Just as with the stock market, there are different levels of quality in investment properties. This is true with apartments, office buildings, industrial warehouses, and it is true with rental houses.
Many brokers and investors qualify a property as A, B, or C. I use that same technique when I evaluate rental houses. However, this qualification is subjective. So I want to quantify here how I determine the quality of a rental house.
Zelman & Associates published a very insightful article once about where people live during their life cycles. They observed that, generally speaking, younger single adults tend to live in multifamily or attached housing. As people get married and have children they are much more likely to live in single-family detached residences. Later, as these adults become “empty nesters,” they are more likely to move back to attached housing (condos, townhomes or apartments).
School quality has a big impact on where people want to rent
In a less scientific way, I have made the same observation for years. Most of the tenants who live in the rental houses we own and/or manage are families with children.
A conscientious parent is going to want his or her child to attend the best schools available. Houses near good schools tend to be in higher demand, and that higher demand is reflected in higher rents or sales prices. The website www.greatschools.com rates elementary, middle and high schools across the country. Their metrics include an overall ranking for the school of 1 – 10.
Our technique for ranking the quality of rental houses
In order for us to consider a rental house as an “A” property, it has to meet two criteria. First, the www.greatschools.com ranking for that local high school needs to be 8, 9 or 10. Second, the market rent for the house needs to be at least $100 per month higher than the average rent for a similar house in that county/area.
For instance, if a typical three-bedroom house in Gwinnett County rents for $1100 per month, then for that subject house to be deemed an “A” quality property, it would have to rent for $1200 per month or more AND be located in a district with a public high school with a Great Schools ranking of 8, 9, or 10. A “B” quality property would rent for about the average for a similar house and the Great Schools ranking would be a 6 or higher. Any houses with a Great Schools ranking of less than 6 would be considered “C” quality by us.
There is also an age component to consider when evaluating quality. A house that is less than 15 years old will cost less per year to maintain than houses that are 15 to 25 years old. Generally speaking, houses under 15 years old do not need new roofs, new HVAC systems, appliances, etc. Between years 15 and 25, just about all of the major systems of the house will be due for replacement, which will drive up the amount the owner spends on maintenance and repair. For houses over 20 years old, the investor/buyer needs information on the age of each system in order to evaluate the effective age of the house to better estimate the amount to budget for maintenance and repair.
Why ‘quantify’ the quality of different rental houses?
Why is quantifying the quality and effective age of a rental house so important? These factors will significantly impact cash flow. Higher quality properties will generate more income in that the owner will have less income lost due to vacancy (higher demand from tenants to live in that area) and reduced losses from delinquency (higher quality tenants are more likely to pay as agreed).
Higher quality rental houses also cost less to maintain. We have observed for many years that C quality properties cost more per year to maintain than do B quality properties, which cost more to maintain than A quality properties.
We run averages each January to look at the maintenance expenses for the previous calendar year so we can more accurately budget how much to expect for maintenance and repair expenses during the coming year. We break down these averages by rental rate and property age to better understand the costs for A, B, and C quality properties.
Some investors purchased a lot of C quality properties during the most recent recession and budgeted losses for vacancy and delinquency based on some industry averages (for all rental houses), then were disappointed when the portfolio was not performing as projected. Their actual losses due to vacancy and delinquency were much higher than budgeted. Correspondingly, the maintenance and repair costs were also higher than they had budgeted.
How do you budget for your rental property?
I don’t believe there is a perfect way to budget for one single-family property for one year. With an apartment complex, averages will work across the multiple units. Correspondingly, our averages work across a portfolio of houses over an extended period of time.
As a “buy and hold” investor, that works for me. I can estimate my Internal Rate of Return on houses I buy with much higher rate of accuracy using these averages based on the correct quality classification for the house.
I have found my “sweet spot” is with B- and B properties. That seems to be where I find the best compromise between yield and risk. Your “sweet spot” may be different, depending on your tolerance for risk and your expectation for yield.
About the Author
Michael E. Nelson, GRI® MPM® RMP®, is president of Excalibur Homes, LLC in Alpharetta, Georgia. Excalibur is one of the few companies in Georgia that have been designated a Certified Residential Management Company® by the National Association of Property Managers®. Excalibur’s expertise encompasses leasing, management and sales. For more information, call 678-825-0412 or email mnelson@excalhomes.com.
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