Ironically, there are times when you should avoid using the “real” numbers in a rental property analysis to prevent deriving a faulty bottom line. In this article, we will discuss what these numbers are and how you should enter them in your next real estate analysis.
Bear in mind that real estate investing requires accurate income and operating expense numbers to make prudent real estate investment decisions, and often it’s just a matter of showing current figures in the real estate analysis, such as current rents or current property tax. In other words, in this case, the “real” number is what it is, and the analyst would want the bottom line to reflect that number.
Okay, let’s look three instances when you should avoid the mistake of using a “real” number.
1) Vacancy rate – the tendency for many is to show a vacancy rate based on the past performance of the rental property—sometimes even at zero percent. This is not realistic, however, because market conditions, property wear and tear, rent increases, and even a change of ownership can (and often do) cause vacancies. It is always prudent in real estate investment analysis, therefore, to include an allowance for vacancies characteristic to the local market. For example, if the market indicates a 5% vacancy, then use a 5% vacancy in your analysis.
2) Maintenance and repairs – it is a mistake to show the amount actually spent over the past several years for maintenance and repairs. Yes, it’s helpful for a buyer to know what an owner has done to maintain the property, but past expenditures are not necessarily relevant to what a new owner might spend in the future. Whereas the current owner might have a relative to maintain the property at reduced costs, for instance, the real estate investor who is purchasing the property might be required to pay top dollar to a contractor.
3) Replacement reserves – most tend to ignore this altogether because reserves for replacements are not a fixed reoccurring expenditure like property taxes, utilities, or trash. It is, however, wise to include an allowance for reserves in a real estate analysis because it provides for future replacement of worn out items an owner must eventually pay for, and therefore it’s best that an investor plan ahead to spend it.
An experienced real estate appraiser or real estate agent who understands rental property can advise you concerning these numbers. Here’s what you want to know:
(a) Typical vacancy rates in the area for whatever-type property you want to analyze
(b) Typical percentage used to estimate maintenance and repairs (you should get one percentage for brand new or newer units and another percentage for older units)
(c) The dollar amount per unit per year to include for replacement reserves.
Here’s to your real estate investment success.
