Calculating Rental Income & Expenses - EP11

Steve, Sherida, and Chase talk about what it's like to calculate income and expenses BEFORE building an investment property.

These estimates can be hard to get right on a build-to-rent investment since it's all somewhat speculative in nature. In this episode, our hosts talk about what strategies have/haven't proven to be effective now that they've done a good number of real estate projects.

"Typically in a property management agreement, The managers are allowed to spend up to $300 a month on just incidental stuff… clogged toilets, broken lights… which without having to tell you. So if every month, $299 is coming out of your rent, you know this has become a business model for them. They’re just going to nickel and dime with maintenance as much as possible." - Steve Olson, B2R Show

Steve Olson: Welcome to the Build-to-Rent Podcast. Good to have you listening to the show today. I'm Steve Olson. I have Chase Leavitt and Sherida Zenger with me. We are going to cover a topic that can make or break your deal.

In our last episode, we went over exit strategies, and guess what? Your exit strategy is toast if you don't get this one right. This is a harder one to get right given its semi speculative nature.

We're going to talk about drilling down on income and expenses and the ways that we've found useful to do that.

So let's get into it a little bit here, because when you buy an existing asset, it's a known quantity, right? You've got to give a better return to your investors on build-to-rent because it's not a known quantity.

There's a lot of things that you can go out there and you can vet out. You can discover that would make a compelling case for why your build-to-rent is good. But is it really good?

So one thing that I've done in the past to quickly vet out, do some due diligence on whether a project is worth exploring more or not is to just use a generic what's called expense ratio to say, I'm going to take 35% or 40% or more of the rental income reserve it for expenses.

And then based on my financing and everything else from. I can back into whether this is a good cap rate, whether it's a good return or not correct, but that doesn't always necessarily work in that, that for an amateur, isn't going to be the way you make the final decision on a, on a project. So let's talk about drilling down a little bit tighter on some of these expenses and how we would determine them.

We'll start with a softball. Okay. Cause I'm, I'm pitching. Right. So number one, what about property management and how do we drill down on property management? What would you, what would you say to the listeners?

Chase Leavitt: So with property management, understand your options and what percentage they're going to be charging because this falls underneath expenses, right? And so we'll see what your options are and see what value they're getting. Not only what they're going to be charged and to manage, but also charging for lease-up. Make sure you get all the fees, all the expenses in. And then that's what you put that in your expense ratio.

Sherida Zenger: Interview a few different property management companies, because one may say one thing and one may say another, but like chase said, make sure you know what fees are included. I know our property management charges, if they're going to notify a tenant because you want to do a walkthrough or an appraisal if you happen to be selling things, there are different fees that they charge along the way.

So make sure you know, all of those fees ahead of time, because somebody may tell you that. A lower rate, but it really isn't all said and done because they have a bunch of Allah cart stuff added on top. Like, are you full service or not?

Chase Leavitt: Yeah. And the other way they can hide that a little bit too is, okay, there's value with repairs. Right. And there's value in having different maintenance guys come in and control the repairs. If repairs are not. But are they going to get a percentage of that or a dollar amount of that? What does that look like? Does it make sense? Because there is time and value that maybe they should get paid, but are they going to be more motivated to get a lot of repairs done within your unit because they're getting paid for it.

Steve Olson: Are they making maintenance a profit center?

Chase Leavitt: Exactly. Yeah. So really take a close look there.

Steve Olson: Typically in a property management agreement, The managers are allowed to spend up to $300 a month on just incidental stuff… clogged toilets, broken lights… which without having to tell you. So if every month, $299 is coming out of your rent, you know this has become a business model for them. They’re just going to nickel and dime with maintenance as much as possible.

You found that out too late, right? We're talking about vetting your income and expenses. This you don't know until later if they're actually doing. Referrals and interviewing on the front end. I mean, we've interviewed a lot of property management companies together because it is a little bit easier of a number to drill down on assuming its apples to apples, right.

Are the cause, you know, if, if it's a manager for a whole apartment complex, they're gonna have very low management fee, but you're going to have payroll and marketing and advertising budgets on top of that, which would typically be FIC. Regardless of your vacancy rate, right? So you have to understand that too, but this number is, is only as good as your rents, which we'll get to drilling down on rents in a minute, because typically most of your management fee is a percentage of rents, right?

So we'll get there. So that's management, this one's a stinker. What about taxes? How do we drill down on taxes? Because this is a new property. It's not on the tax rules.

Sherida Zenger: So we've usually gone to smartasset.com and they've been pretty good. I mean, they, we kind of had John being conservative, so we'll maybe jump up the price and we're basing what we put into SmartAsset on what we think the value is going to be once it's completed or the sales price.

