Landlords often underestimate the true costs of owning investment real estate, so let’s discuss them to help you understand the real return on your investment.
1. Repairs
This is a big one. Pull out your 1040 form, go to Schedule E, page one. That’s where you’ll find rentals. Look at the line for repairs. Maybe you didn’t have any this year, but look several years back.
More than likely, you’ll find that you had to put a new roof on for $15,000 or a new HVAC system in for $10,000. Water heaters and appliances break, windows need replacing. Even cleaning and painting can run several thousand dollars.
Repairs are a big expense that often gets overlooked when calculating return on investment.
2. Deferred maintenance
Deferred maintenance refers to the repairs you haven’t had to make yet. I remember a fellow who called me who had gotten to a point in his life where he was evaluating how much longer he would own his apartment building. He bought it 30 years ago when it was already 40 years old. So, that’s a 70-year-old building.
It was four stories and had an elevator that was not going to pass an annual inspection. He had put off replacing the elevator for several years, and now it was going to cost a LOT of money. That’s deferred maintenance — things that should have been addressed but haven’t been.
3. Taxes and insurance
With the debt that many cities and municipalities have, taxes are very likely to rise significantly as time goes on. Properties are reassessed all the time, with the result being higher taxes.
Even if you haven’t filed a claim, insurance rates are rising. Think of the fires in Hawaii and the West, hurricanes in Florida and tornadoes that crop up every year. Even though you might not have been affected by those disasters, insurers are spreading those costs of claims out to everyone.
4. Vacancies
Inevitably, you’re going to have times when you have empty units. Tenants sometimes need to move because of a job, buying a house, or they just want a change of scenery. Every day your property is vacant, it costs you the same as if there were a tenant there.
5. Administration and legal fees
Administration fees often include the cost of credit and background checks on potential tenants. There are also costs associated with the crafting of leases that protect both your rights and the rights of the tenant.
Landlords can often face legal fees associated with their rentals. These can include tenant disputes, eviction proceedings, lease violations and maintenance issues. What if your tenant had a toy poodle when they moved in, but then they got a big dog that jumped a fence and bit a neighbor? This actually happened with one of my tenants.
6. Depreciation recapture
This can be a complex topic, but I’ll try to explain with an example.
Let’s say you have a $500,000 12-plex you bought a couple decades ago. Now it's worth $2 million. When you sell it, you say, “I've got a $1.5 million gain, right?” No, you must do something called depreciation recapture. Because remember, when you had that tax advantage all those years, you got to write off depreciation. You wrote off $400,000 of that $500,000. Why $400,000? Because we had to allocate $100,000 to the land, and you can't depreciate land. So, $400,000 was to the structure, and that's fully depreciated. You took $400,000 of deductions. And because you were in a low tax bracket during your younger years, such as maybe the 10% bracket, that gave you a $40,000 benefit. That’s $400,000 of depreciation, or at 10%, a $40,000 benefit.
You have to pay a lot more than $40,000 back. Now, in your recapture, you're going to do it all in one year, and you have to pay it at your current 25% tax bracket. Plus, potentially you have your state income tax on top of that. And if you sell it and don't do a 1031 exchange into a Delaware statutory trust, your tax might look more like $120,000 at your highest marginal brackets. That is depreciation recapture in a nutshell.
7. Neighborhood changes
When you bought the property, it was clean, safe and had families living there. Maybe that neighborhood hasn’t had a lot of investment over the years, because it all went to the suburbs. Demographic changes, among other things such as safety issues, can cause your property to not appreciate much, if at all, and sometimes it can even depreciate.
In conclusion
It’s easy and common to overcalculate the return on investment when you’re a landlord. Once we do the proper analysis, about 50% of the time, we find that what you thought was an 8% to 10% return was actually 1% to 2%.
If you’re currently an active landlord, or thinking about becoming a landlord, consider the true dollar-costs involved as well as the cost to your physical and emotional health.
