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3 Steps to Avoiding “Bad Apples” as Tenants

Most landlords would probably agree that, by far, the most critical part of being a landlord is this:Select Good Tenants

It’s better to have a unit that is vacant than to have a unit occupied by a bad tenant.  We want tenants who (1) pay their rent promptly, (2) take care of the property, (3) stay for a long time, and (4) are easy to get along with.  Here are three essential steps in selecting good tenants.

Step 1.  Have prospective tenants complete a written application.

    Showing units can be time-consuming.  To eliminate unnecessary showings, do a pre-interview when prospects call.  Ask for their name, how many people will be occupying the property, where they work, where they live, why they are moving, if they have pets, if they smoke, if they have good credit, etc.  If the caller appears to have no chance of being accepted as a tenant, let the person know.

    Once a prospective tenant has seen the property and wants to rent it, have the person complete an application form.  (Don’t do a verbal application, as many landlords do.)  You can see a generic application form on www.getrichslowwebber.com.  Some landlords give prospective tenants an application form and let them return it later.  This is a bad idea; it allows bad prospects time to get friends to pose as an employer or landlord.  Instead, have them complete the form in your presence.

Step 2.  Carefully go over the application with the prospective tenant.

    Ask each adult applicant to show you his or her driver’s license (or other official photo ID).  You want to know they are who they say they are; bad tenants have been known to use the identities of other people so they can get approved.

    To minimize the chance of selecting someone who will stay in your place for only a short time, ask how long they have lived in your area.  If they have moved to your area recently, find out why they moved to your area, if they like it (including the climate), if they have relatives in your area, and how long they will likely stay.  If an applicant is moving out of a parent’s place and has never rented before, keep in mind that the person may not adapt well to being on his or her own and may move back with parents after a short time.  If the applicants have not lived together before, keep in mind that they may not get along and you may lose one or more of them as tenants.

    When considering the person’s income, make sure you understand what kind of business they are in, how long they have been employed, how much they earn, what hours they work, the name and phone number of their supervisor.  If their current employment is for less than 2 years, get similar information about their previous employment.

    When reviewing where they currently live, confirm the address, how long they have lived there, amount of the rent, who lives with them, if the rent has ever been paid late, and if they have ever received a complaint from the landlord.  Ask why they are moving and if they have let their landlord know they will be moving.  Be sure to ask the same information on the place they lived before they moved into their current residence.  Here’s why.  In some cases, a tenant is being evicted from their currently place and the landlord will give a glowing report; they want them out of the place.  By going back one or two previous landlords, you have a better chance of determining if they have been a good tenant.

    If the person has a pet, ask for a detailed description: weight, color, breed, gender, age, pet’s name.  If you do rent to them, you are giving permission to have that specific pet—not just any pet, or replacement pet.

    By the time you finish the interview you will likely have more of your handwriting that the prospective tenant’s on the application form.  If you don’t have a clear picture of who the applicant really is, continue asking questions until you have a clear picture.  Be sure you don’t ask questions that break anti-discrimination laws in your area.

    Review key elements of the lease (rent, security deposit, when rent starts, total amount due at lease signing, etc.) to make sure you and the tenant are on the same page.  No sense wasting time processing an application that won’t work.

Step 3.  Verify what you have been told.

The rental application and the interview responses may, or may not, be accurate.  Once the interview is over, begin verifying the information.

    A good starting place is to get a credit report and background check on each adult applicant.  In cases where the applicant has no credit history you can ask for the tenant to provide a co-signer; be sure to have the co-signer complete an application, and process the co-signer (including getting a credit report/background check) just as if the co-signer were the actual tenant.

    When confirming employment, verify that the phone number is really for the employer.  Applicants have been known to provide a phone number that is for a friend, not their employer.  Ask for the employer to verify what is on the application. When talking to the applicant’s landlords, confirm what you have been told.  Some applicants may provide you with a letter from their landlord, employer, or even a copy of their credit report.  Keep in mind that the documents may not be authentic.

    Call personal references to see what they have to say.  If the applicant has a pet, make an appointment to visit the tenant’s current residence and see the pet; determine if there are any odors or damage from the pet.  If the applicant does not live in your town and you cannot check out their pet, call the landlord to see if the pet caused any problems or left any odors.

    If you any unanswered questions along the way, call the applicant to get more information.  Some landlords like to drop by the tenant’s current residence, unannounced, to ask questions.  While there, they can observe how the tenant takes care of the place, if there are any undisclosed pets, etc.

If you don’t feel confident that the applicant will make a good tenant, say no!

