“How much does it cost?” is usually the first question that pops into an investor’s mind when evaluating a rental property. However, the sale price is just one aspect of cost to consider when conducting a property assessment.
There is actually a whole host of other expenses involved in owning and operating a rental property that buyers must consider before placing a bid. These expenses are applicable to every asset and can significantly impact a property’s return on investment. As such, they should be included in your underwriting analysis when assessing any property investment and monitored annually throughout ownership.
What Are Operations Costs?
Every business has operating expenses. These are simply the cost to run or operate the business. In real estate, operating expenses include costs to manage the rental business—like legal fees and administrative costs—as well as costs to operate the physical property. This includes everything from repairs and maintenance to monthly utilities. Landlords will incur these operating expenses for as long as the property remains part of the portfolio.
Budgeted Costs Versus Actual Costs
Savvy investors budget for operating expenses at the start of the year, estimating potential costs. Some of these are easy to predict; insurance, taxes and utilities costs are consistent fees that you can easily schedule. Others are not. Big-ticket items—water heaters and air conditioners, for example—are harder to predict, particularly on new investments. Professional inspections are helpful to assess the remaining lifespan of these items, as is basic information, like the age of the unit and history of maintenance. Landlords should anticipate these larger costs, and in some cases should go ahead and replace older and potentially faulty items before they become a late-night repair call.
At the end of the year, landlords settle up, comparing the budgeted costs with the actual expenses. Narrow—or even zero—variances between the budget and the actual expenses is the ultimate goal. When actual costs exceed the budget, the investor has spent more than they anticipated and could potentially lose money if the rental income didn’t cover the overage. Coming in under budget is better, but be careful. This could mean you have unnecessarily tied up capital that could be put to better work somewhere else in your portfolio.
Operating expenses will vary based on the property size, quality, location and even the occupant. We put together a comprehensive list of operating expenses investors should consider both when underwriting a property and throughout ownership.
Closing Costs: Just like purchasing a home or condo, closing on a commercial mortgage involves closing costs, which can be paid by the buyer or seller depending upon the sale agreement. Closing costs usually amount to about 1% of the sale price and can include an appraisal, inspection, repairs, an agent or broker commission, marketing expenses, outstanding debt against the property and title expenses, among other fees.
Financial Advisor: Many people choose to consult a financial advisor before buying a commercial property. While advisor fees vary, this move can often save investors more money on the purchase in the end. Nevertheless, advisor costs belong in the expenses pile.
Appraisal: Commercial appraisals are usually charged by the lender to the borrower as a service or as part of the closing cost. Appraisal fees are usually assessed based on the cost, sales comparison to the market, or income capitalization, and they are typically higher for commercial property than for residential property.
Inspection: Inspections are part of the due diligence process when purchasing a residential or commercial asset. The cost of an inspection varies from property to property, but is usually based on the size of the property. A commercial building inspection can run between 1% and 2% of the purchase price.
Mortgage Payment: In you have places debt on a property, you will have a monthly mortgage payment. The mortgage payment is a regular expense that is directly related to the purchase price and loan terms. Buyers should have a clear pro forma based on expected rental income and expenses when determining whether their mortgage payment is realistic.
Utilities: Unless each tenant is paying for utilities separately, the landlord foots the bill for such items as water, gas, electricity, and trash collection for the property. Having at least a rough estimate of monthly utilities costs before buying is highly recommended.
Professional Property Management: Some investors chose to hire a third-party property manager to oversee the day-to-day operations of the property. Professional property managers can live onsite or offsite, and are paid a flat fee or a percentage of the rental income. Their services include maintaining the property, handling tenant requests and in some cases, even managing the operating budgets on behalf of the investor.
Insurance: Insurance coverage on a rental property includes basic, rent loss, general liability, flood, fire and possibly tenant relocation insurance. Shop around for the best coverage and premiums on this expense.
Maintenance: Common amenities such as pools, patios, a fitness center, a business center, and a lobby or rental office—in addition to individual units—will require regular maintenance, paid for by the owner. The seller should be able to provide a detailed list of maintenance costs as well as a record of when these services were last performed on the property.
Property Taxes: Taxes are an inevitable part of owning a commercial property. The local tax assessor bases property taxes on an asset’s value. Taxes are typically paid semi-annually.
Landscaping: A gardener or landscaping team will be required for regular upkeep such as lawn mowing, hedge and tree trimming, maintenance of irrigation systems and planting.
Repairs and Replacement: Repairs are a given in any property, no less a multifamily community. Typical repairs may include roofing, HVAC system, plumbing, laundry facilities, in-unit appliances and common area elements (elevators, hallways, railings, stairs, windows, pools). When an element of a property is beyond repair, it must be replaced. This may include a new roof, HVAC, electrical system, high-speed internet connections, paint, carpeting, appliances and other in-unit or common-area upgrades.
Vacancy: When a tenant moves out at the end of their lease term, there may be gap period before a new tenant signs a lease and pays the first month’s rent. Property owners should assume a one-month vacancy after a tenant moves out to clean the unit and complete any repairs, but it can take longer if the owner is unable to secure a new tenant. These lag times should be included in the cost of doing business as an property owner.
Brokerage Fees: Owners may hire a professional leasing team to market the unit and vet potential tenants.
Security: Some rental properties require added security, particularly if they are located in high-crime areas or if there have been criminal incidents at the property. The cost of security personnel falls on the landlord.
Accounting Fees: A good accountant or tax attorney is essential to managing income and expenses for a rental property. While these professionals cost money, keep in mind that they can identify operating expenses that can serve as tax deductions, which can offset their cost to some degree and prevent you from facing a huge unhappy surprise at tax time. Also, a tax attorney will represent you in court if you find yourself in a legal situation related to the property, which is invaluable.
Attorney Fees: In acquiring or managing an investment property, you may need legal advice along the way. It’s important to have a reputable attorney you can rely on in these situations and a line item for this expense.
Pest Control: Ants, roaches and rodents are never welcome in a home or community. A good landlord provides preventative pest control as well as treatment should a pest situation arise.
Business Permit: Mature rental property businesses will require a local business permit for operation. An attorney can advise you on whether this expense is necessary.