Vacancy and Maintenance Provisions
Several clients recently asked, "How do you factor vacancy and maintenance costs in your return calculation?" A great question. We decided to broaden the scope a bit as you will read below.
One part of the algorithm we use for eliminating properties that have a low probability of being profitable is estimated return. Note that we use more comprehensive formulas as properties pass through the approval process. But initially, we use the following formula for calculating return for a financed property with 20% down:
ROI = ((Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees)) / ( DownPayment + ClosingCosts)
Several years ago we started with a very simplistic formula much like you will see on most of the investing sites. But, what we were estimating did not approximate the returns our clients were actually seeing. So, we added additional components until we arrived at the formula we use today. Note that there are many factors we could add including vacancy, maintenance, equity accumulation, utilities (when the property is vacant), property manager escrow account for repairs, business license (not applicable to most people), inspection cost, appraisal cost, etc. However, when you are considering what to include into a calculation you need to always consider whether it is relevant to the intended use of the calculation, which in this case is to approximate what you are likely to actually experience before tax advantages.
Note that your actual return is a function of many tax factors which we do not consider. Two examples are:
- Depreciation - The IRS mandates that residential real estate be depreciated over a period of 27.5 (???) years. For example, if you purchase a $200,000 property and the improvements are 80% of the total value, the amount you would subtract from the income derived from the property would be: $200,000 * 80% * 1/27.5 = $5,818 per year. In most cases, depreciation results in a passive tax loss while the property is generating a positive cash flow.
- Note: I am not a tax expert so check out the following with your accountant to tax advisor. Passive losses generated by depreciation can be subtracted form your regular income if your income is below a certain amount. I also believe that no matter your income, passive losses can offset passive gains.
As you can see from the above, your actual return is greatly influenced by your tax situation. Only if you build a financial model where you can take into account your current and foreseeable financial and tax situation can you get a reasonable estimate of your return. When taxes are considered, the return is typically much higher than our estimated returns. The factors we do include in our calculations are determinable and predictable. I also believe we include more costs than what we see others use. However, the formula has proven over time to provide a reasonable representation of what our clients see pre tax. The formula we use for estimating return is shown below:
ROI = ((Income - DebtService - ManagementFee - Insurance - RETax - PeriodicFees) x (1 - StateTax)) / ( DownPayment + ClosingCosts)
I will next cover how you could determine a factor (or provision) for vacancy and maintenance.
Vacancy rate is a factor of:
- The effectiveness of the property manager's screening process. McKenna Property Management (the property manager we work with) has an excellent process. Many property managers will only check credit.
- The tenant pool. With class C properties you are primarily dealing with cash based tenants which are nearly impossible to effectively screen. I have not done the analysis but based on anecdotal data would put the vacancy rate (and tenant turn cost) above 10% of rent which is bout 3 X higher than class A and B properties.
- The specific property makes a huge difference. The typical type of properties we consider have average tenant stays of 3 to 4 years. This is one of the reasons we prefer single family homes. The cost and effort of moving a family is not something that people do with out a very strong reason.
- Time-to-rent. For the 1000+ properties that McKenna manages, their average is 26 days. That means that 50% of properties take less than 26 days and 50% take longer than 26 days. Due to our careful selection and rehab process our properties rarely take longer than 2 weeks to rent.
- Rehab time. It is rare for the people we work with to take longer than 7 days to rehab a property.
If I were calculating a vacancy rate based on various tenant stay periods I would get the following:
1 month vacant / 24 month stay = 4%
1 month vacant / 36 month stay = 2.7%
1 month vacant / 48 month stay = 2%
1 month vacant / 60 month stay = 1.6%
As you can see, the total time the tenant stays in the property can have a huge impact on your profitability. This is why we are very selective on properties (thus the tenant pool) and the property management team we would with. The right property and excellent screening is more money in your pocket.
So, based on the above, ~3% might be a realistic vacancy rate factor. However, we have properties where the tenant has been in the property for over 5 years so averages don't work very well for specific properties. Where vacancy rate averages work well is in multi unit properties. If you have a 50 unit apartment and you typically have 4 vacant, including a vacancy provision of 4/50 = 8% makes sense. With single family properties, they are either 100% rented or 0% rented so vacancy factors do not work as well.
Could we add a constant to all of our calculations, perhaps a 3% reduction in rent to account for vacancy? Yes, but if we included an arbitrary constant to all calculations it would not change the relative return between properties. And, the impact of your taxes has a far greater impact.
In some of our calculations we use an annual maintenance constant for single family homes of $600/Yr. A few years ago we looked at actual maintenance costs for multiple single family homes and it was averaging about $475/Yr. But, if you wanted to estimate a maintenance provision, here is how you would do it.
Suppose I assume that $600/Yr is a "typical" ongoing maintenance provision and the property rents for $1200/Mo. I would calculate the maintenance provision as follows:
$600 / (12 x $1200) = 4%
Or, if I use the actual average we determined of $475/Yr. I get the following:
$475 / (12 x $1200) = 3%
With town homes our experience is that maintenance is less. We have one client who has had no repair calls in 3 years but that is an exception. If I assume two calls per year for town homes and each call is $100 I get the following:
200 / (12 x 1200) = 1.3%
Note that such low maintenance costs are not typical. A lot of real estate sites use 10% of annual rent as a maintenance provision. This was certainly valid (probably a little low) for the properties I owned in Atlanta and Houston. There I was always replacing roofs, siding, gutters, windows (wooden) and landscaping. Almost none of this applies to the construction we have in Las Vegas. See the image below for typical class A and B construction.
The internal systems (HVAC, water heater, etc.) are pretty much the same everywhere. I hear the argument that the AC has to work harder in Las Vegas since it is very hot compared to a place like Atlanta, etc. I do not agree with this statement because the properties here are much better insulated and have double pane windows, etc.
Again, we could add a constant to all of our calculations but it would not change the relative return between properties.
In summary, estimated return is a tool for comparing properties. Adding constants into the equation would not impact the relative difference between properties.
Hope this provide some insight into calculating a vacancy and a maintenance provision. If you have questions, drop us an email and we will get back to you.
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