 

Many landlords turn away 3 or 4 prospective tenants for each one they approve.  If you take care in selecting good tenants, your life as a landlord will go much smoother.

 

 

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How to Quickly Eliminate the “Dogs” When Buying a Rental Property

Many beginning investors make the mistake of spending countless hours investigating each and every

property they hear about. This results in a lot of wasted time. A better approach is to first determine which

properties are worth pursuing, and then to explore the worthwhile opportunities.

One simple approach to see if a property is worth considering is to figure the price per unit, and to

compare the price per unit for similar sold properties. Another approach is to figure the price per square

foot, and to compare the price per square foot for similar sold properties. The problem with these two

approaches is that they ignore (1) location, (2) age, condition, and quality of construction, (3) floor plan and

features, (4) the amount of space devoted to common areas (like hallways, central laundry, etc.), (5) parking

and other amenities, and (6) rental income and expenses. The price per unit even ignores the size of the

units.

A much better approach, in my opinion, is to use Gross Rent Multipliers (GRMs). Here’s why.

When tenants search for an apartment to rent, they consider a variety of factors, including location, age and

condition of the building, size of the units, floor plan, special features, parking, landscaping, and other

factors. The rent they agree to pay is a result of all of the benefits they receive. In other words, the rent

tenants pay does not ignore most of the factors ignored by the cost per unit and the cost per square foot. As

a result, many real estate investors use rents as an indicator of whether a property is fairly priced.

Gross Rent Multiplier = Price/Gross Rent

“Gross” rent is rent before deducting anything for vacancies and expenses. When working with

GRMs, some people prefer to use the annual gross rent; others prefer to use a monthly gross rent. In the

upcoming illustrations, we will use a monthly number.

To determine the GRM in the market, find sales of properties that are similar to the type of property

you would like to buy. Make sure to find sales in a similar area and with a similar age and condition.

Suppose you are thinking about buying a property with 8 to 12 units. You find three recent sales of similar

property, shown below.

Address # Units Selling Price Monthly Rent GRM

512 Center St 12 $1,480,000/$13,300 =111.28

1225 Club Ave 10 $850,000/$8,150= 104.29

1520 Ventura St 8 $705,000/ $6,700= 105.22

Buyers of properties like those you are hoping to find pay between 104.29 times the monthly rent

and 111.28 times the monthly rent, with the average being about 106.93 times the monthly rent. In other

words, the current GRM appears to be about 106.93, which means buyers are paying $106.93 to get $1 back

each month (in gross rent). Buyers prefer low GRMs because they would rather pay less for each dollar of

monthly rent.

Now, suppose you hear about a 10-unit apartment priced at $1,200,000 with monthly rents totaling

$9,100. The gross rent multiplier on this property is:

Gross Rent Multiplier = 131.87 Price

Gross Rent $1,200,000/$9,100

Because the GRM of this property (131.87) far exceeds the 106.93 GRM found in the market, it

appears the property is priced way too high, and is probably not worth spending time evaluating.

Using GRMs is a valuable tool in deciding whether a property is priced in the ballpark. But keep

in mind there is a far more valuable indicator in deciding whether to actually BUY a property: in Get Rich

Slow, we carefully project after-tax cash flows on a property and then calculate an after-tax Internal Rate of

Return (IRR) on those projected cash flows to decide whether to buy the property or walk away from the

deal. But GRMs are a great tool to quickly eliminate overpriced properties. When using GRMs, keep these

things in mind:

• When using GRMs, make sure the properties are similar. GRMs of duplexes will likely be very

different from GRMs of 4-plexes, 6-plexes, or larger properties. GRMs of older properties will

likely be very different from GRMs of newer properties. GRMs of properties in a nice area will be

much different than GRMs of properties in a run-down area.

• GRMs ignore expenses. As a result, it is important when comparing GRMs to use properties that

have similar expense ratios. For example don’t compare GRMs of a property in which the landlord

pays inside utilities with the GRM of a property in which tenants pay their own utilities.

The bottom line is this: Don’t make the mistake of using the same GRM for all properties. If you

are thinking of buying a rental property in a certain area and want to use GRMs to see if a property is priced

right, use GRMs from sold properties in the same area of town, and with similar expense ratios. 

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1031 Tax deferred exchanges

 

•        The properties must be like-kind real estate.  Like-kind does not mean that the properties must be exactly the same kind of property, but it does mean that property held for business, trade, or investment purposes must be traded for property held for business, trade, or investment purposes.  It is okay to trade, for example, a small residential rental property for an office building, or an apartment complex for raw land.  But it is not okay to trade a personal residence or a dealer property for an investment property.

