Rentals Done Right

I love fishing. In fact, I wish I were fishing right now. The fish of choice is the Red Drum. A fish that hits like a linebacker and takes time to land. When I go fishing, I know where they are, I know what they like to eat and I know how to bring them in – just like Big Gramps taught me as a kid.

I just finished an interesting article over at Karen’s Perspectives and it got me to thinking… I’ve never really let you in on what I am looking (fishing) for in a quality tenant. I’m about to fix that!

Let’s start by looking at the lease signing. I insist on reviewing my lease with the tenant, line-by-line, before they sign. Sure it sounds like drudgery, but it lends an important ‘weight’ to the situation. This lease signing is different than any other they have done before. Never before has the landlord taken so much time sitting at a table and reviewing the document. It is a serious time and I take it that way.

By the time we are done, the tenant probably has felt like they just finished a loan closing – so I sum up my lease with 3 points, My requirements are simple:

1. Take care of the property
2. Take care of the neighbors
3. Pay the rent on time

Now, what kind of tenant am I looking for that I believe will meet the above criteria?

1. Take care of the Property – I look at their car when they drive up. No, not an inspection, just a general, subtle look-over. Is it clean or trashy? How they take care of their car will tell me a lot about how they take care of my Property.
2. Take care of the neighbors – Of the 3, this is probably the most difficult. It is hard to get a good ‘feel’ about a person during the interview process (yes, it is an interview). The best way I have determined is by the way they treat me. Were they on time? Are they cordial? Do I get any hint of an argumentative attitude? When they pulled up in their car, how loud was the music? Granted, this is a little more subjective, but if you can keep the neighbors happy, it will save you headaches!
3. Pay the Rent on Time – I do not allow ‘grace periods’ in my lease. If you give a person to the 5th of the month, they will take it. My leases simply state the rent is due on the 1st and late on the 2nd. What is the difference between my way and a lease with a grace period that makes rent late on the 6th of each month? I don’t see any. I review this with them thoroughly – holidays, weekends, etc. do not matter. The rent is due on the 1st. Now, my goal is to NEVER get a late fee – so I look for tenants with the ability to pay. Generally speaking, a person that brings home 3x the rent in pay will be able to afford the property. I DO NOT go below 3x rent in take-home pay. It just puts them in a financial bind and puts me in a bad spot.

Credit checks, while good have had limited value for me. Some of my best tenants have had the worst credit (and vice versa). Talking with their current landlord has no value at all (if they are a bad tenant, they are happy to give a ringing endorsement just to rid themselves of the pain).

Know what you are fishing for, land the great tenant and enjoy the fruits of your labor!

Your Real Estate Investing (REI) is all about the numbers. Sure, the human aspect in land-lording is vital – but your business of REI rises and falls on the numbers.

What numbers?

In a previous post I mentioned how important it was to take the emotion out of purchasing your investment. Don’t fall in love with a property – it will not love you back. I use a spreadsheet to filter EVERY investment opportunity. The spreadsheet is my boss – if it tells me a deal makes sense I do it. If it tells me it is marginal or won’t work I do not. Simple. Quick. Easy.

But what numbers are important? That is an individual question because my investment goals may be different from yours. My current REI goal is income. Because of this, certain numbers are more important to me than others. Let me give you a rundown of what is important to me:

1. Cash Flow
2. Cash Flow
3. Occupancy Break Even
4. Cash-on-Cash return
5. Cash Flow

The way I have set my spreadsheet up, I enter in the variables. These variables include expense assumptions (interest rates, taxes, insurance, vacancy, etc.) and income assumptions (i.e. rent). I am really conservative when it comes to choosing my assumptions. I’m not interested in stressing out over whether or not the deal is going to make it. There are simply too many opportunities out there to settle. Choosing this route has created a “Moat of Safety” around my little empire.

More recently I have ramped up the assumptions by placing prospective properties through a “Rental Stress Test.” Basically, what I do is reduce the assumed rent to 80% of the current market. If the property still Cash Flows, I’m all over it like a buzzard on a gut truck.

1. Cash Flow – this is the life’s blood of your REI. If you cannot produce positive cash flow you should not be making the purchase – period. The lack of cash flow will cause sleepless nights and possibly financial catastrophe. It just isn’t worth the headache – hold out for the right deal.
2. Cash Flow – this is the life’s blood of your REI. If my properties can get through my Stress Test then I know I will have enough cash for emergencies and more investing. PLEASE do not make the mistake of purchasing an investment with poor cash flow with the hopes that you will have capital gains in the future. Let capital gains be the gravy – but be SURE you have the potatoes.
3. Occupancy Break Even – You need to know how much vacancy you can take. Sure we all like to think that our properties will be occupied 100% of the time, but let’s get back to reality – you will have vacancies. This is not a problem as long as you have accounted for it in your purchase. Obviously, a vacancy can not go on indefinitely, but you should know what your bottom line is.
4. Cash-on-Cash Return – Any time I am laying out cash, I want two things to happen: Return on my investment and Return of my investment. If I am going to make a down payment on a property, what will my return on that cash be? How long will it be before the property has refunded my investment through positive cash flow? I want to know these things.
5. Cash Flow – this is the life’s blood of your REI. Cash is KING – always remember this!

I’ve had a few requests for a sample of the spreadsheet I use. I love my spreadsheet, but it needs to be cleaned up before it is published. If you are interested in a copy, let me know  – I’ll get to work on making it look professional and see about the best way of making it available. Good luck and go get’em!

1. I am not a CPA
2. I am not an attorney
3. I do not like CPA’s or attorney’s

Recently there was an excellent article posted on Karen’s Perspectives that reviewed some of the benefits of REI (namely ‘depreciation). If you are not aware, depreciation is one of the most magical and positive benefits in REI.

Depreciation works like this:

• You buy real estate as an investment
• The Feds allow you to divide that investment into 27 1/2 pieces
• You get to write off one piece against your income each year

Here is a simplified example; let’s assume you purchase a property for $275K (value of the buildings, the land is excluded). Each year you get to deduct $10K from your income until the full $275K is written off. So if you make $75K a year, ‘presto-change-o,’ ‘alakazam’ – now you only pay taxes on $65K! That is a bunch of money saved in taxes and all you had to do for it was buy the property.

Now, there are some intricacies but that is the basics. However, there is a caveat:

There is a limit to how much of your income you can write off based on your status. You see, the Feds divide people like you and me into two groups: “Real Estate Professionals” and everyone else. We’ll get to the “professionals” in a bit, but basically most people have a limit of $25,000 they can write off against income each year (remember that $75K income example – that makes it fall all the way to $50K!!).

If you are a “Real Estate Professional” the sky is the limit! You can write off up to 100% of your income, no matter what that income is. You do have to qualify as a Real Estate Professional. In a nutshell, here is what qualifies a person as a Real Estate Professional (credit):

• More than 50% of professional services are provided in the real estate fields; and
• Works more than 750 hours in the real estate fields; and
• NOT an employee (unless he owns at least 5% of the business)

If you can meet the above criteria, more than likely you can write off everything!

I qualified one year and was able to bring my taxable income all the way down to $1080 – my TOTAL tax liability was $108 and my state/federal refund was over $12,000. That is a major benefit!

So, what if you are like most investors and can only take $25,000? Do you lose the rest of the depreciation?

No.

You simply carry the unused portion to the next year and it keeps rolling over until you use it all.

Pretty cool thing, this real estate investing…

Disclaimer: Only a fool would take ANYTHING from RentalsDoneRight.com as any type of legal or tax advice.