A portfolio of residential rental properties is portrayed as highly profitable. As the underlying asset builds equity through market appreciation and reducing the principal owed on a mortgage, the owner’s return on investment (ROI) increases.
There is more to building equity, maintaining a stable tenant, and timely servicing the mortgage loan. The focus must be on acquisition, financing, and operations costs.
This article is for the buy-and-hold investor who must keep diligence over all costs from acquisition through stabilized operations. An owner cannot wield too much influence on the purchase price or the rent, but an owner can control the costs.
Acquisition Costs
All investors in residential real estate, with either short- or long-term hold periods, seek properties with a value-add potential. This means buying at a below-market price, recognizing the scope of renovations to create value at the lowest cost, and selling the property for immediate payback and profit or building wealth by collecting rents over time.
Every investor must understand the components of the acquisition costs. No investment will be worthwhile if the purchase price is too high or the property is over-renovated for the market.
The other costs that will affect profit and the investor’s liquidity are:
- closing costs,
- loan fees,
- recording fees,
- transfer taxes,
- survey,
- legal fees,
- title insurance,
- prepaid escrows, and
- deposits.
An investor must know which costs are paid upfront, non-refundable, and which can be financed into the loan. Upfront and non-refundable fees are paid with the investor’s cash, negatively affecting the investor’s cash position even when the deal does not close. All costs must be considered and factored into a proforma before an investment is deemed financially feasible.
Debt Service
The most significant recurring monthly expense is the debt service. The loan terms, like interest rate and lending ratios, will significantly affect the owner’s ROI.
Before the property is solidly under contract, an investor must locate a lender willing to finance the deal on favorable terms that make sense. The monthly payments could include more than principal and interest. Escrowed funds could be required to cover property taxes and insurance premiums, and mortgage insurance if there is less than 20% equity. These requirements will be prevalent when the hard-money loan is refinanced to a permanent long-term loan.
Investors with a buy-and-hold objective must consider a short-term loan for the acquisition and renovation and a long-term loan for the hold period. These are different loans with separate closing requirements, terms, and costs.
Property Management
Some owners hire professional property managers to handle the tenant-related aspects and operations. These services include screening prospective tenants, collecting rents, and handling repairs and maintenance.
As a portfolio grows, the economies of scale of the management fees will positively affect the overall ROI. Too often, investors believe they are saving money by the DIY approach to property management. Perhaps, early in the investment journey, this theory could prove true.
However, an investor must consider the value of their time. Professional managers have systems and staffing in place that an investor would not. This is a business where relationships and contacts are priceless.
The best relationship a long-term investor can build is with a professional property manager. Depending upon the portfolio size, property type, and location, management fees could range between 8%-12% of the collected rents.
Tenant Turnovers and Vacancies
Properties that are professionally managed and maintained remain stable for longer periods. But things happen. Tenants move, and rent is interrupted. A property manager can fill a vacancy with another qualified tenant quickly; however, the owner must cover all recurring operating costs without the property generating cash.
Planning for vacancies and turnover is an important consideration of any operating budget. This line item must be projected conservatively, meaning accounting for 2-3 vacant months per year. If the numbers work with this conservative projection, the investor will have a great year if no rent interruptions occur.
A lender will add this line item in its underwriting if an operating proforma does not contain any vacancy projections.
Capital Improvements
The planning and budgeting for capital improvements will depend upon the renovation scope performed immediately after acquisition. Capital improvements include replacing the HVAC system, roof, appliances, and any other major investment that extends the asset’s economic life.
These major components are planned by funding a reserve account from the collected rents. This reserve account is a recurring operating cost. Most lenders will require a stated percentage of rent to fund this account.
If these components are not a line item for this recurring expense, a lender will add this line item in its underwriting.
The purpose of this article is for an investor to consider all costs and expenses relative to the acquisition, renovation, and operations of a property, as would a hard-money lender in Los Angeles. The numbers must make sense, and the feasibility of an investment must be known while the sales contract is in the contingency period.
If you are interested in purchasing real estate or need funding for your next project, contact the highly reputable and respected hard money lender in Los Angeles, PB Financial Group. PB Financial is a premier, direct hard money and bridge lender who has been providing quick funding since 2006 and has funded over 2,700 hard money/private money loans. Our objective is to satisfy your financing needs on important real estate projects throughout California in an efficient manner.
To learn more about how to successfully finance your next real estate venture, please contact PB Financial Group at 877.700.3703 to schedule a consultation or visit www.CalHardMoney.com to learn more.
