When you hear the word fixed expenses, you’d assume that means they are … fixed, right? Not so fast. Fixed expenses are never fixed, and when you are analyzing a property over 5, 10 or 20 years, you need to make sure you understand why they aren’t.
Introducing … INFLATION!
What is inflation you ask? According to Wikipedia, Inflation is:
…a rise in the general level of prices of goods and services in an economy over a period of time.
Which really means that as everything you need to buy gets more expensive over time, the money you have gets less valuable.
So, the $100 you have in your pocket today, won’t buy the same amount of goods in 5 years.
Why Is This Important For Real Estate Investors?
Glad you asked!
In Real Estate, like other parts of life, you have expenses.
These expenses could be heat, hydro, water, lawn maintenance, snow removal, repairs to the property, taxes, insurance, etc, etc, etc.
These expenses aren’t going away, and because we have our friend inflation added to the mix, they are going to get more expensive every year.
What I see a lot of times is investors will forecast cash flows for the property out over 5 years, and happily add the 2% or so increase that we can legally apply to rents every year.
Yipee — more revenue/rents coming in!
But they forget one very important thing.
They don’t apply inflation to their “fixed” expenses.
What happens is their cash flow in future years look better than they really will be. This leads to increase optimism, and if they buy on razor thin cash flows to start with, they will be disappointed in future years when the cash flow isn’t as high as they thought it would be.
Here’s an example, where you can see the expenses have increased by $100 a year for 5 years based on a 2% inflation. If we look at the 20 year estimate of expenses of $7211 per year, it is an increase of over $2250 per year!
So What’s the TakeAway?
Make sure you apply at least a 2% increase to your fixed expenses when you are analyzing your properties. With IPCOnline, we’ve made it easy to increase or decrease the percentage depending on what the economy is doing that year. It automatically increases the fixed expenses by this percent every year when it calculates the 20 year cash flow and returns.
We know that inflation is not fixed. By taking this into account when you look at the numbers for a property will help you make a more accurate prediction of what a property will do for you.
Good luck in your investing, and if you have any other tips that you use when looking at properties, please leave a comment below!