May 1992
Vol 15 No 7
Think back to that first income rental property you bought. Remember the thrill at the closing when you realized you’d embarked on the first step out of your journey to wealth and fame? You felt powerful. In control of your destiny. Confident. Assured. Now, reflect on your emotions the first time that a tenant refused to pay the rent and refused to move too. If you were like me, you suddenly felt all that power and confidence draining away and forever to be replaced by a sense of total inadequacy and incompetence – and the feeling that the ownership of property was going to turn into a nightmare.
This month, we’ll take a look at what’s wrong with negotiating a below market price with super terms for the wrong house – and the moment of truth when you need to confront the most vexing point of being an investor: management failure. These positions are poles apart, yet the successful investor has to be able to function capably in each situation. In some ways, the success one achieves as a buyer of rental property can lay the groundwork for the frustration one feels as an unsuccessful manager, and vice versa. Let’s start at the beginning to see if we can’t resolve this paradox.
Management success can only be achieved in a tenable management situation. That’s one in which the product and/or service offered to the public will attract buyers who are willing and able to pay the fair market value of it. Most management problems come from an untenable management situation in which the rental property either cannot be offered at competitive market rates or the ‘tenant market’ can’t afford to pay fair market rents for the property that’s offered for rent. This leads us to the first two mistakes a fledgling rental property investor makes: SELECTION of property that doesn’t meet rental market demand and FINANCING which prevents the property being offered at rents that the rental market can afford. The buyer controls both of these factors.
Of course neither the writer nor the readers of this letter would ever even consider owning substandard rental property, but we’ve heard of those who do. Plug in any definition you like – the property I’m talking about consists of marginal rentals that appeal to the lowest economic class and which would never make financial sense without government subsidies of either the owner of the tenant. I’ve never been able to see much difference between a single parent tenant who is able to pay the rent only through rental subsidies and the landlord who is only able to pay for his property because of those same subsidies being passed through to him or her. Neither party is operating in the real world, nor are both vulnerable to the whim of the bureaucrats and politicians.
There are other considerations too. If investment property value is based upon the rate at which the income stream is capitalized, and that income stream is in turn based upon various government charity programs, it’s unlikely that there will be many buyers who will pay top dollar for the property or bankers who will lend a buyer the financing to completely cash out the seller. Thus, properties bought at a bargain because of the lack of buyers and financing will probably be sold at a bargain too (or on terms) for the same reasons. The result is a fairly low rate of appreciation. Of course, where the owner is able to make significant upgrades which are reflected in increased rents, this is less a management turnaround than a rehab project where the owners are paid more for construction skills than management skills. But there’s more.
Almost all the management horror stories come from low-income marginal rentals populated by low income marginal wage earners who rely upon Section 8 or other subsidy programs. I’m in a strange situation in which the rentals that I own are for the most part middle class residences in middle class neighborhoods. These rentals are the foundation for my Hands-Off Management System for single family houses which is the most successful (and most copied) system in use in American today. The tenants pay on time, take care of minor maintenance – or pay us to take care of it for them – and rarely contact us for repair problems even though our tenant FAX line is always on for them.
But a few properties in other areas are under the control of local managers who still believe in Section 8 rental subsidies. They persuade me that subsidized rents are the highest cash flow generators available for the properties they manage because of the local rental market. But, for some reason, they never produce as much net operating cash flows as the non-subsidized rentals in the same general price range can produce where I live. And this seems to be true in all of the various states in which we operate rental properties. There’s a reason for this too, I believe.
When the tenants comprise a group of people who are incapable of earning enough to provide for basic shelter without government assistance, many don’t have the skills and attitudes of more responsible citizens. They’re frustrated by their position in the under-class and tend to take it out on their families or the property itself. Among the members of this group you find the highest ratio of broken homes, single parent households, chemical addiction, violence and injury. Here’s what the contingent fee lawyer farms his fertile patch looking for damage claims against the hapless Landlord who is perceived to be rich and ripe for plucking.
