Financial Assumptions

[Jason King]

Hi All,

I am a new prospective investor and I am putting together some information for a partner so that we can start the search for our first property! One of the to-do's that I am personally tasked with is to develop a way to analyze potential investments for financial opportunity. I have been researching methods of measuring deals, and I have found that the BP Buy 'N Hold Calculator seems to lump all of the major financial calculations into one, easy-to-use form. Does anyone have any real-world experience using this tool? Has it worked well for you? Is there anything missing?

It also seems that some of the expenses recorded are based off of assumptions. Specifically, Vacancy, Repairs and Maintenance and Capital Expenditures are the three biggest risk areas in my mind in terms of using the correct assumptions. Does anyone have any suggestions on where to find the correct values for these assumptions? Are there industry guidelines to use? I know that these are likely to be area/property specific, but are there any resources I can utilize to research typical rates in my area? I am also curious to see if I can find what they typical Cap Rates are in my area, if anyone has experience researching this.

Any help would be greatly appreciated!

Jason

[Jon Holdman]

Its impossible to come up with accurate estimates for vacancy, repairs or capital. That's like asking, how can I estimate my loss at the craps table? The house edge tells you craps is a 98.5% payback game (on the pass line). So, if you bet $10 per hand, play 50 hands per hour and play for four hours you loss should be ($10 * 40 * 4 * 1.5%) = $30, right? Of course not. You could end up $200 or down $200, but its not likely your loss with be exactly $30.

Rentals are no different. There's a very real possibility a tenant will completely trash the place. The odds of that are low, though, but not zero.

I like the "50% rule" for this reason. That rule of thumb says that 50% of the gross scheduled rents will go to vacancy, expenses, and capital. Thats shown to be true for large set of properties over long periods of time. Like that session at the craps table, your actual experience for one property for one year can vary widely. But for a way to evaluate properties, its a good start.

Then, do your detailed evaluation and look for something that will push it higher than 50%. Often new purchase require some immediate repairs. Or you have a period of vacancy while you're working on it.

The 50% rule does not include debt service.

[Jason King]

@JonHoldman thanks for the advice. I have become familiar with the 50% rule, and it is good to know that this is a time-tested rule to follow. I know that what I am asking will not be a guaranteed number, as each case is specific. I was more looking to see if anyone has had any general ranges of which I should target and take it from there. I definitely want to stay on the conservative side, as I am new to the game and am likely to not run as efficiently as someone with prior investment experience, but at the same time I do not want to rule out any properties because I am being overly conservative. For now I will try to stick with the 50% rule as a general rule of thumb, and work to find more specific line item details as time goes on. Thanks again!

[Raymond B.]

@Jason King

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[Bill Gulley]

Jason, if you're successful at that you won't every need to buy a property!

RE is not a known or measurable widget where future performance can be determined accurately by itself. You would have to consider "the law of large numbers" having a sample population to correlate endless possibilities that could effect one unit. One variable is human personalities, yours and those you deal with, just as an example. A tenant may simply decide to buy something, they find themselves in financial problems, they are late with rents, you attempt to evict, the judge says no, because by that time the tenant can pay. It all happens again 3 months later. There is no way to predict this behavior or the outcome.

If you had 10,000 units under management then you would have enough data to evaluate having statistical probabilities that may be valid. To be valid the units would need to be disbursed amongst independent variables, they could not all be located in one geographic area for example as one occurrence may effect a large number of units or all of them, like a tornado or flood. There needs to be economic independence, if all the units were located in Detroit, you can see difficulties in your predictions.

All financial ratios are, to some extent, are adopted or considered in light of the mean or average of similar populations. Inventory turn over, or an acid test or ROI are particular to industries as a basis to judge performance of one activity. A ratio is rather meaningless without another to judge it against, that is the purpose of measuring performance, is much like asking is 300 miles per hour fast? Compared to my bike it's very fast, compared to a bullet or a rocket it can be very slow.

Stocks and bonds are comparable as they can be in similar industries, there is a wide dispersion of a significant population and performance variances are predictable. I can compare GM stock to Ford or a Utility bond to a municipal bond, I can view risk that has been standardized to look at alternative investments. You can determine expected performance based on past performance and make adjustments for expected economic conditions.

None of this can accurately be done to a property.

The first issue many small investors have comes from the very basic understanding that real estate is unique, there are no two identical properties on the face of the earth. Each property is influenced by different variables, while they may be similar they are not the same.

