As I mentioned in our last post, we bought our first rental property about two months ago. Based on the calculations that I had done I thought it was going to cashflow (the amount left after paying all of the expenses and the mortgage) around $300 a month.
I had been using this excellent spreadsheet from F.I. Nomad to analyze properties. It is a really great tool and helped me narrow my search and filter out properties that wouldn’t be worth my time to walk through if they didn’t meet my cashflow criteria.
Even with this great resource and my penchant for overanalyzing many things in my life, I made some minor mistakes with this first purchase. I just wanted to briefly vent / share some of my lessons learned (so far) from our first rental property:
I knew about this one before I made my offer and factored it into my numbers. However, I didn’t really think about the amount of money lost because of this. If a house falls within a high-risk flood area, lenders require you to obtain flood insurance. This price can vary based on the risk profile of the area and value of the house. This was $900 annually our case – that’s $75 less in monthly cash flow 🙁
Water & Sewage
I plugged numbers into the spreadsheet based on the amounts that we pay on our primary residence per quarter for water and sewage. These matched up with some other estimates that I was seeing on BiggerPockets so I figured it was a safe bet.
I found out at the closing that the city where we bought our duplex charges $108 per unit per quarter for sewage. That was more than double what I estimated. The water rate was also much higher than the town that we live in as well. Beyond that, my family and I are apparently water misers – the average water usage per person per month (3,000 gallons) works out to be over twice the amount that we use in the same time frame. So using our personal numbers as a guide was a mistake.
Repairs and CapEx
When I first grabbed this spreadsheet it had a default of 8% for CapEx and no mention of an ongoing repair budget.
What is CapEx you ask? CapEx is short for Capital Expenditures – large repairs that come up sometimes, but not all the time. Things like roofs, furnaces, water heaters, windows, paint, flooring, etc are examples of CapEx. Repairs are smaller things that occur more often – replacing electrical switches / outlets, replacing a sink or toilet, etc.
The original version of the spreadsheet that I downloaded had no mention of repairs being separate from CapEx, so I just ran with it at 8%. The more and more I thought about things and read other’s stories I realized that this was not going to be enough. I decided to set aside money for repairs separately at 5% of gross rents. I plan on keeping close tabs on this for the first year or so and making a decision on the need to up this. With our situation of having two W2 incomes to cover any overage, we can take that risk for right now.
On the CapEx front – after analyzing all of the major repairs that could come up, how old the current items were, and factoring the useful life of each item – I came to the conclusion that a flat number per unit (based on the actual costs associated with that property) worked much better. Brandon Turner has a great article about this on BiggerPockets.
For example, say that you buy a decent single-family house in a working class town that rents out for $900 a month. A percentage based approach – of say 10% – would tell you to put away $90 per month. But what happens if the roof only had a couple of years left and the furnace and water heater were ancient and they all need to be replaced in the same year, in your third year of owning the property? While no one has a crystal ball and almost no amount of planning would help to deal with multiple repairs coming in at once, it’s better to cater your CapEx numbers to the needs of your actual property.
When It Looks Iffy, Fix It
Slightly related to the topic of CapEx is the importance of being pragmatic when looking at the long term health of a property’s major items. After agreeing to purchase our first rental property as we headed out of town for a week long beach vacation. Upon returning, I met up with a home inspector to walk through the property. Overall, the property had been very well taken care of but it did have some warts.
The biggest one was the state of the roofs – the seller disclosure mentioned that the roof had been replaced in 2006 – and this was partially true. One of the roofs… over a smaller addition to the back of the house… had been replaced in 2006. But the other roofs were in varying states of ouch.
When I initially went to look at the property with my agent and my sons, we approached it from the back of the property. The house is in a very busy urban area and given that it was our last stop of the day after viewing two other houses, we didn’t bother to cross the street and look at the house from a distance. These facts seem trivial until I realize that if I had simply crossed the street, I would have seen that the front porch roof was a total mess (as pictured at the top) and that the main roof was missing shingles. A sharper eye to notice these defects would have made my offer on the house much lower than it was.
I knew that the front porch roof would need to be replaced, and that the main roof needed some repairs. The home inspector also pointed out the deteriorated exterior trim on an attic window and the fact that half of said window was boarded up. Despite the lender not having any concerns about this, I knew that these would all need to be fixed in the short term.
As fate would have it, a few weeks after closing, I received an email from my insurance agent saying that not only did all of the repairs noted above need to happen, but the main roof had “reached the end of it useful life and would need to be completely replaced”. So a mere $2,500 “get to it when we can” repair bill ballooned into an $8,000 “do it right now or we are cancelling your coverage” one.
I could throw my hands up in the air and curse my luck – but why? The insurance underwriter was right, the roof was 40 years old at best guess and needed to be replaced. This again was something that could have informed my decision on how much to offer.
Going forward, I plan on having a sharper eye for repairs and defects with major items on a house. This will allow me to adjust any offer I might make on a property as well as the added benefit of knowing what kind of initial cash layout I need to acquire the property and bring it up to a reasonable habitable level.
Shop Around – Homeowner’s Insurance
One and a half years ago I switched my homeowner’s insurance for my primary residence from an old-guard brick and mortar insurance company to Geico / Liberty Mutual. Their rates for identical coverage were 50% of other’s quotes on my own home. So I just assumed that they would be able to offer the best deal on landlord insurance (homeowner’s insurance for non-owner occupied properties).
