October 1996
Vol 20 No 2
About 45 years ago, with no prior training or experience, my widowed mother was able to support herself by managing rentals for a well to do local investor. It may be hard for today’s managers to believe that back then most people could earn enough to support themselves. Most paid their bills, including rent, promptly, with checks that cleared the first time through. Most formed stable households. Most could provide good credit and personal references. Most stayed the entire term of the rental contract. Most were able to pay deposits plus the last month’s rent. Would you believe much of the above applies today!
Intelligent people can still earn a decent living managing single family rentals when they rent to tenants with average incomes. The vast majority of mainstream middle class Americans pretty much resemble those of half a century ago despite what you may have read in the newspaper. They make excellent tenants. Why is it that so many investor-property managers suffer from a sort of myopia which sees only the bad in people, instead of the good? Admittedly, the news media, and politicians, rarely talk about all those Americans who are drug-free, long-time job holders, financially responsible, with stable marriages and clean-cut kids. The majority of these are able to cope with life’s everyday problems without public assistance, but that doesn’t explain it all. There’s got to be more to this story.
Media’s constant portrayal of Americans as ‘losers’ may not be the only reason for landlords’ jaundiced view of tenants. All some managers ever encounter are litigious, destructive tenants who won’t pay rents and who refuse to move out until forced to by the courts. Media’s negative vision of American society is confirmed daily. Many managers can’t accept that there are millions of first rate middle-class people who happen to rent rather than own their homes. What’s the explanation that will resolve the paradox between these two separate realities?
The operative word above is middle-class. Not only middle-class earning power, but also, middle-class values. There I go being politically incorrect again, but, we’re talking economic reality here. I challenge you to find a manager who rents property to middle-class people who has the problems of low-income landlords. Most of those cynical managers who believe the worst about people, don’t rent to the middle-class. Their tenants come from the lowest income quartile. Among these you’ll find those who don’t have the skills and/or experience to be able to find and keep a job which will support their lifestyle. Those who depend upon subsidies just to stay even and those who create most of the problems associated with management.
Landlords with perhaps 33% of the tenants encounter 90% of all the problems that tenants cause. How do I know? I’ve been there and done that. It’s only natural for those just starting into the real estate business to focus on marginal properties. Without an investment track record and assets, the beginner can’t qualify for financing or the purchase of better properties. In contrast, burned out manager/Owners often make it easy for a beginner to buy their older, functionally obsolete rental properties. They tempt the newcomer with ‘owner financing’ replete with low down payments and deceptively ‘easy’ terms.
I bought my first small apartment building on what I thought were fairly crafty lease/Option terms. My payments were guaranteed to never exceed the actual rents I received less bonafide maintenance costs. How could I lose? It was easy. While vacancy and repair costs wouldn’t hurt me, I’d overlooked little things like insurance, taxes, utilities, garbage disposal, advertising and management. In so many words, unless I was 100% occupied, I had to subsidize these costs out of my own pocket. If rents fell off, I had to pay to work there. All those plans about upgrading the property fell by the wayside. I accepted any tenant who’d apply.
POOR PROPERTIES AND POOR FINANCING BEGET POOR TENANTS . . .
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 ‘homes’. Every day, 24 hours a day, the tenant is going to be involved with the property. It will be where a family invites his 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 who 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 who 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.
HOUSES ARE A LOT LIKE RACE-HORSES . . .
Which race-horse owner makes the most money? The one with a stable full of mediocre horses contentedly munching hay by the bale while losing races? Or the owner with just one horse that wins over and over again? If your objective is to generate income rather than to have the bragging rights to ownership of a lot of unprofitable rental properties (and wide experience in the martial arts), doesn’t it make sense to focus on fewer, better properties than more, worse properties?
If you need income, there’s another point about highly leveraged purchases that should be pointed out. If leverage is good in a rising market, it certainly will produce high gains in equity and net worth, but not necessarily in cash flow. The fact that your properties are increasing rapidly in value isn’t going to motivate your tenants to increase their rents. Try to ‘spend’ your equity buying lifestyle and you’ll see how little economic reality there is to it. Chuck Considine, a friend and mentor, used to define equity ‘as that part of real estate investment that makes you feel better until the day you’re forced to sell’. Practically speaking, selling highly leveraged properties is about the only way to get them to produce cash profits. And that presumes that there’s a cash sale market out there to sell into. It’s been my experience that a person can hold a ‘high equity’ property for several years without finding a cash buyer.
What about ‘borrowing equity out’? There are a couple of problems with this concept. Holding many properties through the use of high leverage is not conducive to being able to borrow against equities to raise cash. A portfolio of debt-laden properties doesn’t make a borrower look very attractive to bankers – especially if they produce marginal, or negative, cash-flow. Buying lots of ho-hum rentals more or less just guarantees the owner a fairly low-paying job. Most of these owners would make out better working for someone else; if the risks and rewards of marginal property ownership were compared with those of a salaried manager of a decent apartment property.
