Whenever we are confronted with a new situation, we like to approach it with first principles reasoning.
If you have not encountered it before, it’s a simple enough concept: a first principle is a basic assumption that cannot be deduced from any other assumption – in other words, boiling things down to their fundamental truth and applying reason from there.
When it comes to real estate, a common thought is that it is hard to be a successful investor because of managing fixed costs, unexpected expenses and generating positive cash flow.
So let’s break it down via first principles:
Managing Fixed Costs in Real Estate
The biggest fixed costs in most properties are divided into three buckets: loan payments, insurance premiums, and property taxes. The standard rule of thumb is to have six to twelve months worth of fixed costs as reserves and it’s a good standard rule. But before you even dive into that, it’s important to break down each component and see what it should actually be.
Property taxes are pretty well fixed – currently in Franklin County, it’s a percentage of the home’s assessed value. But from a first principles approach, the first question should be is there a way to bring down a home’s assessed value? This will lead you to see what the process is to file a tax appeal with the County.
Insurance premiums have some more leeway – it’s a good idea to revisit your policy annually with your insurance agent and see what options are available. But before you even look into what is being insured and what rates are, the first question should be what are the components of the property that are increasing the premium? Are there adjustments that can be made for a minimal cost that will reduce the premium (such as putting a fence around the pool, installing two fire extinguishers per unit, etc).
Managing loan payments is typically the lion’s share of fixed costs, but there are almost always ways to approach it and get it reduced (whether it’s a cash-out refinance to pay off another property in your portfolio or some other option).
But with first principles, the goal is to break everything down to its most fundamental component and then ask why is it done this way? Can we do it more efficiently?
Handling Unexpected Expenses With Real Estate Investing
This is a component many newer real estate investors struggle with – they are excited for the tax benefit from depreciation but don’t factor in the maintenance costs down the road.
This is not as simple as managing fixed costs, but not too different. The first is to outline all of the large (and small) capital expenses that come with a property: appliance replacement, roof, plumbing, flooring, electrical, drywall – literally everything.
Then go get a quote for each component. Let’s start with, say, an HVAC unit. Call up a company to get a quote, and say an exact replacement would cost $8,000 today. And that the expected lifespan is 10 years. You can then make an estimated inflation rate of 3% a year, and it comes out to the replacement cost in a decade will be around $9700. That means you need to set aside $970 a year in reserves to cover the cost.
But to take the first principles approach further, you should first ask yourself why the expected lifespan is 10 years. Ask the HVAC company about what you can do to extend the life of a unit. They may say sign up for a maintenance service program and you should add 5 years to the life. Adding in the cost of twice yearly maintenance plus an extended lifespan to 15 years, you might discover you brought the expected replacement cost reserve requirement down to $815 dollars a year.
Now do that for every component in your property.
Want to have a property manager that thinks like this for your property? Give us a call and let’s set up a consultation to see if we would be a good fit.