The similarities, general type, style, location, price level can be assessed as to value but not performance so much. Management is a factor, if all similar properties were managed identically then valid expectation could be made.

Lack of data is another issue, if all landlords of single family homes reported annual financial information then analysis of certain types, geographic areas, age and amenities could be evaluated as you would have a large population size to make comparisons to and with. But, it doesn't exist since such data is not collected from owners. All you have in this respect is Joe saying what his earnings and expenses might be and Sally and George and John giving their data, not only are they not similar enough but you have a very small population to consider.

Finance and accounting ratios were developed to measure similar investments or similar functions of a process so that an activity can be compared to another to measure performance or debt or asset levels. Ratios are viewed from a base line of an accepted value in different activities or industries where risk may be similar. RE is really the odd ball out when you attempt to assess an individual property, mainly due to the uniqueness of the variables effecting that one property.

While we may compare a rate of return estimated for a property to an expect return on a security, that is really an invalid assumption to investing since the risks associated with these investments are not nearly the same nor do the require the same amount of management or knowledge to maintain the investment.

Another issue is that a security only provides an economic and financial aspect to value, it carries very little as to any intrinsic value, a bond or an annuity is rather limited as to its usefulness. RE carries intrinsic values unlike other investments. It serves a purpose, you can live in it, you can hold on to it for future use or development, how do you measure that as a ratio to the performance or value of a security? It's an intrinsic value and totally subjective and such a ratio doesn't exist.

My point is, investors need to measure past performance, you can't measure expected performance accurately. You can't really compare one unit to an industry standard as there isn't a standard (by population) and no two properties are identical. RE is unlike the functions and activities that financial ratios were developed to measure, the differences are significant. Comparing RE to a bond or an annuity is trying to compare apples and oranges.

Ratios can have meaning to judge past performance to alternative investments. That doesn't mean alternative investments must be like kind or even similar but were past known alternatives.

The very best you can hope for is a range of expected performance. You can have a weighted average approach, defined by various considerations, and have expectations generally obtained for that type or property, in that geographic are, under expected economic conditions assuming prudent management taking into consideration property condition, age of a property, it's location and known variables. That is what appraisers look at, what lenders consider and where small investors need to be in considering an investment. Pinning down a ROI before you buy is nothing more than an exercise that will not ever yield an accurate forecast.

You can only guess at future performance, you can have an educated guess, but you'll never get as close as you might measuring performance of a bond or other securities.

RE is unique, your experience and gut feelings need to be honed to your market rather than running the batteries down on your calculator, IMO. I know, it's fun, it's also a waste of time, but it's better than playing video games! LOL

[Account Closed]

I'd not go any lower than 40% for expenses, repairs and vacancies (not including property management, and of course not including debt service). I'm not a long-term hold investor, the longest I've had a tenant in any property is less than 3 years. But I sell to several buy and hold investors. The ones I trust to do the numbers correctly are at 40% after 10+ years. They do their own management, and they have skills and crews to manage their repairs as cheaply as possible. It's the ten year mark that really matters for many properties. After 10 years most properties will have repairs that will start to include things beyond wear and tear, things that can't be charged back to the tenant or that have to be fixed even if there has been no vacancy (exterior paint and maintenance, water heaters, main lines, roofs, etc.) And if there is a vacancy pattern, you'll see it over the long haul.

I have many friends who own rentals who can't crunch the numbers to save their lives. If there's anything left over at the end of the month, they call it cash flowing. The property taxes are more than 2 months of gross rent. So the two months around tax time they are sad. :) Most of them own multi units and have at least one vacancy month per year, but they don't use that to calculate the overall expenses.

I think you'll find that many people will tell you 50% is too conservative. Ask them to show you proof they are doing better over the long haul.

[Jason King]

Bill,

Sorry, haven't gotten the @ functionality down yet, thinking it may be my browser (IE). Anyway, thanks a lot for your commentary about financial ratios and their application (or lack there of) in the RE world. I think I am slowly coming to some of the realizations that you highlighted; I am just naturally inclined to look for benchmarks as this is what I have learned in Finance. In regard to your point about comparing to past performance, do you mean the performance that previous owner(s) have experienced? Or do you mean compared to personal performance of other properties? I am new to the game so do not have any point of reference personally to compare against - I think this is where my problem lies. If you have any suggestions on how to compensate for this I would certainly be open to listening to your advice; you clearly know what you are talking about!

