House Buying Philosophies

I’ve been working with a real estate agent the past couple days who continues to try to sell me a few overpriced duplexes. I’ve tried to explain to her several times my conservative buying philosophy, but it doesn’t really seem to be getting through to her. Today, I received an email trying to sell me the same property that I turned down yesterday, with justifications about why my thinking was too conservative. She asked a number of questions and made some implications that indicated that she hadn’t thought about (or owned) investment property to any large extent, and I spent some time writing a long email back to her, explaining my buying requirement and my “philosophies”.

I figured I’d post some of that here, so if any other agents I’m working with read my blog, they’ll get an idea of how I think:

1. Why do you figure property management into your expenses? You should just be managing the properties yourself!

My ultimate goal is to own hundreds of units (mix of apartments, houses, and other commercial). While I could definitely property manage 10-20 units myself, once I have more than that, I’ll need to either hire a PM company or start one myself. Either way, I’m going to have to pay between 5-8% for that expense. So, even if I choose not to use a PM company now, I want to know that if I start using one later (if I leave the area, have too many units, etc), that I know each of my properties can still cash flow. I’d hate to be in a situation where I had 30 houses, needed to hire a PM company because I was moving, and then found out that all 30 would start to be cash flow negative because I needed a PM.

2. Why are you assuming $100/month for maintenance when the place is newly renovated and likely won’t require much maintenance at all?

A lot of people might think $100/month is a lot for maintenance on a newly renovated house. Those people probably haven’t owned any long-term rentals; remember that while maintenance might be $10/month this year, at some point in the next 10-15 years the house is going to need a new roof ($4000), new HVAC ($3000), likely to have at least one major plumbing/electrical problem ($2000), etc. Most long-term landlords budget about $1000/year for deferred maintenance and capital expense reserves. While I could make good money on this house for 10 years, eventually there would come a year where I’d have to spend $5000-10,000 to keep the house updated, and if I hadn’t planned for that expense, it could wipe out all my profits from those 10 years! A lot of landlords don’t think about this, and that’s why they end up desperate to sell, because after several years of ownership they have a place that needs $10K in deferred maintenance expenses and don’t have the cash.

3. Why do you assume such high expenses in your projections?

If you do some research (IREM, National Apartment Association, etc) you’ll find that the national average for expenses on a single unit – across hundreds of thousands of units nationwide – is about 45-50% of gross income. Based on that, I will generally assume that for any new property I purchase, I will likely be spending 45-50% of income per year on expenses. If the property turns out to be good (and so do my management skills), my expenses may come in lower, and that’s more money in my pocket. But, I don’t want to assume they’ll be lower, and then lose money. This is why so many landlords lose money, because they *assume* that their management skills will allow them to cut expenses below the national average…I like to assume my expenses will be in line with the national average, and not take any risks. One day when I own a lot of rentals, I’ll be able to project my average expenses (and benefit from economies of scale), but I’m not there yet.

4. This is the cheapest duplex on the block! You really should be looking at the comps when you make your buying decision…

I agree that looking at comps is important when buying a single family home, because resale value will be related to the comps. But, that’s because you are more likely to sell a single family home to someone who will live in it as opposed to an investor. As for a multi-unit residence (duplex, triplex, apartment building, etc), your buyer is going to be an investor. Generally, that investor isn’t going to buy based on emotion or sentiment, he/she is going to buy based on how much money the property will make him/her. So, whenever I deal with a multi-family property, I assume that I will eventually need to sell it to an investor, and I will need to ensure that the investor I sell it to can make money on it (otherwise I may not be able to sell it). If I can’t make money on it, I assume the next person won’t be able to either, and then I’m taking the risk of not being able to sell the place, regardless of the comps. If your duplex were sitting next to million dollar mansions, it doesn’t make your duplex worth millions of dollars, because you can still only rent it for a total of $1700-$2000 month.

5. Why do you care about cap rates?

When assessing multi-family residences (not so much duplexes, but it still applies to a degree), I always figure out the cap rate I’d be getting. If the cap rate is less than 7%, I run into two issues: 1) my cost of capital (the interest rate on the loan I’ll get to pay for the place) is about 7%, so I’ll be breaking even just on the interest I’m paying on my loan, and 2) I can get a 5% interest rate by putting the money in a high-yield savings account, why would I want the headache of managing a rental for basically the same return? So, I like to see a cap rate of at least 8%, which also happens to be the average in this area for small apartment buildings.

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