On the other hand, suppose you only bought houses that would readily appeal to the growing middle-class-family rental market. That means no condos, no town houses, no duplexes, and no zero-lot line houses. Even if you had to acquire properties much more slowly, you’d be able to keep them filled, longer, with more competitive rents. Your tenants would begin to resemble those of my mother of half a century ago. Rents coming in on time, in the right amount, in checks that don’t bounce. People leaving a house cleaned and ready for occupancy, not because of the threat of a withheld deposit so much as because that’s the way they found it. Until you’ve had middle-class tenants, you don’t know how good the house business can be.
Can you imagine someone paying $4500 to move in? Whose banker confirmed that he had over $20,000 in his savings account? What about someone, who after having rented for 5 years, had the entire house, painted inside simply because, as he said it, ‘I want to keep my landlord as a friend after I move out.’ All the above happened to me with my middle-class tenants. I’m not alone in these experiences.
Last spring, once warm weather had returned, one of David Tilney’s Colorado Springs tenants reported a leak in the sprinkling system. This discrepancy couldn’t be discerned under the snow at the time the previous tenant had moved out six months before. The prior tenant volunteered to help dig up the line and repair it for the current tenant. Middle-class values. David teaches the best single family house management course offered anywhere at any price. His documentation is state of the art. If you’re interested, you can contact him at (719) 632-7462.
I don’t mean to bash all you singles, but I’ve found that family and job stability mean more than credit checks when it comes to choosing tenants. Even the best tenant won’t pay rent if he can’t. Some, who lose their jobs, or roommate, move out readily, but others don’t. Either way it costs the owner money in turnover time, repairs, advertising, legal fees, vacancy, and lost rents.
GOOD MANAGEMENT IS 90% LEADERSHIP AND 10% SUPERVISION . . .
What do we mean by ‘leadership’? Military manuals describe it as ‘the art of influencing others to willingly accept and achieve defined objectives’. There are some special words there. The first one is art. Art usually refers to one’s ability to do things rather than to know things. You can study management books until the cows come home and still be a poor manager unless you’re able to do what the books say. That requires lots of practice putting into effect what you learn. When we talk about learning, it’s the process of changing behavior patterns to incorporate new information. In short, find out how a good manager does business, than start using successful practices in your everyday property management.
Skipping ahead to another term, what do we mean by ‘defined objectives’? If you don’t know what you expect of yourself and of those who look to you for guidance, you can’t expect them to do it? Good managers set down in writing goals which relate to how they’ll manage and maintain a property, and how the tenants will be able to help them meet these goals. When they manage for others on a fee basis, they’d define these goals in concert with their employers to be sure they both understand and agree with them. They should do no less with their tenants.
Start with the premise that a tenant wants to meet his obligations to the property and to the owner. That he needs to know what’s expected of him for the entire term of his residency. That he would prefer not have to ask permission of the landlord to do things in meeting his obligations. That he wants the freedom to do things which aren’t specifically spelled out in the rental agreement. That he would like a report card every couple of months so he can see how he is doing and where he could do better. He doesn’t want to wait for the end of the term only to get a failing grade. As the Manager, you should be getting the big picture. You’re going to have to start being as responsible as your tenant, communicating your goals in written form and getting your tenants’ agreement to work toward them. (In the trade, we call this your rental agreement.) Moreover, you’re going to have to work consistently to follow your own rules too.
Let’s look at the middle part of the definition of leadership. You’ve got to influence your tenants to want to do what they’ve agreed to do rather than to merely coerce them with threats of eviction and lost deposits. Several of my tenants have renewed for over 10 years. Others have been with me for many years. Why? Because they’ve become comfortable both in the home and in their relationship with the manager. I’ve found that tenants often make the owner’s objectives their own once they thoroughly understand and accept the mutual responsibilities between landlord and tenant embodied in the rental agreement. The connection has to be made as to how the rental contract terms ultimately will provide them with long term residency in a decent home at a price they’ll be able to afford.
I promise my tenants never to sell their home out from under them so long as they keep it maintained and pay the rent on time. How could an owner make such a commitment? Ask yourself, how could you expect a tenant to remain in the property and to continue to renew his contract every year without your commitment? Besides, why sell a renal if it were occupied by a good long term tenant? Margaret Woodhouse taught that the key to performance is to be firm, fair, and friendly. As a long time employee, I found I performed better under the leadership of those who more or less followed Margaret’s dictum. So do my tenants. Maintaining a formal amicable, relationship, scrupulously following the lease, and sticking to what you’ve agreed to do is the key. Good tenants are like gold. They don’t want to let you down. A wise landlord won’t let them down either.
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