The correct calculation for a rental property’s operating expenses are crucial to real estate investment analysis, and play a vital part in real estate investment decisions.
That seems obvious, and almost redundant to restate, but truthfully, even with quality real estate investment software, many do present APODs (annual property operating data) and proforma income statements with operating expenses commonly skewed in three areas.
- Vacancy rate – the tendency for many is to show a vacancy rate based on the past performance of a 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.
- Maintenance and repairs – it is a mistake to show the amount actually spent over the past several years. It is helpful for a real estate investor to know what an owner has done to upkeep the property, but past expenditures are not necessarily relevant to what a new owner might spend in the future. The current owner, for example, might be a repair-person capable of keeping maintenance and repair costs reduced, whereas the new owner might be required to contract it all out at top dollar.
- 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 investment analysis because it provides for future replacement of worn out items an owner must eventually pay for and therefore plan to spend.
If you are doing a real estate investment analysis, and uncertain what allowances to include for vacancy, repairs, and reserves, ask a local appraiser, or perhaps a local real estate professional who understands rental property.
The important thing is not to make real estate investment decisions based on incomplete operating expense data. It might easily result in your dream investment property becoming your worst nightmare.
