At Eckhoff & Companies we have numerous clients who own rental property, several of which own multiple properties. These properties range in type from single family homes, apartments, retail, and commercial buildings. Many clients have owned these properties for years, decades and even multi-generational ownership. Some are owned solely, while others are owned with partners and some in complex structural arrangements.
In this blog, I discuss the negative trends we are seeing in the net pre-tax cash flow many of our clients are experiencing with their investments and...as always...what to do about it. In future blogs I will discuss the other challenges we are seeing in the rental ownership market along with the impacts we are seeing from COVID-19.
When most people buy investment real estate, they are often looking to diversify their investment portfolio from stocks, bonds and options and include “hard” assets, i.e. real estate. I fully support and believe in clients owning real estate to diversify their investment portfolio. As many of you know, us financial planners have been preaching about the importance of diversification for decades…sometimes a bit overdone, but that is a discussion for another blog.
What Happened to Cash Flow?
It is common for us to speak with clients who have owned property for extended periods of time that have experienced, as I like to refer to as, cash flow leakage. There are many reasons this happens to rental property, but what continuously surprises me is the level at which clients are unaware of what is happening at their property to cause this erosion in profit. Some are not aware it is happening.
There seems to be a certain level of complacency that hits owners the longer they have owned the property. In most cases they are managing the property themselves, but still experience reduced cash flow slowly but surely over the years. In some cases,owners are responsible to manage the property, but put the property on autopilot, and as a result are not engaged and involved enough. Over time things change: the market, laws, tenants, costs may increase, repairs are needed, etc. Are you staying in touch?
Generally speaking, the challenge of novice or hobby investors in real estate is that they do not do enough research when they buy the property and then do not stay on top of the latest material issues and concerns that may impact their investment property. Could you ever imagine someone doing that with a stock they bought, or their advisor bought for them?Not normally. So why does this happen in real estate?
Firstly, when we decide and buy something ourselves, we are redescent to admit we made a mistake or that it is not going well. We have had conversations with clients who are disappointed with the returns on their stock/bond portfolio compared to an arbitrary benchmark, but when it comes to their real estate there is little scrutiny.
Benchmarking - Let’s talk about that for a minute.
According to Wikipedia: “Benchmarking is the practice of comparing business processes and performance metrics to industry bests and best practices from other companies. Dimensions typically measured are quality, time, and cost." It is important to compare your performance with other like-kind and successful properties in your area toascertainwhether the capital you have investedisperforming well and still worth the effort and hassles that may come with it.
Yes, I want you to look at that property as an investment. Far too many people look at their property as a child rather than looking at it unemotionally as nothing but an investment of your hard-earned, hard-saved money.
At Eckhoff & Companies, we believe your minimal goal for net* annualized income from investment property,generally speaking should be:
Managing yourself: 7% - 9% Others managing: 5% - 7%
*Net annualized income should be the result of deducting all operating expenses from income and dividing that net number by the current market value of the equity in the property, not including debt.
Please keep in mind, these are minimal numbers. We realize some people are willing to accept a lower return in exchange for peace of mind, with nohassles. But if you are going to be dealing with the Terrible T’s, we want you to have a return for your invested capital at risk and your time and efforts.
Where’s the Leakage?
Most often we see that clients are not raising rents commensurate with their rising costs or the changes in the market. There are many reasons for this. Sometimes we find that clients want to be nice to their tenants. While we empathize with this notion and feeling of community and stability in your property, we do need to gently remind you that this is a business, and you have significant capital at risk. In many cases this is the biggest investment of saved capital someone owns. This may be a helpful strategy if the tenant is one who takes care of your asset and you are building good will. Let’s just be careful not to go too far with this where we are harming ourselves and our future.
Rent control is another leading reason for rents not rising commensurate with costs or market trends. This is a grave issue with owners. We are seeing increased legislation restricting property owners in raising rent, allowing tenant subletting, evictions, etc. For this reason, we are seeing strong trends of these owners selling and completing 1031 exchanges into more passive ownership.Other cases point out how costs have just skyrocketed. Utilities, repairs, maintenance, and upkeep.
What to Do About It
First, conduct an analysis to understand your cash flow and net yield, as I describe above.
Next, benchmark it to our recommendations or norms in your area.
Lastly, consider your options:
- Should you raise rents?
- Should you fire your management company?
- Can you evict or not renew in order to raise rents and get better tenants?
- What costs can you reduce or eliminate?
- Does a 1031 exchange make sense for you?
- What is a Delaware Statutory Trust and will this help?
Who should I contact?
Eckhoff & Companies - we can help you to analyze and benchmark as fiduciary advisors.
We will also help you understand your options, the advantages, disadvantages, and costs of each of those options.