Again, this is going to be an assessed value in most of the states that we're in. So we don't know what this number is going to be. Not being the same as what you paid for it. You know, they're not going to tell you the secret formula that they have hidden away in some vault.

SmartAssets has been great. Also, another thing is to go to the surrounding areas and try to find a similar property can kind of give you a good idea.

You want to stick with something that's similar. Um, although that doesn't necessarily always matter, just the newer you can find and something that's more of a like-kind again, we err on being conservative. So we always put that a little bit higher.

Chase Leavitt: If you have something that's similar or a good comp and you can see where those taxes if it's been around for one, two-plus years, you can see where those taxes are at.

Just look at the county records. If it's a new area, that's where it gets a little bit tricky and there are not good comps at all. Then you can probably get in touch with the county assessor. I think we've chatted with one in salt lake at one point that was very helpful. Try to chat with some down in Arizona, which was hard.

They have a really, really tricky formula and I can't figure that one out. Um, smart assets. Good. It's a website you go into, as you talked about, you just put in the city and it'll populate a kind of an average of what that tax rate generally. It's pretty liable. It's pretty close.

Sherida Zenger: Title companies can help too. Some title companies don't want to help. I know Arizona, they refuse to give any kind of information. The title company we use in Utah is usually pretty helpful. A lender can help to kind of tell you, Hey, this is what we're going to base property taxes off of and give you an idea.

Those are, that depends on the loan and those, I found those are they're being high a lot of times.

Steve Olson: Well, it's funny you say that. Cause I was going to do another quick poll who is more useless on property tax information, title companies, or the county assessor.

Sherida Zenger: I'm going to back up. I'm gonna say, county assessor. Cause I don't think the county, his sister wants to give you any information.

Because they don't want it to be held against them where the title company can say, Hey, this is past closings. They have a little more data at their fingertips that they're willing to say, this is what closed on another property that we did recently.

Steve Olson: Because you just said that a private entity is more useless than a government entity.

And I don't know when that would ever be the case.

Chase Leavitt: I think either one, just depending on who you're talking to and how much time you want to put into it in helping you.

Steve Olson: Well, when I have these conversations with them, you can coax a formula out of them or the title company can look up rates, but what, where you are going to get nowhere is what is the assessed value going to be?

Cause you know, the formula to apply against the assessed value, but what is it? And that's where we've really found the smart asset resource or looking at comparables in the area I've even pulled up CoStar to see, okay, what are they charging taxes per door, on that complex over there, take it and apply it to the one I'm analyzing.

Maybe bump it up a little bit. So I know, and you're going to look at three or four of them, right? Come up with an average rate, then you're not going to get burned because this is one that's not going away. Right. But property taxes or something, it's a blood sport. And you, you got to decide where you want to appeal.

I got a notice for the property taxes on a fourplex that I. And they went way up and I did not like it, but I looked at the assessed value that they put on it and I could feel like I have to whisper right now. I said this should actually be higher. So I didn't say anything. Right. I didn't want to get them looking at it closer, but, um, you know, I know you've been there before.

Yeah. You might even be there right now.

Chase Leavitt: Yeah. I didn't know if it was Texas.

Steve Olson: So that's taxes, right? I mean, there's some, sometimes it's easier than our time that you should be conservative, but, and plan on appealing periodically. Right. Um, so we did taxes. We did property managers.

Now, now it's kind of blurry. Do you have an HOA? If, if your property management has an onsite manager and you've got payroll and so on and so forth, and you don't have some of these HOA costs, this is just moving numbers around. Different columns. Right. But if you, if you had a manager that gave you a bid on here's my, my bid for shoveling snow and right.

Dicing and landscaping and everything that that's all in there that stuff's probably a little bit easier to drill down on because you can call a contractor. Right? Hey, what would you charge me for weekly mowing? What would you charge me for snow removal as needed? And you can build into that. Right. Um, I think it, I think another one though, that can be kind of tricky is insurance.

Those guys were squirrels, right? You never know where they're going to end up on that kind of stuff. Because every summer, every winter there's a massive hurricane or a massive fire and they might get skittish and raise the cost. So I think if you get an insurance bid on something, that's not going to get CFO for another 12 to 18.

May, you know, move that up. That's gotta be higher than what they told you to today. Cause they're not going to honor that in 18 months.

Chase Leavitt: 2020 remember in March and Utah, all the crazy stuff was happening. And then we had a little mini earthquake. We were all nervous. And we didn't have earthquake insurance on our home.