Wow was I ever wrong. I got a quote from them about two days after agreeing to buy the property and just accepted it… for a few weeks. Then I read around at the rates others were getting, and they were much lower, on more expensive properties. So I reached out to an insurance broker that was recommended by many in a local real estate investors group. He was able to get me many different quotes, all with better coverage then the original policy for about 60% of the price.
My initial decision to not shop around is what led me to getting my current insurance lined up so late, which is what led to the insurance company’s property inspector reporting back to the underwriter right before closing. This in turn, led to the underwriter not informing me of their requirements for roof repairs until 3 weeks after closing. Taking care of insurance earlier would have allowed me to begin shopping around for roofing companies before three weeks of straight rain hit our area and filled up every reputable roofer’s schedule for the remainder of the year.
Shop Around – Lenders
I had the plans and the funds (for a down payment) for about a month before I made my offer on the property. I had made a few exploratory phone calls and emails to a few local banks on loans for investment properties but I didn’t ask the right questions, or even bother to get prequalified. This put me in a position where I wanted a property that I knew already had offers on the table and I felt like I needed to line up financing right away. To this lender’s credit, they were able to get me a prequalification letter in under a day and everything moved as quickly as I needed it to. Also, given the current environment at the time, I feel like I got a decent rate and terms (5% at 15 years) for a non-owner occupied property. But I will be shopping around next time (ahead of time) and comparing various criteria – interest rates, terms, origination fees, etc. to create the best situation for myself.
When we made an offer on this duplex, the upstairs unit was vacant and the downstairs unit was occupied – by the current owner’s son. The plan was that if the son wanted to stay we would offer him a lease to sign (due before closing), and give him a slightly reduced rate for the first year. This was mostly as a gesture of good faith and to save us the headache of finding tenants for two units at once (we were originally planning to self-manage).
As the weeks progressed and the closing drew nearer and nearer, it came to light that the current tenant was actually going to move and he agreed to be out before closing. When we did our final walkthrough the night before the closing, we did notice that the carpets in the most recently occupied first floor unit were a bit rough and would need to be cleaned, and it couldn’t hurt to clean the ones in the lightly used second unit as well.
We also realized that we should get the locks rekeyed for both units as a security measure. This combined with the carpet cleaning were a few hundred dollars of costs that we had not counted on incurring from the getgo. Given, we could have cleaned the carpets and rekeyed the locks ourselves and saved some money, but there are still costs involved.
Even after cleaning the carpets for the first floor unit, prospective tenants were complaining about the smoke smell (as a former smoker of 15 years, I disagree but I didn’t have to live there, and it did smell a bit musty I’ll admit). The unit was getting multiple showings every week but no one was biting at the current price. So rather than drop the rent, we agreed to go ahead and replace the carpeting with Allure flooring – a vinyl flooring variant that has a reputation of holding up well – and have the entire unit repainted. This was a repair that we wanted to do for that unit eventually and spending a few thousand to get the rent we wanted was a decent return on investment.
That all being said, we didn’t account for those expenses because we hadn’t done this before.
To Manage or Not?
In the days and weeks after we made our offer to buy the property, we had aspirations of leasing and managing the property ourselves. I had read a few books on property management and there were many cases of investors managing their own properties littered across the internet. However, after researching leases and state landlord-tenant law and realizing that every time we needed to show a unit, we would need to make the 25 minute commute each way to the property, we started asking around about property management companies.
After shopping around, we decided to go with a property management company run by another real estate investor who had many positive reviews and referrals from the local investor groups. Could we manage the property ourselves? Sure, but there are a few reasons why we don’t.
- There is a steep learning curve and ramp up time to have the proper processes and systems in place to deal with whatever a tenant / property / life throws at us.
- Between a 40 hour work week and a 30-40 minute commute home, adding a commute in the evenings to show the rental (until it is leased) is a large time sink, especially while raising four children.
- Eventually we plan on expanding our holdings to more properties / units and even if we could manage one or two properties ourselves, we don’t need another job.
- The right property management company is going to be run by professionals who know their stuff and have years of experience in the industry. We could spend the time to increase our own knowledge in that area, but we would rather spend our time on pursuits with better emotional ROI (time spent with family) or financial ROI (professional development / training for our full time jobs)
Obviously property leasing / management costs money – generally the first month’s rent for leasing and 8-10% of gross rents for every month after.
While we don’t enjoy spending more money on the initial cash outlay and making less cashflow than planned, we view these bumps in the road as learning experiences that will allow us to be better prepared for future investments:
- All real estate investing is local and every property is unique. Never use numbers, percentages or estimates from anyone else without doing your own due diligence.
- Look closely at all of the major mechanical parts of every unit and be realistic about their useful life. Personally, going forward we are assuming at least $10,000 in repairs on pretty much any future acquisition, no matter how “turnkey” it looks.
- Shop around for everything and ask more questions than you think you need to. Sometimes the only cost to information is taking the time to ask the question in the right way. The right information can be the difference between needing to spending an extra few thousand on repairs or not.
- Take care of the nuts and bolts of closing as soon as possible. We will be lining up quotes from different lenders before we make an offer on my next property, so that we know exactly what rate we can get, how much the closing is going to cost, etc. Then right after we have an accepted offer we will be getting insurance quotes as soon as possible
I hope that this post helps shed some light on some of the realities of getting started in real estate investing.
If you have had better or worse (or simply more entertaining) stories about investing in rental properties we would love to hear about them in the comments