9 Hidden Costs For Operating An Apartment Building That Can Impact Profitability, AKA The Investors Return On Investment!
If an investor is looking at an apartment building to buy, the classic valuation methodology will be Net Operating Income or NOI divided by an assumed capitalization rate for a given neighborhood!
This is true whether the building is one of the shiny new structures dotting the skyline or one of the older buildings that are the glue behind most of the blocks you will walk down, particularly in New York City.
But beyond the traditional expenses, the following article from 22-year commercial real estate finance professional Doug Marshall at his websites blog highlights 9 hidden costs that need to be considered.
9 Hidden Costs Managing Apartments That Can Cost You Big Time!
There are several categories of operating expenses necessary to maintain and manage apartments. We all know these expenses: property taxes, insurance, utility charges, maintenance and turnover costs, on-site and off-site management costs, etc. But less well known are potential hidden costs of maintaining and managing an apartment that in large part can determine the profitability of your investment. They are, in no particular order:
1. Poorly configured operating statements
Operating statements that only show rent received, not gross potential rent do a disservice to their owners. An owner once told me that his property didn’t have a vacancy problem. He was shocked when I informed him that his property for the past year averaged 12 percent vacancy in a market whose average vacancy rate was less than 5 percent. He didn’t know he had a vacancy & bad debt problem because it wasn’t explicitly shown on the property’s operating statement, only the rent received. Those primitive operating statements were hiding the cost of vacancy and bad debt.
2. The time it takes to get a unit market-ready
In a tight rental market, like we are experiencing now, every day it takes to get a unit ready for occupancy takes money out of the pocket of the owner. For example, let’s say a vacant unit has a monthly rent of $1,000. If it takes two weeks to turn the unit it’s costing the owner $467 in lost rent ($1,000 ÷ 30 days x 14 days). If it takes only a week to make the unit market-ready, the shorter time to turn the unit saves the owner $234 compared to a two week turn. I have seen vacant units stay dirty and unrentable for several weeks because the onsite staff have been focused on other issues that are not nearly as important to the property’s bottom line.
3. Mediocre (or worse) on-site manager
The older I get the more I realize that common sense is not common. I shudder to think the impact of an on-site manager that lacks common sense. Sometimes a vacant unit will remain vacant for weeks because the manager is waiting for their favorite vendor to do one small part of the turn instead of hiring one of the vendor’s competitors. I’ve seen where the on-site manager is slow to return a prospect’s call about a vacant unit resulting in the prospect going elsewhere. Sometimes a manager limits the time when a prospect can view a vacant unit so that it’s convenient for the manager not the prospect resulting in the prospect giving up on renting the unit. There are many ways an on-site manager can do significant damage to the property’s profitability. Those examples are just a few.
4. Owners tight with employee compensation
Sometimes the problem is not with the on-site manager, it’s with the owner not compensating the on-site manager well. A good employee is worth their weight in gold. The old adage “You get what you pay for” is very true when it comes to hiring people. Treat them with respect and pay them well so they begin to think like an owner. Incentivize them to focus on those things that you want performed well. For example, maybe you pay them an incentive for turning the unit faster than they normally do. Do not be “Penny wise, and pound foolish” when it comes to compensating your on-site manager. It is short-sighted thinking and it can cost you a lot of money.
5. Not finding water leaks
Water leaks can be notoriously difficult to find. Sometimes you’re not even sure you have a water leak but the monthly bill just seems way too high. If the property has more than one building the easiest way to determine if you have a water leak is to compare water bills between buildings. Should they both have the same number of units the water bill should be more or less similar. But if one is significantly higher each month it’s likely there is a water leak. Spend the money to find the leak. Be persistent until the leak is found.
I once had a client who was purchasing a property with a very high water bill. The first month he owned the property he discovered the source of the water leak and fixed it. Fixing the leak reduced the property’s annual water bill by $30,000!! He bought the property at a 6.5% cap rate so fixing the water leak immediately increased the value of his property by $462,000 ($30,000 ÷ 0.065). Or another way to look at it, the seller not finding the water leak cost him big time.
6. Deferring maintenance for short term profits
Do you member the old FRAM oil filter TV commercials? The auto mechanic says to the car owner, “You can pay me now (meaning you can buy a good quality oil filter) or you can pay me later (meaning you can buy a cheap oil filter now and a new engine later).” It was a very effective TV commercial.
Some property owners haven’t learned the “pay me now or pay me later” lesson. Not only will the maintenance problem not go away, it will also get more costly to fix the longer you wait. And when you defer obvious maintenance problems it makes a statement to the residents. It says to them you would rather have your monthly owner’s distributions than maintain the property. It also makes it harder to rent to well-qualified tenants because the property looks tired, if not run down. There are high hidden costs to pay for not maintaining your property.
7. On-site managers picking bad residents
I’m not suggesting a manager should discriminate based on race, color, sexual orientation, etc. I’m strongly suggesting that the on-site manager do a thorough background check of the prospective renter and read between the lines when something comes up suspiciously. Again use common sense to weed out potential problem residents before they move in. The hidden costs of problem tenants in time, money and aggravation can be huge!!
8. Being fat, dumb and happy with 100% occupancy
If your property is consistently full, especially in a market that averages 5 percent or more vacancy, your rents are too low. Below market rents are a hidden cost. Sure it’s nice not having the turnover costs of a vacant unit but if you do the math, raising all of your rents to market usually pays for the few units that end up being vacated because of the higher rents.
9. A property management company that nickel and dimes you
There are property management companies in Portland that I sense are ripping off their clients. Comparing their operating expenses on a cost per unit basis with their competitors, they are consistently $500 per unit higher for comparable properties. How do they do it? There are multiple ways. One of the most egregious ways is by making their maintenance staff profit centers. Instead of charging the property owner what it’s costing them for the maintenance staff’s wages, payroll taxes and employee benefits, they charge significantly more. Way more!! So every time you use their maintenance guy, they are making a profit. As owners we need to make sure the property management company we hire has a reputation for honest billing of their services.
Tackle these hidden costs head on. The overall success of your apartment as an investment depends on it.
Doug Marshall is a veteran commercial real estate professional of 30 years, 22 of which are related to commercial real estate finance, Doug Marshall is enjoying the opportunity to control his own destiny with this company.
He can be reached at email@example.com or at 516.741.4723.Google+