Dean Graziosi

Where will you be in five years with your rental properties?  Will you be enjoying a lifestyle that suits your personality and interests?  Or will you wake up each morning dreading an argument with a complaining tenant, or having to knock on a door and ask for rent that’s a week late?

We’re not talking here about whether you should be a landlord or not.  It’s more a planning issue, so that you can select properties and invest appropriately in order to accomplish your investment goals in a way that suits your personality and abilities.  An objective assessment of your attitudes and capabilities at the beginning of the real estate investment process is important.

·         Do you like working with people?

·         When complaints are made, can you handle anger or volatility?

·         Have you been stable in other long term endeavors?

·         Can you enforce rules and stand up for your rights?

·         Do you get along better with certain people types or income strata?

·         Can you handle surprises or uncertainty?

It isn’t necessary that you have all these qualities or abilities.  It is necessary that you understand where you excel and where you may need help.  Whether it is you, your spouse, or an employed manager, there are activities that simply cannot be avoided in managing rental properties.

·         Interviewing and selecting of tenants – including turning them down if they aren’t up to your requirements

·         Enforcing your rental and behavior rules

·         Collecting rents when they aren’t on time

·         Fielding complaints from tenants – whether they are valid or not

·         Responding to emergency repair issues – perhaps late at night

·         Doing all of this and more over a period of years

Many of us just seem to gravitate to a certain income strata.  You may do well with higher income tenants renting in more exclusive areas.  Or, on the flip side, you may get highly annoyed by a rich college student making demands on your time.  It could be that blue collar workers with families are just your cup of tea.  It doesn’t really matter.  What does matter is that, if you do lean in one direction or the other, you recognize that fact and invest in areas and properties that will bring you the tenants you’ll enjoy serving.

If some or all of the more people-interactive tasks are not your thing, it doesn’t mean you can’t own rental properties.  You may just need to make purchases that will return on your investment, even if you must hire help on a part or full time basis.  Or you may be able to let your spouse handle some of the tasks.

Learn what you like and do well, and find other solutions for the other requirements. 

We do the research, shop the available properties, and finally make a suitable purchase of rental property.  With everything ready to go, it’s now time to locate a tenant.  We’ll need to know the rent to be charged, so a grasp of the factors influencing rents is important.

Supply – What is the supply situation…how many comparable rental units are available in the immediate area?  Pretend you’re a renter and look through the newspaper ads, drive around and look for signs, and don’t ignore the individual owner-landlord properties.  They are all your competition.

Demand – What factors are out there that may influence demand for your rental(s)?  Is the area growing, with new jobs and industry?  Or, not so good, are people moving away?  Do you know of new commercial ventures coming to the area, or community developments that will make the neighborhood more desirable soon?  Demand is the other side of supply.

Competition and Features – Supply and demand are important, but property characteristics, features and benefits can have an impact as well.  Recent surveys of renters indicate that a large percentage will decline to rent an otherwise suitable property if it lacks their most desired feature.  What might that be?

·         Washer and dryer

·         Security features

·         Modern or gourmet kitchen

·         Large area for entertaining

·         Close to work

·         Close to green areas

With the price of vehicle fuel always climbing, location is more of a concern for many renters.  Proximity to jobs, shopping and outdoor recreation can add value to your property, allowing you to ask more in rent than comparable properties farther away.

Have you done renovations that include the latest in kitchen or bath features found in single family homes?  Whether it’s cable TV, high speed internet access, or some other hot new feature, if your unit(s) offer amenities that are in demand and not found in many of your competitor’s units, then you can charge more for rents.

Your Desires – It isn’t all about the market.  What are your desires or abilities?  If you hate interviewing and selecting tenants, you might want to reduce rents to entice them to stay for longer lease periods.  Lower rents also increase the pool of tenant prospects, making interviewing and selection easier.

Weigh all of these factors and research the competition.  Watch your market area, and make adjustments when conditions or your desires change.

Break-even Ratio – The Lender Cares and So Should You

What is break-even ratio?  Simply, it’s the point at which a rental property goes from negative to positive cash flow, or the point at which we break-even on cash flow to operate the property.  This is one calculation used by lenders to determine the feasibility of lending on a real estate rental property.  Too high a break-even ratio, and you’ll have trouble getting a loan.  So, the lower the ratio, the better.

It is expressed as a percentage, and isn’t a difficult calculation.  In your financial analysis and valuation of a potential purchase, you’ll have all of the numbers in front of you to determine the break-even ratio.  We will be using Gross Operating Income or GOI, Debt Service Cost, and Gross Operating Expense. 

1. Our GOI, or Gross Operating Income, is the amount of money we have to spend after we’ve subtracted vacancy and credit losses (or estimates) from our gross rental income.
2. The gross operating expenses are the costs to operate and manage the property.  This would be all direct costs of operation, including management salaries, repairs, maintenance, taxes, insurance, office and supplies expenses.
3. The debt service is the total of all principal, interest or loan charges paid on the mortgage for the year. 
4. The Break-even Ratio is arrived at by adding the Debt Service to the Gross Operating Expenses, and dividing the result by the GOI.  Or Debt Service + Expenses / Gross Operating Income.  Basically, you’re just taking the total of all the cash you’re putting in for the year and dividing it by the cash you’re getting back.

Let’s do a quick calculation for an example four unit property that you’re purchasing with a $195,000 loan at 7.0% interest.  Rents average $900/month each unit, and vacancy/credit loss is 7%.  You manage them yourself, so no management salaries are involved, making your annual operating expenses approximately $16,000.

·         The loan is $1297/month with no other charges, for a total annual Debt Service of $15,564.

·         Operating expenses are $16,000 per year.

·         Gross Operating Income is $900 X 12 X 4 = $43,200 minus 7% = $40,176.

·         ($15,564 + $16,000) / $40,176 = .785, or 78.5% Break-even

Generally, lenders are OK with 80% or better for this result, but you’ll need to check the market and lender criteria at the time of your evaluation of a property.