HOW TO “QUANTIFY” THE QUALITY OF DIFFERENT RENTAL HOUSES
Just like the stock market, there are different quality investment properties. This is true with apartments, office buildings, industrial warehouses, and it is true with rental houses. Many brokers and investors will qualify a property as an A, B, or C quality property. I use that same technique when I evaluate rental houses. However, this qualification is subjective. So I want to quantify here how I determine the quality of a rental house.
Zelman & Associates published a very insightful article once about where people live during their life cycles. They observed that, generally speaking, younger single adults tend to live in multi-family or attached housing. As people get married and have children they are much more likely to live in single family detached residences. Later, as these adults become “empty nesters” they are more likely to move back to attached housing (Condos, Townhomes, or apartments). In a less scientific way I have made the same observation for years. Most of the tenants that live in the rental houses we own and/or manage are families with children.
A conscientious parent is going to want their child to attend the best schools available. Houses near good schools tend to be in higher demand and that higher demand is reflected in the price, higher rents or sales prices. There is a website, www.greatschools.com, which rates each elementary, middle, and high school across the country. One of their metrics includes an overall ranking for the school of 1 – 10. OUR TECHNIQUE: in order for us to consider a rental house as an “A” property, it has to meet 2 criteria. First, the www.greatschools.com ranking for that local high school needs to be 8, 9, or 10. Second, the market rent for the house needs to be at least $100 per month higher than the average rent for a similar house in that County/Area. For instance, if a typical 3 BR house in Gwinnett County rents for $1100 per month, then the subject house would have to rent for $1200 per month or more, AND be located in a public high school with a Great Schools ranking of 8, 9, or 10 for us to qualify it as an “A” quality property. A “B” quality property would rent for about the average for a similar house and the Great Schools ranking would be a 6 or higher. Any houses with a Great Schools ranking of less than 6 would be considered “C” quality properties by us.
There is also an age component to consider when evaluating quality. A house that is less than 15 years old will cost less per year to maintain than houses that are 15 – 25 years old. Generally speaking, houses under 15 years old do not need new roofs, new HVAC systems, appliances, etc. Between years 15 and 25, just about all of the major systems of the house will be due for replacement which will drive up the amount the owner spends on maintenance and repair. For houses over 20 years old the investor/buyer needs information on the age of each system in order to evaluate the effective age of the house to better estimate the amount to budget for maintenance and repair.
WHY “QUANTIFY” THE QUALITY OF DIFFERENT RENTAL HOUSES
Why is quantifying the quality and effective age of a rental house so important? These factors will significantly impact cash flow. Higher quality properties will generate more income in that the owner will have less income lost due to vacancy (higher demand from tenants to live in that area) and reduced losses from delinquency (higher quality tenants are more likely to pay as agreed).
Higher quality rental houses also cost less to maintain. We have observed for many years that C quality properties cost more per year to maintain than do B quality properties which cost more to maintain than A quality properties. We run averages each January to look at the maintenance expenses for the previous calendar year so we can more accurately budget how much to expect for maintenance and repair expenses during the coming year. We break down these averages by rental rate and property age to better understand the costs for A, B, and C quality properties.
Some investors purchased a lot of C quality properties during the recent recession and budgeted losses for vacancy and delinquency based on some industry averages (for all rental houses), then were disappointed when the portfolio was not performing as projected. Their actual losses due to vacancy and delinquency were much higher than budgeted. Correspondingly, the maintenance and repair costs were also higher than they had budgeted.
I don’t believe there is a perfect way to budget for 1 single family property for 1 year. With an apartment complex, averages will work across the multiple units. Correspondingly, our averages work across a portfolio of houses over an extended period of time. As a “buy and hold” investor, that works for me. I can estimate my Internal Rate of Return on houses I buy with much higher rate of accuracy using these averages based on the correct quality classification for the house.
I have found my “sweet spot” is with B- and B properties. That seems to be where I find the best compromise between yield and risk. Your “sweet spot” may be different depending on your tolerance for risk and your expectation for yield. If you are interested in buying rental houses in Atlanta, and aren’t sure what kind of property would be best for you, let’s talk.
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