How To Figure Operating Income for Investment Real Estate - Part 2 (expenses)

Include All Real Estate-Related Operating Expenses

Operating Expenses. Operating expenses for real estate investment properties will fall into two basic categories: Actual expenditures deductible for the tax year, and Reserves for future expenditures and the possibility of lost income due to vacancy or credit losses.

Management Services. If professional management is to be employed to manage the property, there will be a predictable fee to be budgeted based on the Management Agreement. 7-10% of actual rents collected seems to be the prevailing rate for the Chicago market. This is a tax deductible expense.

Knowing the difference between Repairs & Improvements to Real Estate

Maintenance. Ongoing maintenance and upkeep is to be expected in order to preserve the value of the property and assure the comfort and well being of tenants. Minor plumbing repairs, painting and decorating, incidental roof repairs, and yard maintenance are all examples of maintenance. Internal Revenue Service (IRS) guidelines suggest what may be deducted currently as an operating expense.[1]

“Improvements.” Investors and landlords often have difficulty distinguishing just what improvements to their property may be deducted currently as an operating expense, and what the IRS will deem a non deductible “improvement.” To quote from IRS guidelines (see Footnote above): “An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. ... If you make an improvement to property the cost of improvement must be capitalized.  The capitalized cost can generally be depreciated as if the improvement were separate property.” (emphases added) Capitalized expenses and depreciation will be discussed below.

The following examples of “improvements” from IRS Publ. 527 may help:  


Insurance. The prior owner’s insurance premiums may or may not be applicable to the property under new ownership and management. Long time landlords often neglect insurance reviews (they’re afraid the premiums will go up!).  One is well advised to secure a new quote for the property from a qualified insurance source.

Utilities: Water & Sewer. The prior owner’s operating information should prove useful here. In the City of Chicago, water and sewer taxes are combined in a single billing from the city. Again, within the City of Chicago, water consumption for single family homes and smaller multifamily properties is seldom separately metered for actual usage. For all practical purposes, the City’s billing amounts to a consumption (water) and usage (sewer) tax. Unlike real estate taxes, water and sewer taxes to not change significantly from year to year and may be predicted with reasonable accuracy.

Utilities: Heat & Electric. Heating and electric bills, on the other hand, can vary widely depending on consumption patterns. Some households are conserving in their use, others less so – particularly when it is the landlord who pays the bills! Multifamily landlords generally have control over gas heating but will, together with everyone else, suffer the consequences of particularly severe winters. Single family landlords, on the other hand, generally insist on the tenants paying their own utility bills as a practical check against excessive usage.

Real Estate Taxes. Real estate taxes for the initial 1-2 years may be determined from information provided by the seller or his agent or, in Cook County, Illinois, by going to the Cook County Assessor’s web site.[2] Real estate taxes are fully deductible as a current operating expense.

It is important to note, however, that the taxes being assessed currently on the property are based on inherently dated information; it is not unusual to find properties that have “flown beneath the radar” for years, enjoying unusually low tax bills. In the event the property is being acquired for substantially more than the value represented in the most recent assessment – which is generally the case in an appreciating market – the purchase itself will trigger an automated adjustment to the valuation. The consequence of this upward adjustment to market value, an increase in the tax to be paid, will not be reflected until the next year’s tax bill or, sometimes, the year after that. In any event, at best the new landlord gets a “stay of execution” – the taxes will go up, but it will take a year or two.

The second major consideration in projecting real estate tax expense, aside from the possible consequence of the purchase itself, is the county’s practice of reassessing all properties within its jurisdiction every three years – the sometimes dreaded “triennial reassessment.”  While one cannot with any precision predict the outcome to this periodic reassessment, it is important to recognize this as yet another “unknown” affecting all property owners.

Don't neglect Replacement Reserves

Replacement Reserves. Every property owner recognizes that, even with conscientious maintenance, building components, mechanical equipment and appliances will simply wear out – will need replacement. Some replacements, such as the roof, windows or furnaces, will prove relatively costly. Careful managers will not be caught by surprise by these events. It is the purpose of “replacement reserve” accounts to fund these needed replacements in a timely manner.

