Rental property expenses

[Tim Jacob]

After managing many properties in my state of Maryland over the years I have seen the law of averages even out over time when it comes to expenses in various asset classes so Im posting this to give people some general concepts that can be applied to help in residential real estate analysis in Maryland along with other areas.

To start I think its important to break the expenses into 2 categories.  The fixed/ practically fixed expenses and the variable expenses.  

Fixed/ practically expenses being the mortgage, taxes, insurance, condo or hoa fee, alarm system cost,  and ground rent are examples.  Obviously some of these fees will be not applicable to certain properties.  Also a fluke thing could happen like a big spike in a condo fee or taxes however usually they do not deviate too much.  The tax spike is probably a result of a property value increase which isn't a bad thing anyway.  Usually these expenses are simple to estimate.

On the other side you have variable expenses.  The variable expenses are property management, maintenance, vacancy,  and unreimbursed utilities.  Estimation of variable expenses is what can make or break an investment.  

Property management is many times thought of being 10%.  The 10% is usually negotiable based on asset quality which with proper screening due diligence  will work.  In lower asset classes bump the rate higher though I recommend managing yourself if its too low because most decent pms will not manage there.  I recommend people unfamiliar with neighborhoods in areas they will invest call local pms and ask if they manage there.  If they do not it should beva redflag.  Another problem is there will be add on fees for other pm services.  If you think a property manager will do everything for the management fee think again.  For starters leasing is additional.  If there is a turnover every 2 years and the fee is 100% of 1 month that is a little more than 4% for that on a monthly basis.  There could be eviction fees which based on the asset quality and the pms due diligence.  Evictions can cost a lot just for legal representation let alone other postings and work.  Asset classes can dictate pm fees over the long term.  In higher or mid grade  asset classes with little to no need for legal action I would allocate mimimum 4% plus the management fee.  In low grade assets I would add another 4 or 5% for evictions.  Keep in mind that many times the pm will not have many good choices in terms of tenants in the lower quality assets.  Also keep in mind in Baltimore the lowest grade assets will not attract section 8 though slightly higher grade assets will. This will obviously vary by state based on eviction procedures and if you need an attorney.  In lower income areas think as well you are lower quality pms more apt to steal from you if they don't quit.

Additionally there are usually are usually 10% construction admin fees when the pm has to coordinate, supervise, and inspect any sort of maintenance or renovation work which leads to my next variable expense, maintenance.  When accounting for capex I would allocate an extra 1500 for maintenance FOR A PROPERTY THAT WAS NOT A FIXER UPPER WITH A GOOD HOME INSPECTION OR A RENOVATION WITH QUALITY PROJECT MANAGEMENT.  Project management is stressful, time consuming, and many feel no fun.  That does not mean trust your gc too much and only go to your property sparingly unless you hire a 3rd party project manager with no incentive to help the gc.  Project management is another discusion but  it is a large indirect factor into why low income properties perform poorly.  The tenant becomes disgruntled being in a defective house.  Instead of moving out they fight in court leading to the nightmare situation we all fear.  Sometimes the tenant will fight even though the house is more legitimately functional but you would cut your odds way down with decent maintenance work.  In lower asset areas another way that maintenance becomes expensive is tenant turnover maintenance.  In a high grade asset the tenant pays last month and a small cleaning fee can be deducted or other small reimbursable costs vs they destroyed the entire interior paint job, left  all there furniture as well and the place needs a deep clean along with not paying last month.  This can all cost over 3000. The disparity in maintenace based on asset class can drastically vary based on this.  Especially percentage wise as the lower income property rent will probably be less and capex will nit be proportionate as doing the same fixes cost similar no matter where you are.  A high to mid grade asset can be less than 10% with capex, turnover and all of it.  I have managed many units for years and have changed water heaters, roofs, etc so it isnt the fact Ive been lucky.   The lowest asset stuff can run over 25%.  In Baltimore for lower assets think neighborhoods with arvs less than 70k.

Vacancy is another category which vary widely based on asset quality.  1 thing I would do is ask people in your area about typical times on evictions. I think I would ask the local pms if you are calling them to ask about where they manage as I stated above.  In Maryland the tenant can stall the process by claiming an escrow complaint.  Most won't know how but in Baltimore City they get a free lawyer to help them.  This can take a 2 month process and bump it out to 6 months.  That doesn't include the time it takes between the eviction to get a new tenant in which is usually a few weeks because the place is left trashed so.  Ine way to combat this is if you see the tenant going this direction offer cash for keys.  The amount needs to be enough to incentivize them to move but not too much.  Keep in mind they could break in after that and claim residency while just taking your money. For high assets vacancy should be under 5%, for mid assets around 5% and for lower it can be 20- 25% though the cash for keys execution might cut that a little but not too much.

Unreimbursed utilities is one of the  most underrated expenses.   This would be another great thing to talk to the local pms about.  In Baltimore the water department leaves the bill on regardless if its paid thus if the tenant does not pay it it can run real high over the years.  If you cashflow was 200 before it and it runs 100 you can see how that will work.  In other parts of the state they have water departments that will disconnect after a 4 month period.  I would look into gas and electric bills as well.  In high asset classes you can simply ask for the water from the tenants and always get the money obviously as you get lower asset classes the unreimbursed utilities spike up.. In high grade assets its virtually nothing in mid grade very little and with lower in Baltimore it can be 10% but its area specific based on your municapilty.

In summary I would say the variable expenses can crush you.   I feel a 1% rule property is obtainable in a midgrade asset in a casy flow market however people pushing it with 2% or even 1.5% should really have an understanding of expenses nuch of which will be dictated based on the tenant quality.

I do not believe in the 50% rule.  It might be true if you include half high grade and half low grade assets.  The high grade assets I have had consistently average in the 30-40% range and sometimes even lower.  This includes property management and everything.  The lowest grade assets consistently underperform usually being a combination of 3 or 4 performing properties and 1 with a bad tenant dragging it all down.   

Hope this helps.