How should I analyze a multi unit property?

[Brittany King]

Hello BP family!

 I have a few questions about how to analyze multi unit properties. My questions are 1) when you calculate cap x, vacancy rate, repairs, trash, water and sewer do you always use 5% of the monthly rent? If not how do you calculate what percent you should use?

 Question 2) Would you still buy the property if it did not cash flow after you accounted for these expenses, even if the income was enough to cover the expenses? 

Question 3) Do you calculate reserves into you're monthly expenses? If so what percentage of the monthly rents should go towards it?

Thank you all for you're time and advice. Have a great day!  

[Phil Trietsch]

Brittany,

I'm going to assume that you are looking at a duplex or possibly a fourplex at most based on your intention to house-hack.  The reason I specify these types of properties vs. an apartment community is that they tend to operate a little differently and therefore are often analyzed a little differently.  

Let's start with vacancy rate.  In most Texas markets, I use 8%.  This is approximately 1 month of vacancy per year.  You may say that the property you are looking at has been 100% occupied for the past X number of years.  That may be true, and certainly having long term tenants is an important factor to success with duplex-fourplex rentals.  However, when you do have a unit turnover there can be a lot of expenses including: vacancy loss, utilities during make-ready/lease up, leasing commissions if you offer them to Realtors to help get the unit leased, some amount of repairs/cap-ex that cannot legally be charged to the prior tenant's deposit because it falls under normal wear & tear, etc.  Therefore, if you budget 8% of your annual gross rents...and set it aside in a separate account that you never touch until you have a turn-over...then over time you should have funds to cover these things.  

Next: repairs and other operating expenses.  Again, I advise our clients to budget 1 month of rent per year (and set it aside in the same account) for operations, repairs, cap-ex.  You will probably have years when you have very little repairs and others when you have big ticket items.  Over time these will likely average out.  

You might imagine that these guidelines work best when you are starting with a property that is in good to excellent condition.  If the property that you are considering is not in good shape then you must get it at a price that allows you to put it in good condition immediately.  Otherwise, you could have that expensive year of vacancy and high repairs in year 2 and be in real financial trouble.  Don't be a motivated buyer and go broke on a duplex.  

Most duplex and many fourplex properties are separately metered for water.  In these cases, the tenant is responsible for water, wastewater/sewer, and trash in their name just like their elec bill.  Therefore, you only pay utilities during a vacancy.  If there is only one water meter for a fourplex, you can bill back the water/sewer/trash to the tenants if you set it up correctly in your lease and follow the laws set out in TX for utility billing to tenants.  

I hate properties that don't cash flow.  And I mean cash flow after these vacancy and repair/operating budgets are set aside.  If it doesn't cash flow, you have limited your return to principle reduction on your mortgage and appreciation.  The principle reduction is easy to calculate but appreciation is unpredictable.  In duplex and fourplex properties, appreciation hinges largely on 2 factors...rents and interest rates.  As rents rise, all else being equal, valuations will rise.  However, if interest rates rise quickly enough, you may get flat valuations even in a rising rent environment because the next investor can't cash flow any better with the higher rents because the extra interest expense is eating it up.  I counsel our investor clients to invest first on cash flow, second on principle reduction, last on appreciation.  So my advice is to buy a property that will cash flow when you move out of it and rent the unit that you have been living in (taking into consideration vacancy, repairs, and your mortgage payment).  Then, while you are living in the unit, you will likely have a reduced but maybe not free cost of living there but you will have a nice cash flowing property when you move out.

If you start with a property that is in good condition (roof, HVAC, appliances, water heater, paint, flooring, etc) then there is a reasonable chance that you will accumulate funds to handle future expenses by setting aside the two months of rent each year that I discussed earlier.  You might want to consider a Residential Service Contract (often referred to as a home warranty) for your first couple of investment properties.  It is like having health insurance for your property...you pay an annual premium (say $600)...and you pay a "co-pay"/service call fee (say $75) when something breaks and they send a contractor to fix it.  Most cover HVAC, water heaters, appliances, some plumbing, some electrical, and optional coverage on things like washer/dryer.  

If you are working with a good Realtor that really knows investing (i.e. has done it themselves and/or does property management for investors) then they should be able to walk you through local vacancy trends and rent comps.  

Hope this helps!  If so, and you are so inclined...give me a vote on the response.  And of course feel free to reach out if you have other questions.  Happy investing!!!

Phil