All this translates into higher management turnover, lower skilled managers, higher maintenance and repair costs, higher replacement costs and higher insurance costs, not to mention higher tenant turnover and vacancy costs. Most of the owners I know who operate this kind of housing are intimidated by the legions of tax-paid public agencies and lawyers that their tenants can marshal against them as well as the so-called impartial judges who seem never to find fault with a tenant whether the complaint be non-payment of rent, excess noise, dirt, or destructive children. And the eviction process itself is excruciatingly drawn out without regard to the costs to the landlord. Why do Landlords buy bad properties I the first place? Because of the next trap they fall into: FINANCE.
The second mistake buyers make often sounds their death knell. Many people who start buying houses run out of money almost immediately using conventional financing. When you consider that a lender might want 20% down payment to finance an investor, that can chew up savings in great gulps. Then the entrepreneur starts looking for properties with little equity that can be purchased from a distressed, out-of-work owner. They seek a low down payment or no down payment at all. While FHA and VA financed house loans were still fully assumable, they were everyone’s prime target. The good news was that, in most areas of the country, there were lots of these. The bad news was that they all carried high loan-to-value ratios with payments which rents usually didn’t cover.
Ruinous financing in combination with tax revision decreased net after-tax rental income from these properties, keeping the Landlord in a chronic cash flow crunch. So, (s)he typically resorted to tried and true Landlord tricks to increase cash flow. Needed maintenance was deferred and rents were raised. This drove out the occupants with the highest standards and best payment histories. They were typically replaced by lower class tenants accompanied by their ubiquitous pets – and the attributes of the low-income tenants (high turnover and vacancy, collection problems, unstable family units, repairs).
Even though the properties may have started out in middle class neighborhoods, the downward social migration from homeowners to high grade tenants to low grade tenants turned good neighborhoods into transient ‘rental’ areas with little neighborhood pride. As neighborhoods fell behind, so generally did property values with the result that fewer decent tenants were willing to rent in those areas. This put the Landlords into even more severe financial straits. This as often as not culminated in foreclosures and bankruptcies. Now the neighborhoods are littered with vacant properties – or properties full of vagrants – which cause additional drug-related and vandalism problems.
O.K., O.K. So management problems are caused by selection of properties that appeal to the wrong market segment or which are financed with terms which market rents won’t support. That’s the problem, what’s the solution? PATIENCE! I don’t know everyone who’s bought the wrong properties, but I get a chance to talk to quite a few who are willing to pay a counseling fee in order to arrive at a solution.
In almost all of the cases, people just became frustrated at not being able to do all the things they perceived others to be doing in buying properties. They didn’t have the negotiating skills to wangle feasible prices and terms from owners of the houses they knew they should have been buying, so they bought properties from owners who were more impatient than they or from whom they could obtain the terms they wanted regardless of the location, size, age, condition or feasibility of the property. As a result, they wound up with the wrong properties.
As I’ve been preaching for almost a decade in my Miller Time seminar, the real key is in starting with a large enough ‘universe’ of houses in the right neighborhoods and then trying to find the almost miniscule percentage of people in those neighborhoods with whom you can strike a bargain to get the price and terms you need on the property you need. Again, here’s where I think people go wrong. They all want to find the properties by reading the newspaper. That just places them into competition with everyone else who can read the paper. Innovation brings its own reward, especially when it comes to finding the right properties and owners.
First of all, try direct mail. You probably subscribed to this newsletter because I either mailed you a brochure about it or a seminar at which you purchased it. If you buy a City or County Directory (or go down to the library and use theirs), you’ll be able to look up the name, address and telephone number of almost everyone in a given neighborhood. Get 500 post cards printed ($30) with a message that more or less says you buy or lease houses, that you are ready to act today, and that they should call a telephone number which will be answered during the hours you choose. Or use an answer tape which gives them further instructions as to the best time to call you (to test their motivation) and which always asks for their name and telephone number and house address.