K. Marie,

You bring up some good points here. My primary focus is on long-term ownership, which seems slightly different from your own strategy. I know that capital expenditures, for example, are going to pop up from time to time, I am just struggling with how to allowcate enough funds on a monthly basis to cover these expenses in the long run. I don't want to overstate the profitability of a prospective property because I underestimated on one of these areas.

Another thing that I want to avoid, especially starting off, is running out of cash. I plan to establish an "emergency fund" for unexpected expenses, just not sure what is an adequate amount for this. Is it a sepcific % of the overall value of the property? Should I set aside a % of the monthly rent for this? My lack of experience in this area is what concerns me. Any advice you can provide would be greatly appreciated.

[Bill Gulley]

Originally posted by @Jason King:

Bill,
.......I am slowly coming to some of the realizations that you highlighted; I am just naturally inclined to look for benchmarks as this is what I have learned in Finance. In regard to your point about comparing to past performance, do you mean the performance that previous owner(s) have experienced? Or do you mean compared to personal performance of other properties? I am new to the game so do not have any point of reference personally to compare against - I think this is where my problem lies. If you have any suggestions on how to compensate for this I would certainly be open to listening to your advice; you clearly know what you are talking about!

You should never use the historical data of a previous owner, perhaps if they opened all their information from their purchase you could judge their performance. That usually isn't going to be given, their cash injected, loan costs and expenses, etc.

You can only measure your holdings historically to see actual performance.

You can compare all of your properties as to portfolio performance. The issues you have in comparing to other properties I mentioned above.

One of the first things taught in financial analysis or ratio analysis is "what are you trying to determine"? Any comparison needs to be done with like investments, that's the issue, you won't have another like unit. To go further you need to make adjustment to your comparable properties to make them more like the subject, just as in appraising value, but with a much deeper approach. You would need to quantify aspects of location, market influences (rentablity), these are all subjective, lots of experience would be required an even at that, there is no way to really check deviations without a large population to consider.

Management is another issue, you can quantify your management, time, efforts, phone calls, interviews, etc. and come to a value, but you can't with properties owned by others and be accurate, I'd say if you apply your costs to other properties you'd be closer.

When I taught finance and economics 101/102, long, long ago, the text covered applicability of analysis, the benefits as opposed to the efforts, time, expense as an opportunity cost to obtaining the findings and the accuracy of those findings. I'm thinking that new investors in RE are forgetting those three paragraphs or so. You could easily spend weeks or months collecting data, making adjustments, running different models to adjustments and what do you get out of it, does getting closer to an expected return have any real benefit? I'd say not, not at all.

If you try to apply elaborate analysis to every buy decision, you'll likely never buy, any good deal will be sold before you have a solution.

For those thinking, well Bill is unaware of the power of computers, he's so old, well, garbage in garbage out. I'm rather aware. Can you update your base line data as markets change, can you enter the effects of interest rate changes, economic conditions, inflation, effects of regulatory or government influences, say quarterly or semi-annually? Do you have the ability to accurately consider such factors?

When I went full time in my business, being a finance type, I did the same thing all the other finance types do starting off, attempt to quantify the value of RE and investments, including notes. Didn't take me long to recall those few paragraphs about the applicability and benefits of my efforts. Once I realized I was doing nothing but guessing I realized such efforts simply aren't applicable to small RE or portfolios. I was wasting my time. The value of my guesses wasn't worth the effort. The cost of a proper analysis to provide a more accurate solution was too great.

So, when I see new members attempting to apply traditional financial analysis to a home or a tri-plex, I kind of smile and shake my head, I never said much before now. I'm not saying that someone couldn't come up with a valid prediction model, I just know it isn't in the commonly used ratios applicable to other assets.

All that said, there are norms in every market as I mentioned before, the local cap rate adopted in your area is pretty much the accepted base line. The 2% and 50% rules are quick and dirty assumptions, your debt coverage ration is a quick assessment, your average market rents can easily be obtained for a property. From that you can do a proforma, close enough to add to your loan application, that's about all you really need, just a conservative and simple assessment. :)

[Jason King]

@Bill Gulley thanks again for the response. I feel like you have probably saved me a bunch of time fretting over details with this one simple post. I think for ease of use, I am going to stick mainly to the 2% and 50% rules when evaluating property. I am curious, however, how users experience with the 2% rule has been. From my (very) quick analysis of available properties in my area, there are virtually no properties that pass the 2% rule. I may be either under-estimating rental prices or over-estimating property values - I do try to stay pretty conservative. Is this a red flag that my market is not "ideal" for investment in multi-family rentals? My cash flow/cap rate calculations appear to be strong despite not passing the 2% rule, so I am still looking to move forward in this direction, just curious to see what others thoughts are. Also, when applying the 50% rule, should I use my best judgement for the expenses that I have a good grasp on and apply the remainder of the 50% to the other line items? Do I then take a look at those line items to see if they are reasonable in terms $ values? I know I am still probably fretting too much over the details, but after reading through the Ultimate Beginner's Guide I want to avoid one of the "newbie mistakes" of underestimating expenses.

