Universal Vacancy and Maintenance Provisions
There is a common belief that you can create a universal constant for vacancy rate, maintenance, rehab, etc., which will apply equally well to all properties. In this article I will explain why such universal constants are impossible.
Averages Can Be Deceiving
The universal constants people use are typically based on averages. However, averages can be deceiving. For example, would you be comfortable living in a climate where the average temperature is 72F? Sounds pretty good, right? However, what if I told you the daytime temperature was 445F and the night time temperature was -300F. The average is 72F ((445 - 300) / 2)but it would not be a desirable place to live.
Suppose you were tasked to determine a monthly maintenance provision for the two cars illustrated below.
One is a new small car and the other is a wrecked Humvee. Whatever amount you chose to match the new car, would be insufficient for the Humvee. And, if you determined an amount that would cover the maintenance cost on the Humvee, it would be way more than was was needed for the small car. If you decided to average the cost for both vehicles, you would be way of 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 you have 10 properties. Let's look at two examples where the average maintenance per unit is $500. The rows are the unit numbers and the columns are annual maintenance costs per unit that average to $500.
|Unit #||Ann 1||Ann 2|
If you planed on an an annual maintenance expense of $500/Yr. and owned unit #6, you would not be happy. This is another example where the population (10 units) average ($500/unit) does not equate to the individual unit cost.
Calculated ROI is not necessarily the return you will experience. Return is heavily impacted by your tax situation. Plus, you can have positive cash flow but a a negative taxable income. The only way I know to estimate the actual benefit of a given property would be to create a spreadsheet that accurately represents your total income and tax situation. You could then add the property (deductible expenses, depreciation, etc.) to the model and the differ it creates to the bottom would be a good estimate of your actual return.
What ROI can tell you is which property is likely to do better than another property. For example, suppose the calculated return for two properties is as follows: Property A: 4% and property B: 6%. Assuming all other things being equal, property B will generate a higher turn than property A. How much more, it depends on your tax situation. I have seen over a 10% increase in effective return due to individual tax situations.
Constants and Return Calculations
As we discussed, applying a single (universal) constant across properties of various ages, locations and conditions makes no sense. But, what if there was such a constant. How would impact comparing returns of different properties? Spoiler alert, not at all. For the math inclined, below is an example showing that it would make no difference when you are comparing properties.
Suppose you had two properties, which I call property A and property B. I will designate the return that property A and B generate as Ar and Br. The difference in return between property A and property B would be: Ar - Br. Suppose I subtracted (or added) a constant, which I will designate as "X", to the return of each to account for rehab, vacancy and maintenance. You would calculate the return including the X factors as follows. As before, the difference in return between the two properties is: Ar - Br. Now, if we include the constant X in the equitations: The return for property A would be: ROIa = Ar - X and for property B: ROIb = Br - X. If I calculate the difference in return between the two properties the formula would be ROIa - ROIb. If we plug in the values for ROIa and ROIb, we get the following: (Ar - X) - (Br - X). If I remove the parenthesis I get: Ar - X - Br + X. Since you a +X and a -X, the two will cancel each other. So, the difference in return would be as before: Ar - Br.
Should You Have Provisions?
Yes, setting aside an amount for future repairs and such makes sense. How much to set aside depends on what you expect the expense to be. For example, the most expensive repair will normally be an air conditioner compressor. The two that I recall our client's replacing cost about $2,500. So, what you might want to do is to set a side some amount each month until you reach a number such that if the compressor failed, you would not be devastated. In this case, I would set aside an amount until I reached about $2,500/ And, once you accumulated this amount I would stop adding the the provision.
What if you had 10 properties? Would you need to set aside 10 x $2,500? No, the odds of more than two properties needing a replacement compressor is small. What I might do is to set aside a portion of the rent until I reached $5,000.
Another factor to take into account is the cash flow from the properties. For example, suppose all 10 properties generated a cash flow of $200/Mo. In this example, the properties generate a total cash flow of $2,000/Mo. If you had to replace a compressor, you have the $2000 cash flow from the properties and would have to pay the difference between the cash flow and the repair cost: $2,500 - $2,000 = $500. So, depending on the properties, the more properties you have the lower the reserve you might need.
In this article I attempted to explain why an average maintenance does not apply to an individual property. Also, if there was a universal constant for maintenance (etc.) and you applied it to return calculations for all properties, the difference in return between properties is unchanged. Also, your actual return is not necessarily the calculated return. Actual return is heavily dependent on your tax situation.