•        The replacement property must be equal to or greater in value and in equity.  For example, if the relinquished property is valued at $1,500,000 with a loan balance of $500,000, then the replacement property must be purchased for at least $1,500,000 and the equity has to be at least $1,000,000.  Any cash you receive or debt relief is considered boot and is taxable.

•        An approved, neutral third party must be involved.  This party, called a facilitator, accomodator, or intermediary, should be arranged prior to closing; an agreement should be signed with the facilitator, and the facilitator is required to hold the proceeds from the sale unless the replacement property closing occurs at the same time.  The seller can select a place for the funds and the funds can earn interest, but the seller cannot have access to the funds.

•        The seller must clearly identify possible replacement properties (in most cases, up to three possible properties).  The notice identifying the properties must be presented in writing to the facilitator within 45 days from the close of the relinquished property.

•        The taxpayer must purchase one or more of the identified properties; the closing of the replacement property must take place within 180 days of the close of the relinquished property.

 

IRS rules for 1031-tax-deferred exchanges are very strict.  Before venturing into a 1031 tax-deferred exchange, seek advice from a tax professional and make certain that the guidelines you are relying on are current, as tax laws change from time to time.  Any goofs along the way will likely result in a heavy tax burden.

 

There are a few things to consider before doing a 1031 tax-deferred exchange.  First, remember that the tax from the gain is not eliminated, it is only deferred.  Here’s how it works.  The basis of the acquired property is the basis of the relinquished property plus any cash (or boot) given for the new property.  If the taxpayer has been depreciating the relinquished property, the adjusted basis will likely be substantially less than the value of the acquired property.  While there are no limits to the number of times a taxpayer can use a 1031 tax-deferred exchange, once the last property is sold without using a 1031 tax-deferred exchange, the gain will be calculated based on the adjusted basis of that property, likely resulting in a substantial gain.  And the tax rates may end up being higher than they were at the time of the previous exchange(s).  Keep in mind that if the taxpayer dies before selling the property, the heirs can receive a step-up in basis on the inherited property; they basically get to start over with a basis equal to the current fair market value and don’t have to worry about the deferred tax.

 

Another thing to think about is that the 45-day and 180-day deadlines are, in most cases, not easy to meet.  Investors often find themselves rushed; in an effort to postpone paying taxes on the gain they may end up overpaying for a replacement property.

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Leverage: A Double-Edged Sword 

You may remember from physics that leverage can be used to lift heavy objects.  For example, a person might have trouble lifting a 100-pound rock.  With leverage, the same 100-pound rock can be lifted easily.

Leverage is similar in investing.  Leverage is using borrowed money to control more investments than could otherwise be controlled.  Leverage has a dramatic effect on cash flow, as shown in the two scenarios, below.

 

Reed and Wade are brothers.  Each has $150,000 to invest.  Reed uses his $150,000 as a down payment on a 54-unit apartment building.  Wade uses his $150,000 as a down payment on a 6-unit apartment building.  Reed buys the 54 units for $3,000,000 with $150,000 down and agrees to pay the seller the remaining $2,850,000 at $23,000 per month ($276,000 a year).  During the first year, Reed collects a total of $455,300 in rents and has expenses totaling $141,800.  Wadebuys the 6 units for $400,000 with $150,000 down and agrees to pay the seller the remaining $250,000 at $2,000 per month ($24,000 a year).  During the first year, Wade collects a total of $58,700 in rents and has expenses totaling $18,500.  Each invested $150,000, but who comes out ahead in terms of cash flow?  Here are the results:

 

Reed:  $455,300 (rent) - $141,800 (expenses) - $276,000 (mortgage payments) = $37,500

 

Wade: $58,700 (rent) - $18,500 (expenses) - $24,000 (mortgage payments) = $16,200

 

Using leverage, Reed gets $21,300 more than Wade.  Now, suppose that at the end of the first year, a major employer moved to another state, causing an increase in vacancy rates and a decrease in rents.  During Year 2, Reed is able to collect a total of $302,400; his expenses increased to $157,900.  Wade collected a total of $39,000; his expenses were $20,600.  Here are the cash flows for Year 2:

 

Reed:  $302,400 (rent) - $157,900 (expenses) - $276,000 (mortgage payments) = - $131,500

 

                  Wade: $39,000 (rent) - $20,600 (expenses) - $24,000 (mortgage payments) = - $5,600

 

Reed, who used leverage, must subsidize his investment a whopping $131,500!  Wade needs only $5,600.  If Reed does not have $131,500 sitting around, he will be forced to sell other assets, borrow on other assets, or face the consequences of a foreclosure on his 54-unit apartment building.

