Every investor has heard the saying “it’s all about the numbers” when investing in real estate. What about the numbers that you forget or underestimate? In my previous article, I highlighted 6 hidden costs that investors run into when investing in real estate.
Let me list the six additional hidden costs:
- Seasonal expenses
- Money held in reserve
- Property tax reassessment
- Poor lender connections
- Hiring wrong management company
- Government fees and regulations
Every market has what we refer to as a seasonal expense. Up here in the mid-Atlantic , we have to budget for snow removal in the winter. Down in the South, landscaping fees are more prevalent throughout the year. Two winters ago, we experienced an unusually cold and bitter season. It seemed as if the snowplows were in constant motion for the entire month of February. Boston received over seven feet of snow in one month.
To add insult to injury, I had to pay to have the snow removed from the parking lot because there was nowhere else to push it. This past winter, snowfall was practically nonexistent. My recommendation is to assess the various types of seasonal expenses, such as heat in the Northern climates, irrigation in the South, or air conditioning in the warmer climates. Analyze the actual income/expenses of the property, and try to establish an estimate of the cost. Two years ago, the snowplow expense exceeded $7,000 on one property alone. Last year, the expense was one-third the cost. My remedy for these unexpected expenses is to leave more money in the bank. The only problem with this strategy is that it leads to my second hidden cost…
Every investor would be wise to create a capital expenditure account for each property that they own. As buildings age, certain elements need to be replaced, such as hot water heaters, roofs, and driveways. A CapEx account is one way of setting up a rainy day account to address these issues. You run into two dilemmas when setting up a CapEx account. First of all, you may have to defer taking a draw from the property for a few months to build up the account (that stinks). But this is one of the strategies in real estate to limit your downside risk. If something needs to be replaced, the cash flow from the property will be used, and you will not have to come out of pocket.
The second dilemma comes about if you own several properties, as many of our owners do. Our portfolio is large, and we have a CapEx account set up for each property. We are talking thousands, and even hundreds of thousands of dollars, for operators who own a large portfolio. Unfortunately, that money is sitting idle in a bank account earning next to nothing.
What is the opportunity cost of money? It’s a tough pill to swallow if you just found a great deal, but you don’t have enough for the down payment. Most banks will require you to set up and fund a CapEx account, especially after you refinance the property. They will actually estimate cap ex and withhold a certain amount of the proceeds for the account. I have come to realize that it is just a cost incurred while doing business, even though it does stink!
Property Tax Reassessment
Beware of the taxman once you are about to acquire a property, especially if the property has maintained the same ownership for years. Every municipality has their own set of laws. Some cities reassess properties every year, some every three years, and others on the sale of a property. Check with the city, calculate what the increase is, and plug the new property tax expense into your analysis.
When I built my home years ago, the city paid me a visit six months into the construction and “reassessed” me during the build. My taxes skyrocketed, and I was still six months away from completion. When I eventually finished building, I was paid another visit and received my final assessment. Was it fair for the town to reassess me while I was building? My anger was due to the fact that I was unable to use any of the cities services, yet they felt it appropriate to raise my taxes. Ironically, the city next door gave homeowners a break on the first year of their taxes, while my city felt it was just in charging me extra. Life isn’t fair, and it was my fault for not knowing the town’s rules.
Poor Lender Connections
We were ecstatic to land our first deal, but that enthusiasm came with a price. The terms on our financing were subpar, to say the least. The interest rate was about one and a half points higher than the market, the amortization was only 20 years, and the term was a mere five years. Luckily, our enthusiasm and sheer will propelled the property to success, and we were able to refinance two years later with much better terms. This lack of team building in the initial stages of real estate investing hurt our ability to cash flow — and ultimately led to a lower return.
Ironically, after extracting over $160,000 from the refinance, the payment was practically the same as our initial loan. We received a lower interest rate (4.25% versus almost 6%), a 25-year amortization and a 10-year term. I would expect all new investors to stumble upon this hidden cost. Experience is the best teacher, and once a newbie establishes his team, this hidden cost should dissipate.
Hiring the Wrong Management Company
The ability to hire the “right” management company is one of the biggest complaints when investors shun exploring new markets. Two websites that an investor can use to locate management companies are All Property Management and IREM. Try to hire a company that has the experience and the resources to manage the type of asset you are investing in. Get referrals from brokers and drive by properties that are under their management. Finally, don’t be afraid to change companies if yours is not performing. A terrible management company may blow up your entire investment.
As I alluded to earlier, every city has its own sets of laws, and some cities have different laws within the submarkets of a city. For instance, I visited Phoenix recently and discovered a new term: “point of sale.” It sounded innocuous enough until the broker described what it meant. Basically, the city comes in before a transfer and begins to highlight the deficiencies of a property. The buyer will receive a list of all repairs that are needed to bring the property back into compliance. I wonder why the city wasn’t busy keeping a record of the property before it was sold. In any event, you need to know the laws, fees, and regulations that every city imposes.
In certain submarkets of Cleveland, the landlord is required to receive a C.O. (certificate of occupancy) every time the apartment is turned. The broker told me it was $250, and if the apartment was turned twice in one year, you had to pay each time. That will put a serious dent in your cash flow. As a landlord, you can’t avoid performing these inspections because it is your duty to provide safe housing. If something tragic occurs on the property, such as a fire or an explosion, you will be held responsible if your property is not in compliance.
Being able to understand these hidden costs will limit your risk and ultimately lead to a more profitable investment. Knowledge leads to a reduction of fear, and a reduction of fear will lead a person to take action!
Any MORE items you’d add to this list?