April 1990
Vol 13 No 6
NEGOTIATION MAKES THE DEAL, BUT MANAGEMENT MAKES IT PAY OFF . . .
The key to creating wealth in real estate lies in acquiring it at a cost below the price someone else is willing to pay. True profit must be NET after taxes plus any inflation. You can get this from gain on sale or income. You can BUY AT A DISCOUNT in the distress markets. You can NEGOTIATE a BARGAIN PRICE, either by virtue of the AMOUNT paid or the TERMS/TIMING of payments. You can CHANGE THE USE. to increase value through re-zoning. You can HARVEST the property – extracting minerals, livestock or agricultural products for sale at a profit. You can LEVERAGE property so that your return exceeds the rate of inflation. And you can BUY IN THE PATH OF PROGRESS, and let DEMAND drive up the value of your investment. And of course, you can just get lucky and make a killing.
The problem with real estate is that those who make the great fortunes almost without exception were active in helping their investment grow in value. In almost all of the above wealth-creation techniques, participation by the beneficiaries was required. The management of property to produce gain and income, or to produce a commodity or product, or to make it more valuable because of a higher use or additional improvements involved ACTIVE MANAGEMENT AND NEGOTIATION at one level or another by those seeking a profit. They either did it themselves, or selected and supervised those who did it for them. Unlike investments in securities, currencies, metals; real estate marches to a different drummer to make money.
First of all, real estate is usually leveraged much higher than other types of investment. HUD and VA are both getting touchy about investors taking title to current loans, so this will curb some of the high leverage transactions typically entered into by real estate investors which sometimes rise to 100% leverage (nothing down). That still leaves 80% – 90% conventional loans and unlimited numbers of seller carry-back loans that will still provide high leverage to help the real estate investor pyramid a growing estate. The trouble with leverage is that it has to be paid back – and the only source of funds in most cases is RENTAL INCOME. This is where management comes into the picture, like it or not!
Readers of this letter are usually involved in single family houses and small apartments which include condos, duplexes, triplexes, four-plexes and mobile homes. Few if any are involved in Timbering, Farming, Mining, Commercial Fisheries. So, it's safe to say that the ability to make a property produce rental income on a predictable basis is a vital KEY TO SUCCESS for most of us. Yet, we typically relegate management chores to a few random moments each month between forays into the neighborhoods in search of even more properties to buy with high leverage. It should be obvious that single-minded acquisition of houses without commensurate development of management skills and a management system is a ticking financial bomb. Trace the bankruptcies of real estate tycoons from Zeckendorf to some of the gurus who were stars on late night TV – and back up the ladder from the small investment club member who lost his first house investment to the multi-billions lost by the thrift industry and you'll find that they shared a common vulnerability: THE COULDN'T MANAGE TO PRODUCE INCOME SUFFICIENT TO SERVICE THEIR DEBT PAYMENTS.
IT'S NOT WHAT YOU DO, IT'S THE WAY THAT YOU DO IT . . .
First of all, MANAGEMENT IS A PEOPLE BUSINESS! People pay rent. People don't pay rent. People take care of properties. People don't take care of properties. People break things. People fix things. People sign rental agreements – and people break them. You can have the world's best attorneys draft up a rental agreement, but unless the manager can communicate what's required – and follow up to see that requirements are fulfilled – it won't be effective. The Manager has to be able to influence the tenants to perform at a level which will meet both the FINANCIAL and SOCIAL NEEDS of the owner. In short, the
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Manager must LEAD rather than PUSH, MOTIVATE rather than PENALIZE, and avoid law suits too. Thus, the Manager must be a LEADER who is able to make certain the Tenant really internalizes the requirements imposed by his residency as to his DEPORTMENT as well as his rent payments. There have to be both positive and negative incentives built into the system and the system has to provide both financial and psychic feedback to let the tenant know when he/she is being naughty and nice. Too often, the only contact the Tenant has with the Manager is when something has gone wrong. Here's something you can do.
