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Fishing for Hot Investments in A Cool Market
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· Are the operating costs realistic? Make sure the seller's list is comprehensive and accurate (utilities, repairs, maintenance, property management, insurance, trash, pest control, advertising, supplies, cleaning, etc.). Verify estimates with third parties whenever possible. Get the utility bills directly from the utility companies; call your own insurance company; check the tax records. As a general rule of thumb, you should reserve 10 percent of your revenue for repairs and maintenance.
· Are there any deferred maintenance items that need attention? When was the roof installed? How old are the building's major systems? How old are the kitchens and appliances? Often, these items are neglected in investment properties and can significantly add to the cost. You should also budget an annual capital reserve for unexpected items (depending on the property and the age of the components). Your lender may have a specific requirement, so check. Even if not required, you should build in a reserve of at least 4 percent of your revenue.
· Is there an allowance for a property manager? Even if you plan to manage the property, you should budget a management fee to compensate yourself for your time, in case you later decide to pay a management company and because if you ever sell, the buyer will account for that cost in his model. Lenders will factor in a management fee, usually between 6 percent and 8 percent of revenue for a small residential property.
· Are there reserves for vacancies? A lender in this market will typically factor in a 5 percent vacancy rate in a stable neighborhood.
Now you're ready to build your financial model. To keep things simple, we will build the model for only the first year. Typically, such calculations extend for three to five years.
Let's say that, to be conservative, you have assumed zero appreciation in the building's value. Also, you believe the seller's rent projections are accurate and there are no major deferred capital expenditures. However, you did note that there were no allowances for vacancy, capital reserves or a property manager, and you thought the reserve for repairs and maintenance was too low. So:
· Gross annual rent: $90,000
Vacancy allowance: $4,500 (5 percent)
Property manager: $5,400 (6 percent)
Utilities: $10,000
Insurance: $3,000
Repairs and maintenance: $9,000 (10 percent)
