Rental Real Estate - Dealing with a Rotting Bag of Potatoes
The real estate market is hot. The rental real estate market is equally hot. Since we are in the business of helping clients with investments, clients frequently ask us about rental real estate for their portfolio. I thought I would tell you some of my story.
I am in a partnership with a college friend and a high school friend and together we own several rental buildings for a total of “18 doors.” Almost 6 years ago, my wife and I added a 4-unit building to the mix, as our own investment. As landlords, we get frequent calls regarding repairs, tenant issues, building upkeep, and upcoming vacancies. Now and then we get crazy calls. One example last fall was when we got a call from a tenant reporting gnats all over her hallway ceiling. The ceiling and wall felt damp and the assumption was there was a leak. I went inside the unit and saw the gnats everywhere with no evidence of the cause. I checked the adjoining bathroom for mold, nothing. I checked the attic for a leak, nada. I tried to follow where water would take a path from the gutters into the attic and down the wall. Zippo. I’m out of ideas. Once a call is required to a professional, my wife steps in. A roof expert examined the situation and had the same result; he saw nothing, no leak, and confirmed the attic was dry. By this point, the tenant had gnats in the kitchen now too. It was getting worse! Next, my wife called a friend from a local pest company and together they searched the unit. He declared they were sugar gnats and that they were drawn to areas of fermentation, like grease traps in restaurants. He poked around in the kitchen cabinets and eventually looked in the back of the cabinet under the sink. After unearthing all of the contents under there, he pulled out a petrified rotten bag of potatoes. Yep, the culprit. The gnats made a nest in the sack of spuds. So, after three trips to the apartment, two professional assessments, apologies from the tenant, and a DIY fumigation treatment, the gnats moved out.
We’ve all heard stories of rental real estate headaches and, I can attest, this story and many more are real. The question is, are the headaches worth it? My answer: it depends on your attitude. The market is hot and interest rates are low, so this type of investment is tempting. If you don’t mind the occasional headache, returns can be north of 10% annually with a low correlation to the stock market.
In order to better illustrate this type of investment, I will give you a simple example of evaluating a building for rental real estate purposes.The question I ask is straightforward: Is the building cash flow positive on a monthly basis after paying the mortgage (a 25% down payment is typical for rental properties), all monthly expenses, and a maintenance allowance? If it is, I consider the fact that rising rents will only make the situation better. And I generally don’t include price appreciation as a rationale for the purchase. Price appreciate is gravy. Here are a couple of examples:
Buildings 1 and 3 provide a positive monthly cash flow. In these two cases, I never have to add more money to the bank account to pay any bills. In the case of building 2, if I incur the maintenance expense I’ve estimated, I’m likely to add in cash now and then, not something I want to do. I could go deeper into the analysis by including a 30 year mortgage option. Some buildings include coin operated washers & dryers for added income. In still other cases, a condo fee or HOA fee might apply. Those are each simple additions to the spreadsheet above.
Coming back to the initial question of whether to add rental real estate to an investment portfolio, the spreadsheet is a mathematical, rational, black and white estimator for whether to invest in a building. What can’t be analyzed in a spreadsheet is whether you enjoy dealing with the rotten bag of potatoes. If you’ve ever been to our office or know us personally, it won’t surprise you to know that I don’t mind some of the headaches. I know that my properties are a long term investment and the real estate market provides a diversification hard to replicate elsewhere. Brian, on the other hand, looks at me and says, let’s look at including a liquid real estate ETF that we can buy through Schwab. We may need to analyze which is the best ETF for our clients’ portfolios, but we’ll never deal with tenants or a rotten bag of potatoes.
If you have any questions about how real estate might fit in your portfolio within your financial plan, either rental real estate or a real estate ETF, feel free to reach out. I’m happy to talk the broad topic of real estate as part of a plan. Oh, and follow our Twitter account (@KSWealth) for more information.
Jared
Brian Kellett, brian@kellettschaffner.com. Phone 513-312-6067
Dave Bodnar, david@kellettschaffner.com. Phone 513-258-6973
Jared Kline, jared@kellettschaffner.com. Phone 513-768-2238
Kellett Schaffner Wealth Advisors LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Kellett Schaffner Wealth Advisors LLC and its representatives are properly licensed or exempt from licensure. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Kellett Schaffner Wealth Advisors LLC unless a client service agreement is in place.