Maintenance, Vacancy and Rehab Constants
There is a common belief that you can create a universal constant for vacancy rate, maintenance, rehab, etc. that will apply equally well to all properties. This belief, while popular, is false. I will explain why and provide an alternate method that works. Let's start with a maintenance example. Suppose you were tasked to determine a single monthly maintenance for the two cars illustrated below.
One is a new small car and the other is a wrecked Humvee. If you chose an amount to match the new car, it would be insufficient for the Humvee. If you chose an amount that would match the Humvee, it would be way more than what is needed for the small car. If you decided to use the average cost, you would be wrong on both. Population averages do not apply to the individual members of the population.
Population averages fail even when items are similar. For example, suppose that the table below is the annual maintenance cost of each unit in an apartment. Note that the average annual maintenance cost per unit is $500 for both years. As you can see, the actual cost of each unit is very different. Especially for unit #6 in year 2. Averages can be poor representations of the individual members.
|Unit #||Year 1||Year 2|
A Better Method
I will propose a better approach based on the condition of expensive components. Before I get into this, below are the most expensive maintenance cost items. Note, the numbers below are "typical" for Las Vegas. This means that the numbers shown are not accurate for any specific property.
|Cost Item||Typical Cost||Occurrences|
|Tile Roof Replacement||>$10,000||Never|
|Tile Roof Repair||$1,000 - $2,000||2 times|
|AC Compressor||$2,000 to $3,000||3 times|
|Water Heater||$800||5 times|
Unless you have some reason to suspect a total roof failure, I would not provision $10,000 for a replacement roof. On roof repairs, we have had to make repairs twice, still a low probability. Replacing an AC compressor is a higher probability. So, provisioning for an AC compressor might make sense, depending on the age of the current unit. AC compressors have a useful life of 15 to 20 years. What if the compressor was replaced 5 years ago? Probably not.
Did you notice that I kept using "probability" and "odds"? That is because you cannot predict when something is going to fail. You could have a 2-year-old property and have the roof, water heater, AC compressor all fail on the same day. However, the odds of this occurring are low.
Another problem I have with the universal constant percentage is that there is no cap. Suppose you put aside 7% of the rent for maintenance. If the property rented for $1,400/Mo., below is the amount of money you would accumulate over time. Does this make sense? No. But applying a universal constant percentage suggests this is the case.
The property manager we work with uses $300/Yr. as a maintenance provision. As long as you are not anticipating the failure of an expensive component, $300/Yr might be a good amount, for the A class properties we select. Would this amount always work? No.
What if you had 10 properties and none had the AC compressor recently replaced? Would you need to set aside 10 x $2,500? No, the odds of more than one property needing a replacement compressor at the same time is small. What I would do is to set aside a portion of the rent each month until I reached $2,500. Once I reached my target reserve, I would not continue to add to the reserve.
Another factor to take into account is the cash flow from the properties. For example, suppose each of the 10 properties generated a cash flow of $200/Mo. or $2,000/Mo. If you had to replace a compressor, you have the $2000/Mo. cash flow from the properties and would only have to pay the difference: $2,500 - $2,000 = $500. In most cases, the more properties you have the lower the total reserve you need.
There is also no universal constant for rehab. Every property is unique. I read that the rehab cost for a distressed property in Detroit is between $75/SqFt to $125/SqFt. In Las Vegas, "typical" rehab cost is between $5/SqFt and $10/SqFt. What rehab constant applies equally well to a property in Detroit and a property in Las Vegas?
Vacancy is the same situation. A few years ago I did a study on 4-plexes here in Las Vegas. I found that on average there were 5 tenant turns per year per 4-plex. Looking at the individual 4-plexs, some had less only one turn, others had more than 6 turns per year. On our A class properties, our average tenant stay is over 4 years. There is no universal constant you can use for vacancy. If I had to had to determine a constant for our A class properties, I would do it as follows.
I will assume that every tenant turn (rehab plus tenant acquisition) takes 1 month. If this is the case, we can compute the percentage of time the unit is vacant as follows.
|Years||Total Months||Vacancy (Months)||% Vacant|
I would use 2% as a reasonable approximation for the set of A class properties we select. This number would not work for any other set of properties. Again, this an "odds" situation. Could the tenant stay for more than 10 years? Yes. Could every tenant leave after 1 year? Yes.
There are no universal constants. And, averages of a population rarely apply to the population individuals. You can determine a maintenance provision based on the age of specific components. There is no constant of any kind that will handle rehab. On vacancy, the best you can do is to look at the property and the location and guess. With all provisions, set a goal and then stop adding funds.
This approach allows you to tailor the provisions to each property. Still, it is always a situation of odds. An AC compressor with a useful life of 15 years might fail in 1 year or last for 30 years. Just select a reasonable provision amount and stop accumulating after you reach that amount.
You can combine provisions. Suppose you decided on a $1,500 vacancy provision (one month's rent) and a $1000 maintenance provision. The total provision is $2,500. What are the odds of both occurring at the same time? More than likely a $1,500 provision would cover both.