If you don’t want to mail, then walk the neighborhoods or have kids do it for you, delivering flyers to the residences which say more or less the same thing along with you telephone number. Or hang up notices in prominent places and at busy interactions advertising that you buy house. Advertise that you’ll pay ‘bird dogs’ for leads to motivated sellers BEFORE THEY ADVERTISE IN THE NEWSPAPER in order to stay ahead of the competition. Last, but not least, set up a ‘boiler room’ with people to call everyone in the neighborhood to get them to contact you if they want to sell quickly. Ask yourself if you know anyone who is doing just one of these things regularly. If so, notice whether or not they have the same management problems that other owners have.
Among the ‘universe’ of houses, I always look for the owner who has a non-financial motive for selling his home. It’s too big. Too small. Too far from schools. Too near schools. Doesn’t like the new neighbor. Or the boys who are hanging around his daughter. Has to move to get a new job. My next favorite is the person in financial distress who can’t afford to stay; who has to move to a new job or to find a new job; undergoing a divorce, going into a nursing home, etc. What I’m really listening for is someone who’s more motivated than me to make a deal. I’m willing to go through hundreds of conversations until I find that person with the right property. Like I said PATIENCE. Impatience can cost you money, time effort and satisfaction. Taking the time to really prospect for the right opportunity is the key to management.
Having found the individual, I try to identify the root cause of his or her motivation and provide a solution that’s acceptable in return for getting the terms of payment that I need. Ideally, what I’d like to buy is a house with only about 20% loan to value and 80% equity. That means that I do my searching in neighborhoods that are full of 25-35 year old houses. The price range I seek is within 5% of the median price range in my rental market. Not high and not low.
The terms I want are ideally a single payment within 5 – 7 years without any interest after a 5% – 10% cash down payment. Of course, I’ll make any deal that I can afford so long as the property value and projected rents will justify it. But, with the exception of distressed houses purchased at fractions of true value, I won’t buy a rental that can’t be justified by net cash-on-cash return based upon average market rents for similar rentals in the same general neighborhood area.
This way I know I’ll always have a steady supply of tenants who are either moving up or moving down the ladder. With the lion’s share of the rental market to create rental demand, this way I’ll have a firm foundation for my hands-off management system which ultimately provides the cash flow needed to preserve financial independence. My approach also creates the competitive edge by which I can offer a house for rent which is better situated and maintained at a lower net price. The other Landlords can’t compete because of the reasons cited previously. Thus, over the past 20 years, I’ve been able to maintain high occupancy rates with lower maintenance costs, turnover and higher net cash flows. You can too, if you’ll buy the right house with the right price and terms.
WHERE DO CORPORATIONS FIT INTO THIS PICTURE?
When you present yourself as a corporate buyer, you pick up some credibility by virtue of your corporate image. Quite often, you’ll find that people will agree to accept a corporate note in preference to a personal note for their equity even though it doesn’t make sense to do it. The corporation allows you to maintain a low profile in your own locale and to present an institutional facade with which to manage your tenants. When it comes to asset protection, it’s far preferable to have your corporation dragged through the courts with limited assets than for you to have your personal assets exposed. And when you can legally divert rental income from your high-taxed state into a lower taxed and pro-business environment, you can have your cake and eat it too.
Sooner or later you’re going to start looking for people who will put up the money if you’ll do all the work of finding, negotiating, managing and selling a property in return for half interest. You’re taxable on all profit as soon as you start to earn your share. Instead, you might form a corporation into which you put a purchase contract for a target property. Next, investors put in cash in return for a 50% interest. This way you might be able to avoid any tax for many years. But you have to know the territory. The tax code is riddled with nifty little things that corporations can do – which ordinary citizens can’t – to reduce their tax bills. These only work if you’ve touched all the bases in setting up and operating your corporation to best suit your real estate needs. Done correctly, you can shelter 100% of your rental losses, accumulate corporate income at low tax rates, siphon off corporate earnings in fringe benefit packages and pension plans. You’ll find it hard to believe the difference being incorporated can make.
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