimate, and how much to set aside for CapEx?
3) If I plan to manage myself, should I still factor in "management expense" of about 7% in my calculations, or can I just assume a higher cashflow?
4) How should I estimate for legal fees, court costs, advertising, etc?

Michael Totman · Answer

Craig, I take offense to your request to know how to "accurately" "estimate" something.  In my experience an estimate is an estimate, and accuracy is up to your accountant to get right after you blew your budget...but seriously I had this same problem when I started.

You've got the majority of the categories you need to estimate, so just start plugging in the actual numbers on the project you're concerned with.

If you have HOA fees you should know this up front, so plug in the number. You can likely get a decent average of utility cost from your town or city.  My utility gave me an average monthly use on a property I was looking at for the previous year.  Of course that depends on what you know about the occupancy from the previous year.

Vacancy, I use 1-2 months rent the first year starting from when any reno is complete, then 1 or no months rent depending on the tenants history and my knowledge of how much he likes his apartment.

Landscaping, snow removal, maintenance, etc depends.  Will you do it yourself, do you know anyone to do it?  Landscapers are a dime a dozen in my area, so call a few and get quotes and references.

Capital expenses, well, if I had a crystal ball I'd be retired from my cubicle job by  now.  It's specific to the property, you gotta just look.  Are the roofing shingles in multiple layers, dry, cracked, and peeling up? You'll need a roof soon.  If not, get a contractor to estimate a remaining life for you.  For my mechanicals (furnace, a/c, water heater etc) I have a plumber come do a clean/service when I first buy a place.  I then ask him to give me an estimate as to when he thinks it will need to be replaced and a cost.  He's pretty accurate in my experience.

Maintenance will also depend on the current condition and any rehab you do before a tenant moves in. Also, is it in a bad section of town? Likely maintenance will cost more as they trash the place.   A higher quality tenant in a better area may be more careful.

I manage my four myself, so do not calc management % but rather look at monthly cash flow vs. monthly time spent.  Most managers I believe will cost 1 month rent to fill it plus 10% gross rent/month and charge cost + 25% for any repairs needed.

I hope I could help.  I'm not the most experienced on this blog and am new to the forums, but this is based on my real life experience.  Sounds like you've done the homework, now pull the trigger and find out how accurate you were!

Jon Holdman · Answer

For any particular property in any particular year you can do a bit better than the 50% number.  Or, you can do MUCH, MUCH worse.  Your upside is limited by the fact you have a number of fixed expenses - taxes, insurance, and in your case, PMI.  The downside is essentially unlimited.  A very big expense, like a roof or furnace, is a real possibility.  You can "watch your costs" all you want.  But if the heater fails on the coldest day of winter you're going to be paying a premium to get a repairman out there ASAP.  Spending $500 at the drop of a hat is something you MUST be prepared for if you own rentals.  IMHO, you want a minimum of six months PITIA (A is anything else like HOA and PMI) in cash reserves.  Six months total scheduled rents would be better.

So, yes, 50% is inaccurate for a specific property for a short time period.  But there's no other method that is any more accurate.  And all those little slices lead you to succumb to reducing this one and then that one until you're down to some ridiculously small percentage.  Its impossible to accurately predict "black swan" events.  I spent about $500 last winter servicing a furnace that was only four years old.  About the same over the summer with a pest issue.  Tenant move out with little notice and you have a month long vacancy (hint - a long term lease has NO effect on this.)

When I buy a property I consider the stuff that needs to be done right away to be part of the acquisition cost.  The IRS does, too, by the way.  If there's something that can be put off a year, then its part of the 50%.  But you'll have to come up with the cash sooner rather than later.  But once done, it shouldn't have to be done again for a while.

Be careful about what you  do.  You mention windows.  Ask yourself if you can get any more rent or a higher sales price if you spend a few grand on windows.  Probably not.  So think twice about doing this.

Lisa Lunger · Answer

The National Apartment Association provides information on average income and expense line item costs.  IREM also has information based on age, size and location of the units.

