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Understand the Costs Involved in Maintaining a Rental Property When Evaluating Whether to Make That Deal

Understand the Costs Involved in Maintaining a Rental Property When Evaluating Whether to Make That Deal

In recent articles, I have discussed the need for “financial literacy” and an understanding of the terms, concepts and fundamentals of cash-flow analysis. We have looked at estimating effective gross income. Now we turn to operating expenses. These are the expenses that are paid by a real estate investor to keep the property generating revenues on a monthly basis. Operating expenses do not include mortgage payments, depreciation or capital improvements.

The accompanying table illustrates some of the typical operating expense categories for a standard residential rental property. These account categories were taken from the default operating expense settings from The Property Ledger a cloud-based real estate investment software developed exclusively to assist the average real estate investor in analyzing real estate investment opportunities.

The most common operating expenses as they relate to residential real estate include:

Property Taxes

Represents the property taxes that you as a property owner will pay on an annual basis related to state, county and municipal government as well as school district operations. You may obtain a property’s current property tax bill by going online to the respective county treasurer’s or county assessor’s website and searching by parcel number, owner or address. Remember, when you purchase a property at a price higher than that paid by the previous owner, your property tax payment will increase from that shown on the current tax bill. Make sure you take this into account when calculating your prospective investment’s property tax payment or you may underestimate this expense. In my mind, it is always better to be conservative (meaning selecting a higher number) when estimating operating expenses.

Property Insurance

Property insurance is necessary to protect both you and your lender from loss in case of fire, flood, earthquake or other catastrophe that may damage or destroy your investment property.  It also includes liability insurance to protect you in case a tenant or tenant’s guest is injured while on your property. As is the case with property taxes, if you are paying more for a property than that of the original owner, your insurance premiums will likely be higher than that of the current owner. The best way to zero on this expense is to call your property insurance specialist and give him or her the details related to your purchase along with the coverage you desire for the property. The agent will then be able to give you an exact quote related to this expense category.

Repairs and Maintenance

Repairs represent the items that need to be fixed over the course of a tenant’s use and include such things as leaky sinks, heating and cooling repairs, minor plumbing repairs, and electrical or appliance repairs. They basically represent those costs necessary to keep everything running for the tenant’s use of the facility. They do not include replacement of an air-conditioning unit, remodeling of a bathroom, replacement of windows or other additions that increase the useful life of the property.

Management Fees

Management fees represent the fees paid to an outside party to manage and lease your property. Typically, these rates range from 6 percent to 30 percent of the effective gross income generated by the property and are dependent upon the type and location of the property. Even if you manage the property yourself, you should factor in a management fee, as your time is valuable and you should recognize the economics of your time. I can assure you that when the time comes to sell your property, if the profit and loss statement that you present to a prospective buyer does not show a management fee, the buyer will add one to his or her own analysis, thus increasing the operating costs of the property and thus reducing the price they will pay for the property.

Utilities

Utilities relate to electricity, natural gas, heating oil, water, sewer and possibly trash pickup. Depending upon the type of property you are analyzing, the tenant may pay a majority of these costs. I know that for all my single-family residential units, the tenants pay all of the aforementioned utility costs. In order to get a good indication of what tenants generally pay in relation to a potential acquisition, look at the individual leases. Typically, the tenant’s responsibilities related to utilities will be spelled out in the lease. Additionally, in most states you can call the respective utility company and it will provide you the actual utility billings during the last year for the property in question.  You also will want to look at the seller’s tax returns related to the property in question and compare the tax return to what the seller and the real estate broker may be representing in terms of operating costs. Obviously, if their costs are much higher on their tax return than their selling pro forma, you will want to investigate the difference. When in doubt, use their tax return figures, as these typically will be more reflective of actual operating costs.