Have you ever made pancakes and discovered you just have just enough syrup left?
Sometimes things work out just right.
It happens in rental property investing too – my Memphis property had an exceptional 2015.
I like to think in terms of property-years. No, this isn’t a real term, it’s something that makes sense to me and might sound crazy to everyone else.
What is a property-year you ask? It is 1 rental property for 1 year.
I think about things in terms of property-years to better understand randomness. Humans struggle to interpret randomness – it’s just the way we are wired.
We see something happen over and over again and expect it to keep going that way forever. Like expecting good weather in the summer, then being shocked that it rains one day.
We notice a result and make up some cause and effect that just isn’t real. Like a lucky pair of underwear the baseball player wears all playoffs.
We need a way to keep things in perspective and remind ourselves that randomness exists.
The Expected Randomness in a Property-Year
There are any number of expenses that you can encounter for a rental property.
Some are predictably periodic: they happen every X years. You can simply count down until the next time you have to take care of it. An example is insurance, every year I’ll have to pay it, so each month I add a portion to my escrow account.
More difficult to understand are the expenses that will probably occur eventually, you just don’t know when. The fact that it doesn’t happen one year doesn’t necessarily make it more likely the next year.
Here are a few:
- 1 in 2 property-years: a tenant moves out
- 1 in 10 property-years: replace the water heater
- 1 in 12 property-years: replace a major appliance like fridge or dishwasher
- 1 in 15 property-years: a major plumbing expense like a broken pipe
- 1 in 20 property-years: replace the roof
- 1 in 30 property-years: replace the garage door opener
- 1 in 50 property-years: evict a non-paying tenant
The accuracy of the numbers isn’t too important, just the concept. This isn’t a complete list of course – there are many more expenses that could crop up unexpectedly. For example I recently heard about an investor who had to do a tree removal because it grew too large too close to the house.
The property-year view gives me perspective. The perfect year with no expenses isn’t going to happen every time. The bad year can be expected every once in a while, but it won’t be the norm.
Looking at a Perfect Property-Year
Let’s look at my Memphis property for 2015. The tenant stayed in the property the whole year, rent was paid on time, and there were no major expenses.
In fact, it went even better than I could have predicted! When the tenant’s 1 year lease at $975/month was complete, he opted to stay month-to-month at $1075/month rather than signing a new lease. So the rent collected was $600 greater than expected!
With $12,300 in rent collected, here is a complete list of all the expenses for the year:
- Principle paid of $1,049
- Interest paid of $3,951
- Property Management of $1,230 (10% of income)
- Taxes of $1,086
- Insurance of $635
- Repairs of $150 (replaced thermostat)
The principle paid is like a savings account in my name. It just becomes equity that I can access later, so while it is listed as a cash expense above, it actually is neutral.
My taxes also show depreciation of $2,796. This isn’t something I actually had to pay for so it’s not listed as an expense above. The depreciation gave a tax benefit of $1,043 for 2015 (based on my 37.3% marginal tax rate).
Doing some quick math, here are the results for 2015:
- Cash in my pocket: $4,199
- Tax savings: $1,043
- Principle paid down: $1,049
Not to mention Zillow believes the property increased in value $5,000. All told, this property-year was worth $11,291!
Just kidding. I know all years won’t be this good and I should save some of that money for future expenses.
Note: In fact, the tenant moved out on December 31 which led to some significant lost income in 2016. The new tenant is now moved in and later on we will take a closer look at how the tenant turnover process went.
But man, that was a good year! It was roughly 50% of my initial investment!!!
Overall, what do you think? Is the property-year a good way of thinking about the randomness and not getting overly excited about a great year?