Today’s show is about protecting rookie investors from making bad investment decisions.

This weekend I was speaking at an investment conference. I had several people approach me and ask advice about buying properties in markets where purchase prices were low and tenants don’t have the funds to pay the rent.

Yes folks, don’t get ahead of me now. I know many of you have seen this movie before. You know the ending.

One investor in particular bought a multi-family property in Chicago. It was clear to me that he did not do his due diligence. He didn’t know which streets were the dividing lines for rival gangs in the area. He relied upon the publicly available heat maps that were available on the crime statistics websites. He didn’t know that the city had cut back on policing in many neighbourhoods and that violent crime had jumped by 60% in a period of months. He relied upon the broker’s information about the property. The financial model he constructed followed what he had been taught in a real estate training workshop. He had allocated 8% of his gross monthly income to maintenance. He chose that percentage in his financial model because that’s what he was taught. He liked the fact that the government subsidies for rent were above the market rent and the property was going to produce strong cash flow.

But here’s the problem with that approach. All of these spreadsheet based approaches neglect the reality on the ground. The spreadsheet approaches neglects the true cost of maintaining the property when maintenance events occur. Some maintenance events are somewhat difficult to predict. You don’t know when a refrigerator will die and need to be replaced. You don’t know exactly when a water heater will die and need to be replaced. But you do know that a water heater costs exactly the same in an apartment that rents for $2,000 per month as an apartment that rents for $650 per month.

The water heater doesn’t care how much rent you are collecting. You are looking at hiring a plumber to replace it. If it is powered by natural gas, you may also need to hire a gas contractor to disconnect the old one and reconnect the new one.

If the water heater died the way most of them do, you are probably facing a significant cleanup and repair from the water damage. You are replacing flooring, repainting, possibly having mold remediation. All these things happen the same to an apartment that brings $650 per month or $2,000 per month.

If the 8% budgetary number is appropriate for the $2,000 apartment, then it’s way too low for the $650 apartment. You would need to reserve 24% in the case of the $650 apartment to equal the same dollar amount.

When a tenant moves out and the apartment needs to be cleaned, the cost of the cleaning is going to be roughly the same, regardless how much rent was being charged.

Your financial model needs to consist of listing all the expected maintenance costs that could come up for an apartment. It’s then your job to estimate how frequently these events will occur. A water heater will need to be replaced every 10-15 years. Carpeting will need to be replaced every 5-8 years. Ceramic tile will need to be replaced every 15-20 years. Air conditioners will probably last 15-20 years. Apartments will need to be painted every 3 years.

When you add all that up, then you can estimate the real dollar value that you need to reserve.

But here’s the other problem that often arises in the financial model. You construct a model where the rents increase with the rate of inflation, perhaps 2% per year. You might model the same 2% for your expenses.

I can show you examples where energy costs have increased 10-15% in a single year. If you construct your model using arbitrary percentages, you run the risk of overlooking the real situation on the ground.

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