Given the fact reserve accounts are funds “set aside” for future use, reserves are not tax deductible. When funds are drawn from such a reserve account, the expenditure will have a tax consequence in that year. Depending on the nature of the replacement or improvement, the expense will be either “expensed” currently – be fully deductible in that year – or “capitalized” as a depreciable building improvement over time. (See “Maintenance” and “Improvements,” above, for further discussion.)

The amount reflected in the Replacement Reserve account is derived from a review of all major building components, evaluating their expected “useful life” and estimating the cost(s) to replace the building component in question. A simple table or worksheet will suffice –

How To Figure Operating Income for Investment Real Estate - Part 2 (expenses)Building Component
Useful Life (years)
Cost
Reserve Required
Roof
15
$4,500
$300
Windows (new)
20
$3,000
$150
Furnace(s)
10
$2,500
$250
Hot water heater
5
$350
$70
Refrigerator (new)
10
$650
$65
Stove (new)
15
$400
$27
Carpeting (new)
3
$950
$317
Floors (tile/refin.)
10
$1,400
$140
Annual Reserve Required

$1,318

The arithmetic is straight forward: Make a conservative estimate of the remaining “useful life” of the building component (in years); estimate the cost of the improvement at today’s prices; and divide the cost by the number of years. Do this for each major building element. The total of the annual reserve – in today’s dollars – required for all the elements is the amount that should be set aside each year in a building reserve account ( a savings account or certificate of deposit ).

It is the percentage  that counts: This amount – in the example $1318 – should then be calculated against the property’s Annual Gross Income to determine what percentage of the Gross Income should be set aside.

Annual Reserve X 100 ÷ Gross Income = __%

Over time labor and materials required for any project will cost more due to, if nothing else, inflation. If a new roof can be applied today for $4500, in five years that same roof will cost well over $5000. For that reason, it is recommended that the annual amount set aside to fund reserves is indexed to keep up with inflation. This “indexing” is accomplished by making the annual contribution to reserves a percentage of the annual gross income rather than a fixed amount from year to year.

As gross income increases due to inflation – rents tend to rise with inflation – the amounts contributed to reserves will increase proportionately. In future, as funds are required to maintain the habitability and value of the property, the investor will be prepared.

Allow for Vacancy Credit Losses

Vacancy and Credit Losses. Vacancy and credit losses will occur with any investment property. In today’s market, multifamily landlords routinely estimate vacancy and credit losses at 10-15% of scheduled gross income (the amount to be collected with 100% occupancy and no credit losses). Single family landlords, on the other hand, rent primarily to families who tend to be less transient, less inclined to move, unless prompted by poor maintenance or negligent management. In general, single family rentals are relatively hard to find; tenants tend to be jealous of their single family housing opportunity and reluctant to leave. Nevertheless, it is prudent to budget for vacancy.

Should a tenant decide to move, it is unusual for a replacement tenant to move in immediately. Generally some days, or even weeks, will be required to make the property fit to show prospects; and once the new tenant is identified, additional time may be lost due to inspection and lease approval delays. Should there be need to evict a tenant, many weeks may pass before the eviction is accomplished – weeks during which no one may be paying rent. In a word, years may go by with no vacancy but, when a vacancy occurs, it may be several months until occupancy is restored. It comes with the territory.

Recognizing these many “peculiarities” of the business, it is well to budget at least minimally for vacancy or credit losses, recognizing one or more years may pass without such losses. When such losses do occur, however, they often result in a real disruption of Cash Flow. Whether budgeted, as in our example, or set up as a “vacancy reserve” account in the first year or two of ownership, a budgeted allowance for vacancy will prove useful in maintaining an uninterrupted income stream from the property. #

- Philip Elmes

Investing In Affordable Housing © 2002-2013

[1] See IRS Publication 527, “Residential Rental Property,” for the year 2005, pp 2-3. For a downloadable copy of the current edition of this IRS publication, go to www.irs.gov.

[2] Cook County Assessor’s web site is www.cookcountyassessor.com. The easiest way to access the information is to have the property’s “PIN” or property identification number (a 10 digit number) in hand. Alternatively, it is possible also to search by street address. See the Assessor’s web site home page for instructions. In most cases, one will also find a (sometimes dated) photograph of the property included.