[Bill Gulley]

You gut feeling will always guide you, your assumptions of expenses should be reasonable in reality, you need to value properties in light of market conditions along with fair market rents. The 50/2% rules are guidelines, not a basis for a purchase decision as, while fairly on target, they are not applicable to every market. Your quick assessment of your use of funds and alternative investments at that time need to be considered. Never fall in love with a property, I never had one that loved me back! :)

[Account Closed]

Originally posted by @Jason King:

@Bill Gulley thanks again for the response. I feel like you have probably saved me a bunch of time fretting over details with this one simple post. I think for ease of use, I am going to stick mainly to the 2% and 50% rules when evaluating property. I am curious, however, how users experience with the 2% rule has been. From my (very) quick analysis of available properties in my area, there are virtually no properties that pass the 2% rule. I may be either under-estimating rental prices or over-estimating property values - I do try to stay pretty conservative. Is this a red flag that my market is not "ideal" for investment in multi-family rentals? My cash flow/cap rate calculations appear to be strong despite not passing the 2% rule, so I am still looking to move forward in this direction, just curious to see what others thoughts are. Also, when applying the 50% rule, should I use my best judgement for the expenses that I have a good grasp on and apply the remainder of the 50% to the other line items? Do I then take a look at those line items to see if they are reasonable in terms $ values? I know I am still probably fretting too much over the details, but after reading through the Ultimate Beginner's Guide I want to avoid one of the "newbie mistakes" of underestimating expenses.

IMO, The 2% rule and the 50% for expenses are two different things. The 2% rule is just one, somewhat limiting, way of looking at returns when getting into rentals. It mostly applies to markets with lower valued props (by my standards). The 50% for expenses and vacancy thing is helpful when trying to estimate cash-flow on any property. 50% will be overly conservative in areas where rents are high but turnover is low and construction is new. 50% will barely be enough in some areas where rents are low and houses are old. Technically, the cost of a new roof is the same whether the tenant is paying $600 or $2500.

[Roy N.]

Originally posted by Kristine Marie Poe:

For the most part, though we might spend a little more on an architectural shingle on a house where the rent is 2500/mth ;-)

[Bill Gulley]

Originally posted by @Roy N.:

Originally posted by @K. Marie Poe:

For the most part, though we might spend a little more on an architectural shingle on a house where the rent is 2500/mth ;-)

And if the other property was in the same market. my guess is that the roof would be larger, much larger containing more materials, squares, for the 2500 rental than a 600 rental. I'd even go as far as to suggest the pitch of the roof on the 2500 would be greater, adding more cost to labor. Apples to apples assumptions. I know if I had a unit that would rent for 600 I probably wouldn't use copper cladding on it or custom cut slate. :)

[Account Closed]

Originally posted by @Roy N.:

Originally posted by @K. Marie Poe:

For the most part, though we might spend a little more on an architectural shingle on a house where the rent is 2500/mth ;-)

Come on down to So Cal where a $2500 rent doesn't get you an architectural shingle. Or any architecture at all. No shortage of crappy stucco boxes with aluminum frame windows and sad, tired apts. renting for $2500+.

[Account Closed]

Originally posted by @Bill Gulley:

Originally posted by @Roy N.:

Originally posted by @K. Marie Poe:

For the most part, though we might spend a little more on an architectural shingle on a house where the rent is 2500/mth ;-)

And if the other property was in the same market. my guess is that the roof would be larger, much larger containing more materials, squares, for the 2500 rental than a 600 rental. I'd even go as far as to suggest the pitch of the roof on the 2500 would be greater, adding more cost to labor. Apples to apples assumptions. I know if I had a unit that would rent for 600 I probably wouldn't use copper cladding on it or custom cut slate. :)

In Bakersfield I can show you an $800 rent and an $1800 rent for SFHs with same square footage and same roof line. In Santa Barbara I can show you a $2K rent and a $4K rent for SFHs with same square footage and same roof line. No slate, no copper, no red tile. Just asphalt shingle, and if you're lucky you get rain gutters.

[Bill Gulley]

Jason is in Rhode Island :)