How following one dumb rule of thumb cost me thousands of dollars

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When I first started buying buildings, I needed a quick and dirty way to estimate operating expenses.

I hadn’t owned any buildings long enough to have historical data upon which to base assumptions.

At the time, I was using an accountant who knew just enough about real estate to be truly dangerous. I asked him if he had a good rule of thumb. He told me to estimate that operating expenses would be approximately 35% of rents.

That sounded reasonable, so I proceeded to underwrite a whole bunch of deals using that 35% expense margin to calculate the yield I would be able to achieve by buying and renovating apartment buildings. Keep in mind this was 2009, when things were very, very cheap and I was trying to leg into 8% unlevered yields (that was my threshold for whether to do a deal or not).

Do you know why it is really stupid to use a blanket 35% expense margin to estimate NOI for a repositioned building in CA?

  1. When you buy a cheap building and renovate it to raise the rents, your property taxes are going to remain pegged to the acquisition price. Since you will presumably add a lot of value to the deal, your property taxes should comprise a lower portion of the expense mix than they would if you acquired the renovated building for fair market value. Treating the renovated building the way you would the acquired building will lead you to over-estimate property tax on the renovated building;
  2. There is no difference in the expense an owner bears when renting out a $1500 1 bed / 1 bath vs. an $1800 1 bed / 1 bath. Both units will use  the same amount of water, generate the same amount of trash, break things at roughly the same rate, etc.. If you blindly estimate 35% expense margins, you will be charging yourself 35% of that $300 difference in rents, $105 / month, for no reason. $105 x 12 = $1260 in annual NOI. If you put a 7% cap rate on that, it means you’re stupidly vaporizing $18,000 in value. Spread over, say, 6 units, that could be the difference between doing the deal or not.
  3. When you replace all of the plumbing and electric and all of the appliances, as we do on almost every building, you’re going to have lower maintenance bills because **NEWS FLASH** everything is new.

As a result of my stupid reliance on the 35% rule, I systematically over-estimated expenses on every deal I underwrote.

The good news is that the deals we actually did turned out to be 9-10% yields, instead of 8%.

The bad news? I passed on probably 5 deals that I desperately wish I had done. I conservatively estimate the lost earnings to me personally in the low hundreds of thousands of dollars. All because I relied upon a short-cut without actually taking the time to think through the implication.

Do you know what I should have done? Taken the time necessary to get some reasonably accurate estimates for the annual operating cost per unit and applied those to my pro forma stabilized (eg post-renovation) rent roll. That’s what I do now.

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