Michael D. · Answer

Not necessarily, and I don't think anyone else said that. Actually, if the other numbers still work out you will likely have much higher cash-on-cash return with such a small down-payment - if you have any cash-flow at all.

As others have mentioned, you need to be looking at your long-run expenses even if you're only holding for the short run. Your roof is costing you $100/mo, regardless of whether you installed it yesterday or it's 20 years old. Your roof is still losing $100 of value every month.

Add in $25/mo for a water heater, $50/mo for a furnace and you're starting to get the picture. I'm making up numbers here, yours may be different, but the concept is the same. They're costing you money/value every month.

Trying to guess about when exactly these things will have to be replaced clouds the issue about your real cash-flow expectations.

I will concede though that imminent required repairs do affect your short-term CoC return.

Michael

Craig S. · Answer

Will, yes I was agreeing with Steve and trying to say that I have been told that by others as well. I do agree it would be much better to have 20% down--eliminating PMI insurance.

Will Barnard · Answer

Secondly, Jon mentioned that when you get a non owner occupied loan in todays market, you are likely placing a minimum required down payment of 20%, therefore, no PMI would even come into the equation which adds extra gravy to you if you have been calculating such an expense.

Craig S. · Answer

Steve Babiak, I was told by others that PMI insurance would come off of my debt service side of the 50% rule--not the operating expenses side. So if I had a property renting for $1,300 per month gross, I would have $650 going to operating expenses, and $650 going towards debt service, PMI insurance, and then cashflow. PMI is the same thing as Mortgage Insurance as I understand--unless there is an additional UFMIP (up front mortgage insurance premium.)

I have factored the PMI into my deal analysis and still have positive cashflow for this duplex. I will be posting my actual numbers on BP once I get a good faith estimate on the exact PITI.

Steve Babiak · Answer

Although you are paying PMI and mortgage insurance in your deal, these aren't "insurance" - they are part of your "debt service".  A 50% rule analysis wouldn't consider these since we're assuming 100% cash used to purchase.

Craig S. · Answer

Jon Holdman, thanks for your reply. I will be using FHA financing as an OO, so will also be required to have PMI for at least the first 60 months (unless I refinance out of it later on). 3.5% interest and 3.5% down.

I agree that on AVERAGE OVER THE LONG TERM (10+ years) that using the 50% ratio might be very accurate. However, how would the 50% rule be correct if you purchased a property that needed a new roof, furnace, or all new windows within 1 or 2 years? Would you just consider those costs as essentially part of the purchase price? What if the property needed some upgrades that were not urgent but needed to be done relatively soon? I agree that over time these may equal to about 50%, but I am trying to watch my costs closely--especially for the first year, second year, etc. Sure looking at 20 years overall I can see 50% being close, but looking at a 1 or 2 year term, this seems to be more inaccurate. The more time goes by, the more accurate the numbers will seem. Do you see what I mean Jon?

My goal is indeed long term buy & hold, but what if I decided to buy & sell in 5 years. Wouldn't my "50%" average be considerably off if I had a major CapEx within that timeframe?

What are your thoughts?

Jon Holdman · Answer

Its dead simple.  50% of gross scheduled market rents will go to vacancy, capital and expenses.  No new investor every believes this.  But every time anyone's had any significant amount of data, and there have been a couple of very large samples posted in the past, this number has been very close.  There are sticky threads in the Landlording and Rental Property forum on this topic.

If you're a small investor, management is closer to 14% of gross rents than 7%.  You'll pay, typically, 10% of collected rents plus half a month's rent to fill a vacancy.  With one vacancy per year, that works out to about 14% of the gross.  So, if you're willing to manage your own units and do it for free, you could use 36% for vacancy, capital and expenses.

If you're looking at an actual property, look for something that would push you to a higher ratio.  If you try to convince yourself its lower, you may be in for an unpleasant surprise.

The 50% ratio does not include debt service.  Debt service is the P&I part of your payment and, if it applies, PMI.  PMI would only apply in OO situations.  You won't get an investment loan these days if your down payment is so small as to require PMI.

Best way to estimate operating expenses on a rental?

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