You Must Consider Vacancy and Turnover Costs in Every Real Estate Investment

I hope everyone had a wonderful Memorial Day weekend Let’s start off this week with another discussion of real estate investment analysis. It is my contention that vacancy and turnover costs are an area that optimistic real estate investors bury their heads in the sand when they consider an opportunity. I wanted to jump into this topic and provide some education on how to make better decisions when you consider your next deal.

The Overview

I have much respect for people who work in private equity and investment banking. They have complicated financial statements to analyze and conform to similar types of companies in order to determine valuations. Real estate, on the other hand, is a really easy business to analyze. You have rental income, then you factor in some vacancy factor to arrive to effective rental income. You subtract out your operating expenses to arrive to net operating income. You assign and divide a capitalization rate to that net operating income to come up with a value and you’re done. You don’t need to go to Harvard Business School to learn how to analyze real estate financials. I’ll show you how it looks like below:

Income

+Gross Rents

-Vacancy Factor

=Net Effective Rent (A)

Expenses

-Insurance

-Property Taxes

-Utilities

-Landscaping

-Management

-Repairs & Maintenance

-Commissions & Turnover

=Total Expenses (B)

=Net Operating Income (C) = (A)-(B)

-Mortgage Interest Expense (D)

=Net Income (E) = (C)-(D)

In a typical setup of financials like the above, the opportunity for you to suppress expenses is minimal. You get very little room to negotiate your insurance rates. Your property taxes are set by the county it resides and requires a formal appeal to lower it. Your utilities can sort of be reduced through efficient design and solar, but that requires a significant capital investment that may not pay off in the short to medium term. Maybe you can save on management fees at the expense of having an apathetic property manager running your very valuable asset. Finally, landscaping cost is what it is, so please don’t come after your landscapers’ paychecks as a strategy to boost your cash flow.

Commissions & Turnover Expense

So with the above in mind, the only place to maximize your cash flow is through higher rents. However, the cost of turning a unit over can be lethal to your long term plans of achieving consistent, steadily growing positive cash flow. Successful real estate investors have a long investment horizon and rarely succeed when they pursue quick or short term gains. Just ask the majority of the house flippers back in 2008 how that went for them. My business partner, Eric Cuevas, always reminds me that slow and steady is the way to win the real estate game.

I believe the most typical type of product you see aggressive underwriting assumptions are with smaller properties adjacent to universities. Usually, these type of properties command premium rents because students will pay to live there and usually pay a premium over other longer term residents since their housing costs are paid for by a combination of parental support and student debt. As a result, inexperienced investors look at the premium on these rents as being one with no downside. However, you should consider that in a 3 bedroom apartment, for example, there might be 4 or even 5 students living there during the year. So you’re talking about quite a bit of usage of that property which will cause your repair expenses to spike in comparison to a smaller household. Further, the concept of student housing is transient in nature, since students don’t go university for the rest of their lives. Therefore, you have to factor in vacancy in your calculations. Even if you nail your re-lease perfectly, you still need at least a few days to a week to turn the unit over and prepare it in a condition that’s suitable for the next tenant. Assume 7 days, which is 1 week out of 52, or roughly a little under 2%. Therefore, even if you rent the space for $3,000/mo, your effective rent is really 98% of that or $2,960. This is very important to keep in mind as you set your expectations for your investment.

Also, let’s not forget leasing commissions. Few property managers are delighted to negotiate new leases without some form of compensation over above their monthly management fee. Typically, the monthly management fee handles the routine and day to day basics of running a property. A typical professional property manager would charge a percentage of the entire lease for a leasing commission. Assuming it’s 6% of the entire lease term, that would amount to an immediate one time payment of $2,160 on a new lease of a $3,000/mo unit ($3,000x12x6% = $2,160). So if you divide this over a year, that’s a reduction of $180/mo in rent that you’re effectively collecting. Combined with a perfect turnover scenario like the above, your $3,000 per month rent looks like $2,780 in reality. If I found an opportunity with a much longer term tenant for around $2,800/mo, I’d probably take that investment.

Also, as a final thought, it’s a really good idea for your property manager to take charge of the leasing effort and if they have to work with outside real estate agents to source new tenants, that they feel comfortable with the tenant opportunity. Solely relying on outside agents might cause you nightmares since the agent is primarily incentivized to close the deal and doesn’t have to live with the problems a potential tenant might cause down the line.

Hope this helps you as you consider your next investment. Let us know your thoughts!

-Stephen Morris, CPA, MBT, CCIM