Thursday, October 19, 2017

How (NOT) to Buy Rental Property with Positive Cash Flow

Signs Of Trouble

Signs of Trouble
I am fairly superstitious and have to admit that I constantly knock on wood and spit over the left shoulder. So I should've known better when I purchased house #66 with unit 6...

It turned out 666 was probably one of the most valuable experiences of my life. Simply because it provided me with an opportunity to learn how to be a landlord hands-on.

I also learned what NOT to do when you buy a property with positive cash flow.

Clues I Ignored

Looks Great, but 66% Vacant
Unfortunately, I was so in love with the idea of purchasing a six-plex that I didn't pay close attention to the following signs of trouble.

After the inspection I knew that, out of 6 apartments:

  • A unit was used by the seller as a storage.
  • Another unit was used by the seller's girl friend as a storage.
  • One more tenant just left last month.
  • A tenant was being evicted for non-payment before closing.

My Thought Process at the Time

Totally Oblivious
Back then, it all seemed just fine to me! 

Sure - it is okay that the seller and his family are using two units. I knew the seller had the building for over 30 years. My assumption was that the mortgage was paid off over this time. So he probably didn't have to worry about income & expenses that much. Therefore, why wouldn't he use a couple of units for himself?

It also made complete sense to me that if a tenant left just before the building was put for sale, it would be better that the unit remained vacant.  My preference was to find my own tenant, increase rent to market, and have everything under control going forward.

Lastly, eviction seemed as really great news to me. In fact, with all my heart I was grateful to the seller for letting me know about the issue and going through the eviction process before closing. I knew it was much better to have another vacant unit, than to get a non-paying tenant right off-the-bat. 

What Did I Miss?

All of the thoughts were self-talk. I convinced myself that the situation was perfectly acceptable. I didn't look at the numbers, knowing that at least 3 units were vacant.

Lesson 1: Never Buy Based on a Pro-Forma Statement

Find Your Truth

When you purchase a rental property, seller provides an income statement, which shows rents collected and expenses paid.  

In most cases, you'd get a pro-forma statement instead of an actual income statement. Key differences between pro-forma and actual:

  • Pro-forma shows what income would look like, if all tenants paid you market rent every month. Then a market vacancy rate is applied (ex., 2%).
    • Actual income statement shows the money that was collected during a year or last 12 months.
  • On pro-forma, some expenses are adjusted from actual. For example, the seller might subtract 25% from electricity cost because the government is planning to issue a refund up to 25% next year.
    • Actual income statement would show you an amount exactly as on utility bills.

  • Only vital expenses are shown: Utilities, Insurance, and Property Tax.

    • Actual income statement would also include other common expenses: property management fee, garbage removal, snow/grass care, handyman, plumbing, fire inspection, cap-ex, etc.

Lesson 2: Always Verify All Numbers 

Be a Detective

To make sure I am operating with actuals rather than pro-forma, my rule of thumb now is to double check every number. I then put worst case amounts on my property evaluation spreadsheet. This helps me understand if the property is a good or bad investment at the purchase price.

To do this, I find an alternative source of information to check both rents and each of the expenses.

Here is how I go about it:

  • If landlord pays water, I call the city and confirm what they typically estimate for water expenses. In one of the cases, city staff told me they use $55 per person per month, for every other month. So now, if I see a 2 bedroom apartment, I estimate water at 4 people x $55 x 12 / 2 = $1,320 per year.

  • Similarly, if landlord pays electricity or gas, I call local vendors and confirm typical costs for a year for a similar property.
  • On the city website, I find out the expected increase in property taxes for next year. I use next year's tax amount in my calculations. You can also look at several similar properties on MLS ( and check taxes and see if there is any information regarding changes to property values in the area on MPAC.

  • It helps greatly to call several property management companies in the area and confirm their fees for managing a property of similar size in the same location. You can also confirm and make sure the area is not a D area (D for drugs, disaster tenants, etc.), ask about typical costs for snow / grass and any other services property manager provides to their clients, and verify current market rents.

  • Your real estate agent can help you find out from the seller how they handle garbage, snow, and small fixes. Often, this gives insight into pricing and scope of additional contract services.
  • Confirm current market rents on Kijij. If units already have tenants, I always use current rent (especially if market rent is higher). It takes time to turn tenants over, so it's safer to stay conservative on income side.

  • For Vacancy rate, I use 5%. This is what most lenders would use in their underwriting as well.
  • Don't forget to budget for minor fixes and major upgrades per inspection.

Happy End

The biggest mistake in my numbers was around the cost of utilities. Since 3 units were vacant,
Have Fun Learning!
utilities listed on pro-forma statement were a lot lower than actual. After the purchase, it turned out that utilities cost was twice what I thought it would be. This resulted in a negative cash flow at the price that I paid for the property.

As a wise real estate coach once told me: "In real estate, time corrects all mistakes".

Over two years, we renovated all units. Got good tenants in all of them. Increased rents to market. Separated electrical meters. 

With a little bit of luck, some market appreciation and an awesome real estate broker, we sold the property and broke even. 

Big bonus - I learned a ton.

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