Many landlords don’t know, or are not willing to admit, that they don’t know their average costs for vacancy, repairs and administration (management).
Why is this important?
Because cash flow is the most important driving force for almost all landlords and you can’t estimate your cash flow if you don’t know your “VRA” costs.
In addition, if you don’t know your estimated cash flow before buying a rental property, you can’t estimate your cash-on-cash return which for most landlords is a crucial metric since it reflects how efficient you are in leveraging your finite resources. Cash flow and cash-on-cash return are the most fundamental parameters for measuring performance of rentals.
There are four approaches to incorporating vacancy, repairs and administration (VRA) into your cash flow calculations. I use the fourth approach below.
1. Ignore
This approach of simply ignoring altogether the cost of VRA is the easiest to calculate since putting one's head in the sand requires no effort and no calculations whatsoever.
I don't have hard data, but I'm guessing that at least 1/4 to 1/3 of landlords simply ignore VRA when they are estimating their cash flow when evaluating single family homes for purchase as rentals, before the lender forces them to think about it. I doubt if any investor who buys multi's ignore VRA.
2. Pulling a VRA Number Out of Thin Air
Pulling a VRA number out of thin air is the second easiest approach. In Anthony Chara's course on apartment investing, he strongly recommended that if you don't know the historical average for a specific apartment complex for vacancy for example, use a minimum of 5%. That does not include maintenance, management and other costs.
3. Using VRA Numbers Provided by Broker-Property Managers Who Specialize in Rentals
There are commercial real estate brokers who specialize in rentals and they have the most recent hard data for the aggregate VRA numbers for properties in your class, in your location within a specified period of time in recent history. If you know such a broker-property manager, you can graciously ask if they will share that number.
But, in my never humble opinion, none are as valid as Approach #4 which is the one I use and teach.
4. Calculate Your INDIVIDUAL VRA Numbers
I have owned single family home rentals for 12 years and my approach to accounting for VRA is to actually calculate my personal VRA numbers. It is not hard but it requires about 30 minutes of work which I update every few years. This works well if you have good accounting records. I have everything in Quickbooks, so it's easy to export my data into Excel where I can do the calculations shown below in a few minutes.
First, we calculate how many "rental-months" we have had since we filled our very first rental with a tenant. A rental-month is like a "man-hour" since it accounts for the total amount of time that is the subject of the calculation. The table below is from my highly detailed 91-minute presentation “06 How to Choose Houses for Rentals” in the “Smarter Investing” home study course.
Here is how it works.
Let's say that you have been buying rental properties roughly every two years over the past decade and you now have 5 single family home rentals. Look at the date that you purchased each property and write down the number of months that have elapsed since each purchase. Record that number for each property in the second column of the table next to the property address (which is the first column of the table).
Add up all the rental-months and that is your total rental-months for your portfolio. In the hypothetical case of the table above, it is 367 months.
Then go back and look at the months for each property for which you did not receive rent. This is called economic vacancy, as opposed to physical vacancy. If you are the type of landlord who doesn't file for eviction shortly after tenants do not pay rent, your economic vacancy will be significantly higher than your physical vacancy.
You should easily be able to tell which months you did not receive rent if your accounting records are good. If they're a mess, none of this matters much because you probably don't understand your business well enough for these calculations to be meaningful.
As you can see from the table, some properties seem to have higher vacancy months than others and it's not just the property, it's how you have been managing them. In the table above, vacancy months are shown for each property in the third column and the total vacancy-months are shown at the bottom of the column, 15 in this case.
In this hypothetical case, the vacancy rate was 4.1% (= 15 vacancy months divided by 367 rental-months). The monthly dollar amount for vacancy can be calculated by multiplying the vacancy rate by the average rent in the portfolio.
Here is something you will likely find very interesting and even useful...
About a year ago, I calculated my vacancy rate for my first 7 years of landlording. It was 5.7%. I then calculated my vacancy rate for the last 4 years of landlording and it was 2.9%.
Why the difference?
In my early years, I was nowhere near as disciplined in my tenant screening process as I became later after being burned a few times. In the early years, I believed tenant candidate stories such as that the drug rehab worked two years ago and that someone needs to give the tenant candidate another chance. I then evicted that tenant a year later for non-payment of rent when they were in jail for robbing a convenience store to get money for heroin. In recent years, I stick closely to my written tenant screening criteria and magically, my vacancy rate decreased by 49%.
I then go into Quickbooks and I easily identify the maintenance and admin expenses, including things like telephone, accounting, mileage, REIA dues and other stuff not plainly obvious to be attributable to a single property. I divide that total dollar amount by the number of rental-months and now I have my own personal historical number for repairs and admin that I can use to estimate my cash flow for my next property.
Another important point is that I almost always buy distressed properties at a low price that I fix up to be the highest quality rental at the price point. That means that I usually have new HVAC, updated electrical/plumbing etc. and the roof replaced or repaired to be in great shape. My kitchens are almost always new. In other words, in the first few years, I have little to no deferred maintenance. This is why my repair and maintenance numbers are low and my average cash flow is high.
In summary, if you want to truly understand your business and you have been keeping good accounting records, you can pull your VRA numbers in about 30 minutes. If you just want a VRA number for your lender without having to be honest to yourself, ask the lender for their number. If you don't care or are too lazy, don't worry, be happy and you should not be reading this far.
Last point...the way to increase your cash flow and reduce vacancy is by implementing best practices for tenant screening and tenant management. Those best practices are described in great detail in the 90-minute lecture “07 Establish Acceptable Standards of Behavior with Tenants, Tenant-Buyers, Other People’s Children and Other Humanoid Life Forms” in the “Smarter Investing” home study course.
If you are a landlord and wonder why the amount of money you have left at the end of the year is not the same predicted by the difference between rent collected and PITI, I recommend that you calculate your VRA. This will also help you more effectively choose your future rental properties.
