By Ouida Vincent,
a physician, active real estate investor and entrepreneur

http://ouidavincent.com/

Understanding Real Estate Losses

I was talking with my mentor, Chuck, the other day and was pouring over my year end statements calculating losses in rental income over the year. I do this by calculating the expected income: rents times units times twelve and divide that into rents actually collected for the year. That gives me the percentage of rents collected for the year. Subtracting that percentage from 1 will give me the percentage of income lost for the year. As an example, we expect to collect $50,000 in rental income for the year, but instead we collect $45,000. Using the above formula, we collected 0.9 or 90% of rents for the year. To determine our loss we would do the simple calculation of 1-.9 = 0.1 or 10%. I was lamenting that one of our buildings had a 22% collection loss for the year. Chuck then asked me if it was really a collection loss or some other kind of loss. Turns out that there are 3 kinds of income losses on a property. They are:

Collection loss: the tenant is in your unit but not paying rent.

Market loss: the unit is rented for less than its market value.

Vacancy loss: the unit is vacant and, therefore, not earning rent.

Understanding Collection Loss

Collection loss can be a direct measure of your or your property manager's ability to properly screen tenants for your building. Anyone can fall on hard times and a tenant who has been in your unit for several months then fails to pay the rent may not reflect on a property manager's ability to find suitable tenants for you, but a tenant who defaults within 90 days certainly does. As a general rule, housing costs should be no more than 28% of gross pay and total debt payments (housing plus consumer debt) should be no more than 33%. This rule applies whether the property in question is a home to buy or a home to rent. In an attempt to keep a property full, a property manager may bend the rules or run rent specials both of which expose the property owner to income loss. An example of a collection loss is as follows. Unit A rents for $600 dollars per month. Bob Smith moves in and signs a one year lease. At $600 dollars per month, you expect $7200 dollars income from Bob Smith over the course of the next 12 months. At month 3 however, Bob Smith stops paying, it takes 30 days to evict Bob and another 15 days to turn the unit over so that it can be re-rented. Bob occupied your unit for 30 days while not paying the rent. He paid the rent for 60 days. The expected rent collection for the time that Bob was there was $1800 dollars. Bob paid $1200 dollars and then defaulted. He was in the unit an additional 30 days while you took him to court. The loss to you was $600 dollars, just under 10% of the expected income for the year. The unit is vacant for 15 days while it is turned over for a new tenant. This loss is called a vacancy loss and it amounts to $300 dollars. Now the total loss for that unit is $900 dollars or 12.5%

Understanding Vacancy loss

Vacancy loss occurs when the unit is empty or vacant and unable to earn an income. A unit can be vacant because of the rental climate, the unit itself needs renovation, or your property manager is unable to market the property appropriately to keep it full. In the current economic climate, the national vacancy rate is now 11% up from 7%, units are simply, due to market conditions, taking longer to fill. Your property manager tells you that it will take $500 dollars to make your unit ready for a new tenant. Fortunately Bob left a $400 dollar security deposit which will be applied against unpaid rent, but you balk at paying $500 dollars to have the unit fixed up and ask your property manager what is the minimum that you can do to re-rent the property. He suggests new paint at a cost of $150 dollars and a cleaning at a cost of $75 dollars but tells you you will have to re-rent the unit for $550 because the unit has to be in mint condition to rent for $600. The difference between the $600 dollars you could get and the $550 you will get for going cheap on the make ready is called a market loss.

Understanding Market Loss

There are several reasons that a property will rent for less than it is generally worth.

Soft rental market. As vacancy rates go up, rents often drift down eroding some of the value of a property.
The owner wants to keep the property full and will rent each unit for less than market value to do so.
Ignorance of the market value of a property.
Failure to keep a property in good condition.

Market losses are important because under-renting a unit has long term implications for the value of the property. Remember that a rental property is really only worth a multiple of the gross monthly rents. Under-renting then will affect long term value for the negative.

At the start of our example, our unit is worth about $72,000 in the market place. That is $7200 dollars times 10. In Month 3.5 the unit is re-rented for $550 and stays rented for the remaining term of the original lease, 8.5 months. The total rental income collected during that time is $4675. The total income for the 12-month term is $4675 + $1200 + $400 =$6275. The yearly loss is 13% or $925 dollars. The losses break down as follows:

$200 dollars collection loss this is because the owner was able to apply the $400 dollar security deposit against unpaid rent;
$300 dollars vacancy loss;
$425 dollars market loss.

Notice in this example that the greatest dollar loss was caused by the property owner who chose not to spend $275 dollars in order to fix his unit up to bring it to market rent. That decision, though didn't just cost him $425 dollars, it doubled his income losses for the year and it also cost him $6000 dollars. The decision to forego that additional $50 dollars per month in rent lowered the value of the property by $6000 dollars. Had the property owner fixed up the unit properly after Bob Smith was evicted, his collection loss for the year would have been 7% not 13%.

Being able to analyze your losses can help you analyze all of the decisions that go into running a real-estate business.

Published - May 2010