Why Estimating Maintenance Cost By A Percentage of Rent Is Wrong

When you are evaluating a potential investment property, one of the more important considerations is maintenance cost. A common method of estimating maintenance cost is to assume an arbitrary percentage of the rent. While easy, this approach does not work. Every property is different and its maintenance cost will be different, depending on geographic, climate, building materials and major system components, etc . In this article I will explain why the percentage method fails and offer a methodology that is property specific and has proven to work in the residential and commercial world. First, why any "average" maintenance percentage fails.

Population Averages Do Not Reflect Individuals

The concept of using a percentage of rent as the maintenance cost is based on average maintenance cost for a population of properties. I will use an example to show where this falls down.

Suppose you were considering buying a condo in a large complex. During your due-diligence you talked to the property manager and learned that the average annual maintenance cost per unit is $500. Based on an average $500/Yr. maintenance, the property has an acceptable return. Should you expect the maintenance cost of your unit to be $500? In a word, No. See the table below.

As you can see, the average maintenance cost per unit per year for the complex is $500. However, the actual maintenance per unit per year was almost never $500. Below is a chart showing the average 5 year annual maintenance cost by unit. The red line is the $500 annual maintenance.

Notice that none of the properties actually had a 5 year average of $500/Yr. The 5 year average for Unit #7 was close at $534 but the actual annual maintenance was: $0, $900, $90, $1,500 and $180. If you planned on $500/Yr maintenance, you would be very disappointed. The lesson is that population averages are not representative of the individual units.

Another problem with the percentage approach is that it implies you will always spend (lose) this amount so it is a fixed reduction in return. For example, if you set aside $500/Yr for unit one, you would have "lost" to maintenance $2,500 over the 5 year period when your actual total maintenance was $245. Would you have "thrown away" the $2,255 allocated to maintenance but not used? No, but your return calculations would be based on actually having spent (lost) the total $2,500 on maintenance.

A Better Method

The method I propose is how maintenance costs are provisioned in the commercial world. Simplistically, establish a maintenance reserve for each high cost item based on useful life and replacement cost.

When I owned properties in Atlanta and Houston the major cost items included roofs, termite damage, replacing wooden windows, water damage to siding, exterior painting and landscaping in addition to water heaters and AC compressors. Properties in Las Vegas are built to withstand the desert climate. There is no "siding", wooden fences, lush vegetation, wooden windows, composition roofs, gutters, etc. In 10+ years, we've never replaced a roof, painted the exterior of a property, repaired a fence or made major stucco repairs. See the image below. In Las Vegas, the only major cost elements are the HVAC and the water heater. Because of the climate and construction, maintenance costs are comparatively low.

My point is that major cost items will be different depending on property age, climate, construction and other such factors. How do we provision for maintenance like with commercial properties? It is easier to explain using an example. As I stated, in Las Vegas the AC compressor and the water heater are the two expensive maintenance cost items. Below are the typical useful life and replacement costs:

Some considerations:

• Useful life - This is an average based on the national population of all units. No consideration is given to climate, manufacturer or anything else. As you saw earlier in this article, the average of a population is not a good predictor of individual members. So, could an AC compressor fail after 2 years? Yes, but it is not likely. Could it last 20 years? Yes, but it is not likely. So the useful life average is the best guide I know.
• Replacement cost - This is once again an average. For example, the last AC compressor we replaced was $1,250. The one before that was $2,800. If you had to replace the entire HVAC system, the cost would be in the $7,000 range. However, we have never replaced an entire system. Think of an HVAC system like a car. If the alternator fails you would replace the alternator, not the entire car. The same is true with the HVAC system. The AC compressor is the most common and expensive item we see fail.

At some point in the future, every expensive component will need to be replaced. What you want to do is to accumulate funds over time such that when you reach the probable time of failure (end of useful life) you have the necessary funds. So how fast do you need to accumulate the replacement cost? It depends on the remaining useful life. See the table below. I added a column on the right showing the remaining useful life.

The next step is to determine how much you need to set aside each year in order to reach the replacement amount in time. See the table below. I added another column showing the amount to set aside each year (replacement cost / remaining life). For example, the replacement cost for the AC compressor is $2,500 and there is 7 years of useful life remaining. Thus, you need to set aside ($2,500/7Yrs) $357/Yr or $30/Mo. to handle the future replacement of the AC compressor. If you add the annual set aside for the compressor and the water heater, you need to set aside $517/Yr ($357 + $160) or $42/Mo.

There is another factor to consider, the odds of both the AC unit and the water heater failing the same year are small. If you accumulated $2,500 it would cover the cost to replace either the AC unit or the water heater. So, you really only need to accumulate $2,500 (an amount that would cover either the AC compressor or the water heater), which means setting aside $357/Yr. or about $30/Mo.

Important: Once you reach your maintenance reserve level you do not need to keep adding to it until an actual expense occurs.

There is another advantage to this approach when you have multiple properties. Suppose you have 10 properties, all with the same major cost elements. In the table below I combined all cost elements for each property into a single line item and gave them a single useful life. This is overly simplistic but it keeps the example simple. The column on the right shows the cash flow per property per month (rent minus all expenses).

Again, the numbers above are only intended to convey the concept. In real life you would have a separate line item for each major cost item along with the associated useful life for each component in each of the 10 properties. A few considerations:

• Remaining Life - You will note that the remaining useful life ranges from 2 to 15 years. Thus, it is very unlikely that you will need to replace all major component in all properties at the same time.
• Replacement Cost - The total of all replacements is $25,050. However, the largest reserve is for property 10 at $4,000.
• You have a monthly cash flow (after all expenses) of $1,815.

So how much of a reserve should you have for this set of properties? Let's look at when we are likely to need the reserve based on the useful life. Your largest cost item in the near future is property #9 at $2,700. Do you need to have $2,700 set aside? No, you can use the cash flow to cover some of the cost. In the case of the $2,700 expense, with $1,815 cash flow, you only need to set aside: $2,700 - $1,815 or $885. The lesson here is that you typically need a lower cash reserve with multiple properties than you need with a single property.

Key considerations:

• All properties are unique - The maintenance reserve is based on the age of the expensive components, not the age of the property. For example, suppose you purchased a property built in 1900 and the foundation, electrical system, plumbing, roof and HVAC were recently replaced. Despite the age of the property, this property would likely require a lower maintenance reserve than a property built in 2000 with all original components.
• Amount of reserve - The amount of reserve you need is based on the remaining useful life of the major cost elements in each property. Once you reach the reserve amount, you would not need to continue to set aside funds.

Summary

Using arbitrary percentages of rent for estimating your maintenance cost makes no sense. Every property is different and you can more accurately estimate the amount you will need based on the remaining useful life of the key cost components and their replacement cost.

Best regards,

Eric Fernwood
702-358-8884
[email protected]