Keep some postcards in the glove compartment of your work car. Anytime you see that a Tenant is improving the appearances of the property and taking a positive interest in it, drop a card at the next mail box and mention how much you appreciate it. I like to send a NON-RENT-RAISE letter even when I know the market won't sustain an increase. I first say that I'm increasing the rents, but because of their PROMPT PAYMENT RECORD and ACTIVE EFFORT IN MAKING IMPROVEMENTS, I'm waiving the increase. Alternatively, I can INCREASE THE REBATE they receive for making payments on time and performing minor maintenance as required.
The key to our Rental Contract – which is possibly the most copied document in the civilized world – is our REBATE. For about 10 years we tried a variety of incentives which included a credit toward future rent increases, a bonus which grew each month that the tenant paid on time with no maintenance calls, a reverse rental deposit equal to the tenant's original deposit paid into the management escrow every time a tenant renewed the rental agreement, etc. Then we developed the DISCOUNT PROGRAM which is in wide use today. But we discovered that the use of the REBATE had a much larger impact and increased the effectiveness of our program by reducing late rents and maintenance calls by about 30%. This has been the experience of those who've switched over from the old 'discount' approach.
The RENT-UP INTERVIEW is an essential. part of building a tenant-team to help you make your payments and maintain the premises. Because we are continuing to break ground as Managers, many of the features in our current rental agreement are a new experience for our new tenants. So we spend a lot of time both in our telephone qualifying techniques and in the interview itself going over each provision of the rental agreement so that the tenant APPLICANT fully comprehends WHAT, WHY, WHEN, WHO, WHERE and HOW he/she fits into the total management system. I like to think of rent-up as if I were hiring a new employee to perform a specific job and evaluating his/her potential. Time spent here saves many hours later on.
Our goal as Managers is to attract decent, solvent and stable people who will turn our house into their family home. We expect that they'll renew over and over again, and our Rental Agreement builds in a renewal option to achieve that. The way we prepare our houses, the way we run our ads, the way we handle the transaction all build to that result. While it may seem to be a lot of trouble, it saves hundreds of hours of our time. I haven't shown a rental to a tenant since 1975. It's up to the applicant to peer through the windows and arrange his/her schedule to catch maintenance people in the property, or to acquire a key. That's the first test to see if the relationship is going to be in our best interests over the rental period. The applicant has to want the house more than we want to rent it to him/her! Rent up is just another form of negotiation as we'll see.
By getting a motivated tenant into the system from day #1, and keeping him/her there year after year, we solve a lot of financial problems – including tax savings. Under current tax law, real estate rentals are PIGS (Passive Income Generators) or PALS (Passive Activity Losses). The Manager's job is to try to match PIGS to PALS in such a way as to generate the most income at the lowest possible tax rate. Ideally, we'd have exactly $25K in PALS which could be used to offset all other income of active owners. The rest of the PIGS would be used to pay mortgages, maintain the property, and expand the holdings. By avoiding the big 3 of expenses – Vacancy, Turnover and Maintenance we sustain our PIGS.
And when this happy, stable tenant takes an active interest in keeping property maintained, our job as managers boils down to supervising routine property improvements rather than engaging in stress-filled confrontations with militant tenants.
WE HAVE MET THE ENEMY AND HE IS US . .
I believe that a Landlord's convention would be a riot. I've never met an owner of real estate who didn't have enough tenant tales to fill an evening. But, if the truth were known, Landlords bring it all on themselves when they first buy their rental property! Let's compare a small investor with someone who is representing a major real estate company. How does each approach his task?
SMALL INVESTOR – looks for the property that can be obtained with the least down payment, or at the lowest price because of the personal/financial situation of the current owner. He or she want to use some variety of 'creative financing' to effectively discount the price even more. He/she accepts the seller's word concerning revenue and expenses in the absence of any actual financial records (or alternatively, accepts any preferred records as being the true reflection of operating profits and losses). Financial terms are given priority over other factors such as marketing area, neighborhood trends, traffic flow, market niche, etc. Actual physical inspection is often relegated to a quick walk through and a general estimate of critical repairs needed to attract tenants. Thus, the seeds of disaster are sown.
