How To Avoid the Money Pit

Anyone who has owned a home knows there are constant expenses to keep the home maintained. Hopefully your experience wasn’t like the 1986 movie The Money Pit. In the movie, Walter (Tom Hanks) and Anna (Shelley Long) buy a $1 million distressed mansion for only $200,000. Thinking they scored a great deal, they planned to renovate it into their dream home. However, everything falls apart—the house, their budget, and their relationship. To complete the Hollywood ending, the couple reconciles, and the house gets put back together.

While The Money Pit is an extreme example, houses constantly need to be kept up. If you have kids, you know that flooring and wall paint doesn’t last nearly as long as it should. With pets, perhaps the landscaping doesn’t mesh with their habits. Water heaters fail, HVAC units need seasonal servicing, garage door coils snap, concrete cracks, and paint fades. The same issues that arise in a house, also arise in apartments. It’s just magnified by hundreds of units.

Homeowners don’t plan very well for these annual expenses. And anything major (roof, systems, etc.) was hopefully caught during the initial inspection or will be covered by insurance. But if we own the home long enough, those major expenses become our responsibility. So, what do people do in that instance? They delay. And delay some more. Perhaps they’ll even try to pawn it off to the next buyer. That strategy works in a seller’s market. It doesn’t work when the buyer has the leverage.

Apartment investors routinely budget for annual repairs. If an investor uses an agency lender (Fannie Mae or Freddie Mac) for the acquisition loan, the lender makes you plan. They usually take $200 to $300 per unit per year and amortize it over a 12-month period. That way, there’s money set aside for routine repair and replacements. Because the lender holds back funds, owners must complete the repair and then submit paperwork for reimbursement. There’s an incentive to do the work and to return cash flow to the property.

What the lenders and buyers are bad at, especially in hot markets, is planning for the big expenditure. When the business plan is to buy, renovate, and sell within a 3-year period, many are not concerned with non-revenue-generating repairs. That roof replacement can wait. Those leaky windows aren’t that bad. The potholes don’t bother tenants too much. When there’s fierce competition to buy deals, you can’t budget for these items. You won’t win the deal. We lost plenty of opportunities from underwriting the necessary capital.

Those 3-year business plans have been elongated for many owners who bought in 2021/2022. All the capital earmarked for unit renovations and other revenue-generating items has been spent on interest rate caps, loan extensions, and rising expenses. Because they’re being forced to operate older assets, they now understand how expensive it is. This is causing a shift in mentality for investors. We all want newer, better located, and less capital-intensive properties.

With more investors now cognizant of the true cost of operating older apartment assets, underwriting is more realistic. We can account for major replacements in our underwriting now. A roof replacement in Year 7. A full exterior paint in Year 3. Programmatic HVAC replacements can be budgeted beyond the $200-300 annual reserve. Accounting for these costs doesn’t preclude us from being a competitive bidder today. The same is true of these operating expense categories: repairs and maintenance, turnover, and contract services. This set of expenses runs around $1,000/unit per year. Years of neglect from short-minded owners cause these expenses to stay high. Again, today, we’re not penalized for underwriting realistic expenses.

The most in-demand apartment investment right now is 1990s or newer vintage properties in core markets. Our business plan for the Calvera Income & Growth Fund (CIGF) highlighted this close to two years ago. Now everybody wants in. As competition heats up (it’s not competitive yet), investors will again look the other way on key expense categories. A property built in 1994 is 30 years old. It may be newer than a property from 1984, but the list of needed repairs is the same.

Because we were early to this idea, we bought 27TwentySeven, a 2016-vintage apartment building in Dallas, in June. This is an example of a property new enough to have fewer capital needs. Cash flow is preserved, and more is available to distribute to investors. With a longer hold period envisioned, we need to ensure we maintain the property. Preventative maintenance and regular examination of the building systems will help ensure we avoid the unexpected “big one.” We are committed to finding more deals like 27TwentySeven in Dallas.

At the same time, we’re more open now to those older vintage deals. That is where the true distress is. Many of their owners weren’t prepared to operate capital-intensive properties. Not only is the yield today higher (i.e., more cash flow) on those assets, but we can underwrite real operating expenses and significant capital. That capital can now add value by reducing future expenses. Fewer calls to the plumber, roofer, electrician, or HVAC specialist will bring operating costs down. Younger assets are easier to operate with far fewer headaches, which is why most buyers today are focused on them. Opportunities are often found in overlooked segments of the market. This is why we’re spending an increasing amount of time today evaluating older assets for investment.