You and I chat about this and yeah, got a good connection and went and got earthquake insurance. It was pretty high, but I mean, worth getting it, just to get that.

Steve Olson: The next person I told about that after you called me and said, they're not taking any more policies. When an insurance company gets 30 people calling them in one day wanting the same product, they get nervous.

Chase Leavitt: So we renewed the next year and it went up, but we still got it just to have that reassurance.

Steve Olson: Well, I'm in a new house. I should do that again. Yeah, who knows? So insurance, those guys are squirrels and you've got to manage that.

What other expenses should we be paying

Chase Leavitt: Cleaning and maintenance.

Pretty easy for us or FIG (Fourplex Investment Group). Cause when we do our new construction build, it's very low. It's minimal, right?

There's the one-year builder warranty. And then after that, there's not a, not a ton of cleaning or maintenance. So what do we put in there?

Steve Olson: 1%. Yeah. Something like, well, because the HOA has taken all the exterior means.

Chase Leavitt: Yeah. So it's just the interior. So there's some formula and maybe you guys know that as the property gets older, that percentage is going to go up. So how do you factor that in or how do you calculate that?

Steve Olson: Well, in our proforma software, there's a way you can do an assumption for the expense annual expense increase.

There you go. Right? Wow. And so two and a half percent or something, we run it at three and we run our income inflation rate two and a half to help have a gap there because the property is just going to get older over time and it's going to pro-rata per dollar is going to cost you more. Right. Um, so another big one is a vacancy, right?

That's an expense that we have to deal with. What are your thoughts on, on vacancy? How do you determine?

Chase Leavitt: Talk with property management or different managers or call in different locations, different apartment buildings to see how full they are. If they're being leased up, we can look online and get data and read.

Google is a great source and, and see what the vacancy rate is for that area.

Steve Olson: CoStar will tell you per apartment complex, what their vacancy rate is, um, sites like Rentaller or rental meter pulling up Zillow. If you see a whole bunch of rentals, That should probably make you feel, feel nervous about your vacancy rate.

On the other hand, I see some news reports. I think I put it in our slack channel, local news in Phoenix interviewing tenants that are crying, saying every time I apply, it's already gone. That's bad for them. But if you're the owner, if you're trying to figure out rent projections, that would tell you, you could probably be a little more aggressive.

Sherida Zenger: I think we're seeing that in all the states we're in right now, too. Not much as sitting around for very long,

Steve Olson: If it's sitting around and I know a few of that are, but those are exceptions and different scenarios.

Chase Leavitt: So you can really gather a lot of information just by calling around on the comps as we talked about, we're talking about the vacancy, right? You can call and see, okay. What's vacant. You look at the similar floor plan, whether it's a three-bedroom, two-bath, two-bedroom, two-bath, whatever. And if that complex is fully leased up and has a waiting list, what does that tell you? So you go off of what the vacancy is in that city or that area.

And then if you have comps that are just completely full, that's a pretty good sign. We'll still be conservative with it, but that's a really good sign.

Sherida Zenger: And while you're asking them about vacancies, just go ahead and ask them about what their rents are.

Chase Leavitt: Exactly. Which can lead us into something.

Steve Olson: Right. You're pulling up Google. You're looking up these vacancy rates, trying to get an idea of how much competition is there. Right? You can listen to city council meetings about new proposed projects, because what if your vacancy rate is 2%, but there are a thousand doors slated for a local sub-market that maybe has the ability to absorb 600.

Chase Leavitt: That's a good point. I don't think a lot of investors take it to that next step. That's huge.

Steve Olson: Those city councils coming huge. Talk to the developer that you're working with. What else have you heard about what else is going in here? And it's just not that something is going in, but what kind of product is going in, because if it's different than yours, that might be okay.

The point is, is you don't want to slam the market with too much of one thing at one time, which we have been guilty of a number of times

Sherida Zenger: when we did that in American fork. Remember we had Eastern park. And I don't know if we were aware or weren't aware of what else was going on around, but we had some delays in that project, I think really set us back and then it ended up all of a sudden we have all these neighbors and rents there for rent too.

And the rents had to go down a little bit below what proforma. So it's taken a while. They're back up to getting, you know, market rent right now. And that project is great, but it did,

Steve Olson: it took some time to, you know, I tell people, you know, absorbing is like, if you eat a, a 50-ounce steak, right. Could be a good steak, but it's gonna take some time.

Right. I think what Chase Leavitt said, if you want to go really deep, I think the most valuable confirmation you have of any of this high-level research is you go into that leasing office. And I've been guilty of saying, you know, going in and saying, I'm, you know, I'm Billy Bob and I move in some employees into the area.

