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Here’s a neat concept that everyone can use, from professional poker players to Warren Buffett. In Alice Schroeder’s biography, The Snowball, she describes how in his youth, Warren was good at assigning odds to each horse in a race. This is called “handicapping.” Schroeder uses this as an analogy to explain how Buffett calculates investment probabilities.
It’s also the same concept underlying my previous post, How much is my startup worth?
Here it is in simple terms:
Your roof is leaking somewhere. The roofer offers a complete replacement of the roof for $10,000. He offers a 100% guarantee that your roof will be leak-free for three years, or else he’ll come back and completely replace it again for free. He gives you an alternative, as well: he can patch this one mossy spot for $2,000. He estimates that there’s a 25% chance this patch will fix the leak.
If you choose the patch, you have a 25% chance of saving yourself a $10,000 replacement. That’s kinda like saving 25% of $10,000, or $2,500. To get this chance, you have to spend $2,000 for the patch. In mathematical terms,
Value of Patch = -$2,000 + 0.25*$10,000 = $500
The $500 is what I’m calling Sklansky dollars, and it represents the increased economy of trying the repair first.
Crucially, these 500 Sklanksy dollars were still there even if you elect the repair and it doesn’t work. Now you’re in for the cost of the patch, $2,500, plus the cost of the replacement, $10,000, or $12,500 total. It hurts. But it was justifiably the right call to try the patch first because you had positive Sklansky dollars for that decision.
For further reading, read it in poker terms.
People usually say there are three important things: “Location, location, location!” But in rental real estate, it’s mostly just price.
The Economics of Real Estate
In any decision to purchase — any decision to invest — you always look at “what you get and when you get it” vs. “what you pay.” But there are a few things you should keep in mind about real estate as an investment class, regardless of the rents you get.
The majority of costs for a rental property are related to the property as an asset. They’re things that even brilliant management can do very little about once the property has been purchased. They all scale with purchase price:
- real estate taxes
- insurance premiums
- base depreciation
Let’s take a typical property as an example. The purchase price was $250,000. Twenty percent was put down at time of sale, so the interest payment at 4% is about $8,000/year, or $667/mo. Real estate taxes might be, say, as high as 2% of asset value per year, or $417/mo. Insurance for replacement value might run you, say, $170/mo. Base depreciation as a residential property, per the 2012 IRS tables, might be $5,000/yr, or another $417/mo.
Now here you might object, saying that depreciation is not cash out the door, so it shouldn’t count. But it does represent a real long-term expense, namely, what you’ll need to keep putting into the place to keep it from falling apart. Pricier properties generally need bigger budgets.
Add up all those expenses and you find that $1,671/mo of expenses have nothing to do with how well you manage the building as a rental property. They’re just tied to the purchase price.
So you can see that if you buy the wrong property, a management strategy to reduce utility costs, avoid lawsuits, and get the best tenants will matter comparatively little at the beginning. It can take long time for this cost avoidance to show itself on an income statement.
The moral is “shop around before you buy.”