Once the title has changed hands, the eager real estate pyramider discovers that there are some gaps between the portrayed operating income and the actual net funds received. And there are more expenses that originally estimated. In some instances, tenants have been bribed to keep mum about problems in return for reduced rents during the sale period. Then there are legions of inspectors who materialize to 'discover' myriad code infractions that need to he cleared up immediately (thus motivating the new owner to continue the schedule of pay-offs to them that the prior owner had been making to avoid said code infractions). So our new owner is beset by a sea of troubles even before the ink is dry on his deed. He's got to generate revenue to cover his shortfall, so he starts to fill his vacancies with any warm body who can pay the rent and deposits. And he looks fondly on Section 8 and other housing subsidies which will guarantee him a predictable INCOME (in return for extra EXPENSES caused by down-grading of his tenants). The professional investor does things differently.
PRO INVESTOR – starts with an idea of the marketing niche he wants to compete in. So he researches the local market demographics, employment, income trends, traffic flow, customer mix between young/elderly, married/single, empty nesters/families, etc. From this data, he develops specifics of the property he's looking for. These might include the neighborhood location, type of construction materials, age, amenities of both the property and the area, traffic routes/times to major employment areas, schools, potential for appreciation, and number of bedrooms, square feet, lot size. He builds in financial parameters such as the payment as it relates to HIS projection of income. By and large, he totally DISREGARDS the financial figures presented by the seller, preferring to develop his own based upon either personal experience or averages made available by local management firms and Brokers.
He has set and funded his financial goals as to YIELD on investment, DOWN PAYMENT, total price including the TERMS available discounted to PRESENT VALUE. He's learned that as much as 50% of gross income can be swallowed by vacancy, maintenance and management costs. He raises necessary funds to make his purchase at a point where the debt load can be paid with REALISTIC assessments of the NET OPERATING INCOME after all expenses. And because he is putting down a substantial amount of cash, he is able to negotiate better terms on the balance of the debt. In short, he NEGOTIATES his ultimate management solution up-front by his buying the best property with the best terms which his targeted tenants will be able to afford and will be willing to COMPETE for. Of course, this is an idealized version of what the pro is trying to achieve. He may never bat 1000, but at least he's not striking out!
NEGOTIATION IS THE KEY TO BOTH INCOME AND GAIN . . .
Over and over I've seen investors crash and burn because of their reliance on layers of debt to buy a property with 'nothing down' rather than to rely on their ability to NEGOTIATE with the sellers to achieve the same result with much greater safety and yield. I think the reason why investors would rather deal with a friendly lender than with a seller is because they perceive the lender to be doing them a favor while the seller isn't. He's TAKING their money. The lender is GIVING THEM MONEY. What they fail to realize is that the lender is RENTING them money which is being used to MEET THE SELLER'S GOALS, not their own necessarily. The first step in negotiating a purchase is to revise Buyers' thinking somewhat. They are DOING THE SELLER A FAVOR BY BUYING HIS HOUSE. It is up to the Seller to motivate them to buy, not vice versa. In effect, he's BUYING THEIR MONEY WITH HIS HOUSE. The mortgagee should logically be the seller. After all, he's the principal beneficiary at point of sale. They may have some financial reward later on after taking on a lot of risk and hard work, but the seller is meeting his financial goals ahead of them.
My attitude is that negotiating to buy a house is a lot of fun. As soon as I buy one, I've spent my money and now I've got to start managing it. So long as I just negotiate, I can keep it up every day. So I've really got to have a good deal before I spend my money. The seller, on the other hand, is usually in a hurry. My job is to discover WHY and WHAT will happen if I SLOW DOWN the transaction. This way, he's likely to give me more of what I need in the transaction than if I let his urgency become my urgency. The more anxious that he becomes, the more relief he'll feel to conclude the transaction and the closer I come to achieving my own goals. As I pointed out earlier, I set my goals BEFORE NEGOTIATING.
Negotiation is more art than science, although many books on the market seem to approach it as a science. There are plenty of classical techniques, ways to close a deal, ways to maneuver the other party. but I think the best approach is to ask probing questions, listen carefully to discover the true reason for selling and the true time period, then structuring your own offer to meet the NEEDS of the seller rather than the WANTS. This year, we're going to try to give you some of the tools you'll need in several special courses.
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