Want to Buy Rental Property? Consider The Expenses
If you are considering buying rental properties, you should already know how to analyze an investment by penciling out your real estate deal. Within that analysis, one of the critical tasks is accurately estimating how much your operating expenses -- property taxes, HOA fees, lawn care, property management fees, insurance, maintenance expenses and all costs other than the mortgage -- will be on the property.
Properly estimating your operating expenses will give you confidence that your analysis is on the mark. So to help you better estimate those amounts, let's talk about some percentages in a broad range and then specific items and costs.
Operating Expenses Percentage
When people pro-forma, or estimate the projected financials of a real estate deal, the operating expenses are typically 35 to 80 percent of the gross operating income, depending on the type of rental property.
So let's say your GOI is $1,200 per month in rent, and your expenses are $450 per month. Your operating expense percentage would be 450/1,200 or 37.5 percent. For a bread-and-butter house, duplex or triplex building, 37.5 to 45 percent is probably a good estimate. Generally, the fancier the building, the higher the ratio of operating expenses to GOI. Some types of properties -- such as vacation rentals -- could have a 70 to 80 percent expense ratio.
Beware: If your calculation is below 35 percent, there is a high probability that something is wrong in your estimation. Make sure to independently verify your projected costs with a few other experienced property owners.
While using an expense ratio is a fair general guide to penciling out your deal, you really need to get into the nitty gritty numbers to be as accurate as possible. Here are the typical expense categories for a normal rental property and how to calculate the costs.
Maintenance and Miscellaneous
This is typically the hardest category to estimate, and often people underestimate the amount. A general rule is 1 percent of the property value per year. So a property valued at $180,000 would have $1,800 per year, or $150 per month, in these costs. Many things can impact this, such as the condition, age, size and type of property. Also, in a single family home, the owner pays for the roof, painting and other costs that typically are covered by HOA fees in a common interest development, so take that into account. Either way, don't forget about those big capital repairs and replacements. It's highly likely that maintenance and repairs will be more than you anticipate.
You can contact your insurance agent, run over the property specifics and get an exact estimate of the cost for the coverage you need. Don't forget to consider earthquake, flood, umbrella liability, HO-6 interior condominium unit policies or any other special insurance you may want or need.
You should contact the county assessor to get the exact amount for the current property taxes. Make sure - especially you Californians under Proposition 13 - that you know how much you will be paying in property taxes after you close escrow. It could be significantly different from what the seller is currently paying.
You should be able to look at the for-sale listing and/or call the property manager to confirm the current HOA fees. Make sure to investigate beyond the current fees to determine whether the fees are scheduled to rise quickly, if they have risen often and if any special assessments are coming.
If you plan to have an outside manager, call around the see what the cost is for that service. Typically it's 6 to 8 percent of the rent, and that may or may not include re-leasing costs, which could be half to a full month's rent in addition to the monthly fee percentage.
Gardening, pest control and utilities paid by the landlord also need to be considered. It's smart to make the tenants cover water (even if pro-rated between units), electricity and gas. I've learned when a tenant pays the bills it costs X per month, but when the landlord pays those same bills, they're 3X or 4X per month. People generally only conserve when they have the pain of paying the bills.
That's some general guidance on how you can estimate the costs of operating an income property. Talk to other real estate investor-owners, real estate agents and property managers, too. And remember, don't underestimate your expenses. It likely will cost more than you think!
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