Management difficulties begin when a buyer selects the wrong property. What's the wrong property? It's one that won't attract decent people because it is either located in an unattractive neighborhood or because it doesn't appeal to them as their home. Sometimes it's hard to remember that the owner is offering a 'rental'. The tenants are choosing their 'home'. Every day, 24 hours per day, the tenant is going to be involved with the property. It will be where a family invites its friends for a social evening. It will be a safe place where the kids can easily walk or catch the bus for school. Convenient to neighborhood amenities, major access routes to jobs and recreation. When the tenants can't take pride in where they live, those tenants whom you want won't want you – and vice versa.
Where does poor financing fit into the picture? A lot of people like to brag about their 'Nothing Down' property purchases. Maybe they don't realize that the guy who coined that term was in the book business, not the real estate business. What's wrong with 'nothing down' financing? Let's see if we can't dissect a transaction to see if we can't find out.
Suppose you were selling your own home. Why would you ever entertain an offer to buy with 'nothing down' or a low down payment? Take your choice: (a) Because you were desperate to sell and had had no offers? (b) Because the price, and terms, were both above the fair market value? (c) Because there was something wrong with the property which would require additional cash investment which you couldn't afford? (d) Because the existing financing had something wrong with it such as above market interest rates, payments that guaranteed negative cash flow for a long time, or a balloon payment coming due in the foreseeable future?
Of course, there might be other conditions which would prompt a highly leveraged, risky sale. These might include a forthcoming fundamental change in the neighborhood such as a pending HUD project. That happened to one of my neighborhoods. HUD bought an entire complex. In the next month or so, drug sales were introduced into the school for the first time. Police now patrol because of roving gangs which were never there before. If such a future prospect were presented to you, wouldn't that motivate you to offer quick-carry-back financial terms to a credit-qualified buyer? The neophyte who bought your property might experience a few months of easy management until decent people refused to move there and rent it. At that point, he'd have to lower his standards in order to survive.
It gets worse. When a property is purchased on long term mortgage terms that consume all its cash flow, the buyer becomes little more than an indentured servant to those to whom payment must be made. If an investment's only return is loss which can be offset against earnings from another source, a couple of things usually are happening, neither of them good. (a) The owner is taking profits from other properties, or wages from his/her own job, and paying it out each month to support a poor investment. (b) The owner is effectively working for nothing at a job that he's paying to hold. If he quits work and stops paying, it could ruin his personal reputation and credit record for years. By far, unfeasible financing can be blamed for more financial failure in real estate than any other factor.
The combination of a financially distressed owner and a vacant, old-looking property in a declining neighborhood is what creates the opportunity for marginal tenants. When strapped for cash, jobs, rental stability, and credit are overlooked. Tenants of any kind are readily accepted to fill up properties and to start generating income with which to pay bills. Avoiding this situation is the first step toward becoming a successful rental property owner or manager.
Targeting decent housing with decent financing makes it easier to offer competitive rents. This will attract those middle-class tenants that hold the key to profits in the rental markets. Failing to do this, will guarantee that owners will repeat the cycle of drudgery with little hope for long term financial success.
