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A moat was a medieval form of security. Just pull up the drawbridge and watch as your enemies fail to get across the water, or if they do, to scale the wall of your castle. Although physical moats have no place in modern real estate (can you imagine the lawsuits?), an “economic moat” is Warren Buffett’s choice metaphor for what makes a business resistant to competition. Real estate as a business has a few good economic moats.
First of all, it’s very expensive for a tenant to change their real estate provider. This is called “high switching costs.” Think about the search for a new apartment, giving notice, cleaning and repairing the apartment to get a security deposit returned, moving all that stuff, and unpacking it all on the other side. This could take days, and if some of the security deposit is withheld or a moving company is hired, it could cost hundreds of dollars on top of that. This means that a rational consumer of rental housing will grudgingly accept any rent increase below their moving costs. That’s good for your business.
The second moat is the potential to be the low cost provider. A lot of real estate businesses are run suboptimally. They’re saddled with high debt, old equipment, and bad rental agreements. A business run with reasonable debt, reliable equipment, and good tenants (or else, good conflict negotiation mechanisms) can operate at a lower price than average. This helps you get the best tenants and keep them, translating into lower turnover and lower vacancies, both good for business.
The third moat can be location. Although I poo-poo’d it in my last column, saying that price mattered most of all, location can be a valuable intangible asset. You might reasonably pay more to acquire a property on a public transportation route, for instance, because it makes your property more desirable to prospective tenants. Once you have it, this kind of benefit is hard for competitors to replicate.
So the next time you think your rents are a bit low, or you paid too much for a property in a prime location, remember that these moats may be contributing to your economic success. On the other hand, a little rent raise probably wouldn’t hurt, either.
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.”
What will you do if that old roof floods your top floor apartment, or if a cast iron drain pipe cracks just as you’re paying for bedbug extermination? What if the jobs cost $10,000? Do you call up your regular contractor and cut a check without batting an eyelash, or is this is a crisis necessitating soul searching, an emergency loan, or perhaps even a brave attempt at “deferred maintenance”? If you couldn’t afford a $10,000 emergency repair, you’d be in good company. Most small time property owners have a shortage of operating cash. But you can do better.
For large, established companies, there’s a test used to evaluate their ability to survive a “disaster” scenario. It’s called “the acid test.” The phrase comes from bygone days when gold was authenticated by dropping acid onto it. Gold won’t react, so if it’s “good as gold,” the acid has no effect. For businesses, “passing the acid test” usually means having enough liquid cash to cover more than an entire year’s expenses. That’s a heavy burden for a rental property, but if you manage that way, you can have some measure of peace of mind.
You can calculate the “acid test ratio” for your property by adding all your cash accounts for the business and dividing by all your liabilities for the next year. Your liabilities include the total of all interest, all insurance premiums, all real estate taxes, and all expected repairs. Suppose you have $12,000 set aside in the property’s rainy day fund. Suppose each month you pay $800 in interest, $300 in insurance, $300 in taxes, and $200 in repairs. All those expenses, times 12 months in a year, means you have liabilities of $19,200. Your $12,000 in cash divided by your $19,200 in liabilities means you have an “acid test ratio” of 0.625. A typical publicly traded manufacturing company has an acid test ratio of 1.25 to 1.5, more than double.
Now I’ve spoken with landlords about this, and most express shock and dismay that they should have to keep so much cash set aside. With monthly income guaranteed by leases, you might reasonably use another test, called “the quick ratio,” which lets you count receivables as “cash” because you’ll get them quickly. We can calculate this using the example above. If your tenants are obliged to pay $1,000/mo for the remaining nine months on their lease, you get to add another $9,000 in “cash.” Now $12,000 cash plus $9,000 receivables = $21,000. Divide this by $19,200 and your quick ratio is greater than one, just where you want to be. But be honest and don’t count month-to-month’s at face value. And if you’re dealing with tenants who might be headed for eviction or non-renewal, don’t count a full year of their lease at face value, either.
However much money you choose to set aside, the moral here is that large, established businesses set aside a lot of money for rainy days. As a small business, perhaps with limited credit, it’s important for you to do so, as well, and to keep that money allocated separately as a rainy day fund. You’ll be able to weather any storm if you do.