Cause what do I, what am I going to say? Like, Hey, I'm going to build an apartment complex next to you. I'm your competition. Yes. I have been that direct before. They don't care. Sometimes they don't care.

In fact, I think we even hired, somebody wants because of a conversation like that in Idaho, but those conversations are really, really.

Where they say, oh yeah, we've we don't have any of our three bedrooms available until next November. I've got six, two bedrooms right now. And there's a special, what, what does that tell you about the market?

Chase Leavitt: Yeah, so they're, they're keyed in there talking with the tenants. They know they are there. They're getting feedback on a daily basis for the last six to 12 months.

Sherida Zenger: Yeah, that's huge. Yeah, no. We've had to make phone calls from time to time to different apartment complexes, our competition if you will. But I think really the value is going in because you're actually going to be able to see what those units are like. They can show you pictures online, but I think walking through the project, getting the feel, and then knowing how your property is going to compete with that property, or you going to be nicer. Are you going to be the same?

Steve Olson: Some, some little tweaks to floor plan and stuff could make you more or less confident. You know, we rolled out a floor plan recently, a two bed, two bath unit it's kicking butt.

I was a little worried about it at first, but we did three key things. We gave them a balcony. They have a huge kitchen pantry and they have a huge master. That's stuff that rents units and it keeps tenants in units.

Sherida Zenger: We fought for that balcony.

Steve Olson: People died to get that balcony. I just feel like we need to clarify that we did not kill anybody. Yeah. Okay.

Sherida Zenger: Nobody has died on any of our job sites.

And we, in one of our projects that we did that next to us, we had three bedrooms, two bedrooms, and one bedrooms. And the funny thing was they were out of two bedrooms. Like that was what was the step. So we were like, Hey, we're hitting a grand slam.

Steve Olson: There's a good case to be made for, for two bedrooms and a reason why a lot of apartments.

And that's a whole long story and construction value and average family size and a bunch of things like that, but it totally depends on the market that you're in.

Sherida Zenger: If you can mix it up too, that's nice. Cause I know we're doing that same floor plan, but on the fourth level we're doing one bedroom, which kind of gives you a little bit of diversity, which is nice.

Steve Olson: Building looks better too. It's not as boxy. Should we give the people what they came for and talk about rents. I mean, that's why anybody's here. If anybody is still listening. So, um, Let's talk about drilling down on those, on those rants. So you of course have to understand your floor plan. That's probably the biggest key, but what would, what are the two of you going to do when you're trying to back into a pro forma rent, knowing that this isn't going to be done for another 18 months?

Chase Leavitt: I never project on, oh, it's going to increase over the next 12 to 18 months. I look at the comps on what it's currently. And a lot of times we've been in a market where it has increased and that's just the cherry on top. So basically like we've been talking about just really doing your research, making those calls, making those visits, understanding the product type or the comps in the surrounding area, and digging a little deeper.

Sherida Zenger: Yeah. Use Rentometer, Rentler, CoStar. There's a lot of great tools out there. Zillow.

Chase Leavitt: I mean, there are some good tools online when it comes to. Renting for what? And what does that look like online? And then you can get your boots on the ground too if you need to.

Steve Olson: So I have two things to say about that.

Number one is when we talk about digging a little bit deeper, something that's really important to remember. We've looked at listings on, on CoStar and online, and it says, Hey, you know, 1295 a month. When you get into that fine. You oftentimes find a different story to be told? Well, and guess what? The pet fee is $50 and we have a technology package of a hundred dollars in a parking fee of $30.

Right? All of this stuff impacts monetization streams that you might have, or that you might be missing out on. And so you have to take that into account as well. I wanted to add one more thing. Something that we've seen once or twice as you go out, you dig around for info. There's a time to push it.

And then there's a time to not push it. But I've evaluated projects before where there aren't comps. So, so what do you do? I mean, sometimes that makes you say, well, why aren't there, but in a market with a low unemployment rate where growth has been happening, You're calling your shot. You are setting the market.

Now that takes a lot of courage. I am not going to sit here and tell you that on your build for rent project, you can, or you should do that, but I'm not going to tell you that you don't have it available to you. If you're feeling confident, you could potentially call your shot and say, you know what? A three-bed, two-bath townhouse doesn't exist in this market.

But the vacancy rate is extremely low. I'm 1600 bucks. And you know what? I know the people are going to line up and they're going to figure. How to take, cause I see all the other projects, projects out there I'm evaluating a community in Indiana right now. The newest apartment complex is from 1990. The unemployment rate is, uh, three and a half percent in the market.

