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The Management Fee: Return on investment or pay check?

Do not include what you earn (or save) by managing your own properties as a return on your investment. It's not. It's your paycheck, and it doesn't count. Let's dig a little deeper...
When you make an investment, whether in the stock market, bonds, or even a savings account, you'll do some homework before you invest to make sure it's a suitable place to put your money. But once you do that, you'll just write a check and not think about it anymore. If you invest in 50 shares of IBM, you don't have to go up to the headquarters on weekends and do the bookkeeping, return phone calls to distributors, or sit in on board meetings. That would be called a job. Now to be clear, some investments do require more ongoing homework than others. If you invest in individual stocks vs index mutual funds, you might need to keep up on the health of that company and the economy in general. But that's just standard due to diligence, which will increase with the amount of risk an investment poses. It's not "work" per se.

It's easy to forget this concept when it comes to real estate investing. Many investors just consider their return on investment to be whatever is left over after all expenses. It doesn't matter whether they do showings, do the books, or hire others to do those tasks for them. If they've invested $25,000 and they have $2,500 left as profit, they figure their return on investment for that year is ten percent; whether they broke a sweat or not.

But how about the ongoing chore of property management? What if the owner in this example really does make $2,500 a year on his four-unit, but he also does everything himself. He takes maintenance calls, does regular checks on the units and tenants, calls for oil deliveries, collects rent, collects laundry money, schedules showings, drafts leases, does the bookkeeping, pays the bills, etc. We call this endless "to-do" list property management. Management does not include things like mowing the lawn or cleaning in between tenants. That's maintenance and should already be factored into your repairs & maintenance line items. Management is the time spent "dealing with" the maintenance, as well as other tasks. Fixing the toilet isn't property management, but taking the call from the distressed tenant, calling the plumber, paying his bill and entering it in Quick Books is. It's important to understand this because it's easy to compare the money you make in real estate with the money you might make in a savings account or mutual fund. If your comparison is based on faulty data or assumptions, you might not be making a sound decision.

Even though we manage all our own properties, I add an 8% property management fee into my expense projections. That way, I know how much I'm making on my money, and how much I'm making for my time. If you manage your own properties, you're going to make more money on average than if you hire a management company. But part of the money you're making is from your "work" in the business, while the rest of it is from cash flow, which represents your return on investment in the property. Another way of putting it is that the extra amount you keep as a result of managing a property yourself is your salary, while the rest of the money you make--the cash flow--is the "dividend" from investing your money in the property.

Failing to separate these two streams of income is like working as a teller in a bank, where you also keep your savings, and thinking that your return on your savings account is the 3% you get in interest, plus the paycheck you get working as a teller. Of course that makes no sense, because the difference is so obvious, but really it's no different than investing in and managing real estate. I want to know what I get for parking my money, and what I get for being a manager. At the very least, knowing these numbers will help me decide if I'm making good choices with my time and money. If my 8% management fee is most of my return, maybe it would be wiser to open a real estate management firm and put my money somewhere else. If my cash flow is substantially more than my 8% management fee, then maybe I should outsource the property management and spend more time doing what I love. (Assuming it's not managing real estate).

This concept becomes super important when planning for the future. For example, let's say you've been managing your own property for a couple of decades, but decide you want to start traveling, or you want to retire but keep your properties to avoid capital gains and depreciation recapture. You figure you've been earning $50,000 a year on your real estate investments, which you've figured to be approximately a 20% return on your money. That's a great number but you want to know how much it will cost to have someone else manage it and you discover it will be about $16,000 a year, leaving you with $34,000. Now you've got to get creative. You see that all these years you've really been making 12% on your money (which is still great by most standards), and then you've had a job that paid you $16,000 a year. When you "retire" from that job, the income stops. Many property owners find themselves in some scary positions. Imagine coming into retirement thinking you've earned 10% on your real estate all these years. Now you're facing an 8-10% management fee. Now you're only earning 2% or less on your money. It doesn't even make sense now to own these buildings.

I suspect a lot of real estate investors miss this point because their investment wouldn't be profitable on paper if they deducted a management fee. It's easy when you're analyzing properties, especially when you find one you really have an emotional attachment to, to justify not using a property management fee in your numbers simply because you'll be self-managing. This is a big mistake. Real estate is hard work, and it's not always profitable. Don't trick yourself into thinking you'll be making passive income when you'll really be working your ass off for it.

Like what you've read about the difference between the money you earn on your money (return on equity) and the money you earn with your time? (property management) If you're hungry for more, see our purchase options below. We think you'll earn back the money you spent on this package with your first deal.

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