And the vacancy rate is 2%. I think I'm going to call the shot on that. Right, because it seems to me like that's a market that's begging for inventory. Any thoughts?

Sherida Zenger: So going to be conservative, right. So you're going to set your rent at what you think, Hey, this is maybe a conservative number, but that doesn't mean that you can't ask for more.

Steve Olson: Why not? Yeah. You, one thing that I did and I've always wanted to do this and we should do it more, you know, when a mortgage company evaluate somebody and as to whether they can afford a house payment or not, I think it's what, 33, maybe 35. Of their gross income per month. They say we don't want to have a mortgage of more than that.

And a lot of landlords use that too. Like they don't, if a tenant is applying for a thousand dollars rent and they make 2000 a month, that tenant is probably overextended and can't really afford the rent. And so I used a great website called neighborhood scout and pulled neighborhood reports all around this property that I'm evaluating.

And I looked at the median household. And I wanted to make sure that the shot that I'm calling could be supported by not charging more than 35 or so percent of the average annual household income in the area. So then, you know, okay. If I call it somebody there, can somebody actually afford it?

Sherida Zenger: If you can't find a comp, maybe you can find some single-family homes and kind of dumb it down from there?

In the sense of, Hey, maybe they're going to have. Less responsibility living in a townhome, but maybe some people want the yard and the townhome doesn't have the yard. So I think there's some give and take there too. That, yes, it's not the perfect comp, but at least it can help give you an idea and guide you to figure out what the right comp is.

Chase Leavitt: Let's talk about Laguna farms and Napa just for a little bit. Remember, three years ago, what was the comp there? Nothing. Well, almost nothing across the street. There are fourplexes. That was the box building. They were nice, but they were stacked right. A completely different floor plan. And so we had to take a look at those and then we also had to consider, okay, what's in our other project or first one in Meridian, that's the location at that time was probably better, good location in Meridian, the area probably better, closer to Boise state.

And so you just have to kind of go off your gut sometimes with taking in what you know, and what you can see are the comps that are there. And then when you do be conservative about it. And so that's what we did with Laguna farms and we, we probably shot too low, which is okay, we're 1300.

And then over a year period, they're at 1400.

Steve Olson: But it was a low vacancy rate, positive net in-migration. Right. Not a lot of new stuff coming. And we took a look at the market as a whole and said if I'm a tenant that moved here, what are my choices? And that one paid off. We, we called it, we set the market.

We could have been more aggressive.

Chase Leavitt: Laguna farms. I just want to bring that up. That was in my mind was probably a good example. I'm sure we've had other ones off, okay. There's not really a whole lot out.

Steve Olson: Well, we've had the other side of that one too, you know, it's, I mean, that's, we could talk about this forever and maybe we should do another episode on it, so, well, that's some good stuff. I think that was another good high quality yet.

Chase Leavitt: But the thing that I liked that you brought up, and this is the last thing I'll bring up is, is the ad-on.

So when you're doing you, your comps are looking at different apartment complexes or different comps close by what are the ad-on and we haven't really talked about that. Maybe just a little bit, but the add-on. What is the property management company, or whoever's going to be renting that unit? What extra are they going to have to pay for?

Are they gonna have to pay for water, sewer, garbage electricity? Are they going to have to pay for, to get into the clubhouse, to the gym, to use the laundry? You'd be surprised at how many add-ons there are with the comps. And then that might allow you to bump your rents up just a little bit. Depending on what the add-ons are.

And you're never going to know what the add-ons are usually online. You have to make that call dig a little deeper.

Steve Olson: They're not very great. And I think it's because they don't want you, you know, they want a tenant.

Well, they want to get the tenant through the door.

Sherida Zenger: We do the same thing, right?

Our property management does the same thing. We have a tech and amenities package that we add. So we have our base rent, but it gets people, at least coming to the door saying, Hey, I'm interested in this unit. Oh. And by the way, this is what's included when they see that there's value there, though. They're usually fine with that.

If you're saying, oh, we're going to have this add on and you're getting the clubhouse and you're trying to charge them 105 bucks. That's not, it doesn't feel good.

Steve Olson: And that tenant here's 1200 in rent and they're going to have it. What about my internet? What about my water? What about my trap? They don't know the real story. So the lower number gets them in the door. But like you said, if the value is there, then they'll take the deal.

Chase Leavitt: Okay, what's the add-ons, but what are they getting for that? And how much extra that you mean? I mean, if it's a long list and it's $500 more, they're probably starting to get a little bit nervous. What are tenants really seeing?