 

TIP	don’t get crushed

 

As you can see, leverage works to the advantage of an investor when conditions are right but leverage can lead to financial ruin under adverse conditions.  Using our physics analogy, it is possible for the “lever” to break or the rock to slip.  Be careful in selecting the right size rock (investment) and amount of leverage (loan) so that if something goes wrong, the rock will not crush you as it comes tumbling down.

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What’s the Best Way to Buy Rental Property with Others?
Getting partners can be beneficial when investing in rental real estate. Having partners means less down payment
for each person, less risk in case rents drop or vacancy rates increase, and less cash needed from each person for a renovation or upgrade of the property. But there can be disagreements on who will do the day-to-day management
of the property, what to do with excess cash flow, whether to make major improvements, what to do if one partner
needs to sell early, and deciding when the entire group should sell. If you get partners, be sure to agree on these
things up front, preferably in writing.
Having partners with different skills can be valuable. For example having a partner who is a real estate
agent can be helpful in locating properties. Having a partner who is a lawyer can be helpful in dealing with tenant
issues. Having a builder as a partner can be helpful for properties that require upgrading. And having a property
manager as a partner can answer the question of who will do the property management.
There are several ways to invest in rental property with others. Here’s a quick breakdown:

Simple Joint Venture
Basics With a simple joint venture, each investor takes title to his or her share of the property separately. If the investors take title as joint tenants, when one of the investors die, his or her share goes to the surviving joint tenant(s). If the investors take title as tenants in common, when one of the investors die, his or her share does not go to the survivors; it goes to his or her heirs. Suppose that Nelda wants to own 40% of a property and Jack and Jill Berry, a married couple, want to own the other 60%. Nelda could take title to her 40% as a tenant in common with the Berry’s, who could take their 60% as joint tenants with their spouse, but as tenants in common with Nelda. Because laws differ from state to state, get legal advice before deciding how to take title.

Number of owners Two or more.
Income taxes Investors report their share of income and expenses on Schedule E and any gain from the sale
on Form 4797 and Schedule D of their individual income tax return. Personal liability Investors are personally liable for the debts.
Cash distributions Distributions of cash are not taxable.

General Partnership
Basics Investors create a formal general partnership under state law. A partnership agreement spells
out each partner’s duties and rights; partners do not necessarily share profits equally. Title to the property is held under the name of the partnership.
Number of owners Two or more.
Income taxes The partnership reports income and expenses on a partnership return, but pays no tax with the
return. The partnership gives each partner a Schedule K-1, showing the partner’s share of profit or loss; this amount is reported on Schedule E of the partner’s individual income tax
return.
Personal liability Each partner is personally liable for the debts of the partnership; creditors can collect 100%
of the debt from any or all partners.
Cash distributions Distributions of cash are not taxed.

Limited Partnership
Basics A limited partnership requires special documentation with the state, showing who are general
partners (these people run the business and make decisions) and who are limited partners (these people contribute money but are not involved in making any decisions).
Number of owners Two or more.
Income taxes A limited partnership handles income taxes just like a general partnership. However, if there
is a loss for a particular year, the limited partners are generally not allowed to deduct their share of the loss; instead the loss is used to offset future income.
Personal liability General partners are personally liable for the debts of the partnership; limited partners are not
personally liable.
Cash distributions Distributions of cash are not taxed.

Corporation
Basics A corporation, formed under state law, is a separate entity, like a person: able to buy assets,
borrow money, and perform other business activities. The corporation issues shares of stock to investors (called stockholders), who becomes owners of the corporation.
Number of owners One or more.
Income taxes The income and expenses of the corporation are reported on a corporate income tax return
and income taxes are paid by the corporation. For some corporations (those with no more than 35 stockholders), the corporation can elect with the IRS to be treated as an S
Corporation; the corporation files a tax return for informational purposes, and provides each
stockholder with a Schedule K-1, showing the stockholder’s share of profit or loss. Each stockholder then reports that amount on his or her individual income tax return.
Personal liability Individual stockholders are generally not personally liable for debts of the corporation beyond
their personal contribution, except in the case of fraud. Because of the limited liability on debts, corporations may have a hard time borrowing money unless individuals (like one or more of the stockholders) agree to be personally liable.
Cash distributions Distributions of cash (called dividends) must be reported by the stockholders. This is a form
of double taxation: the corporation pays tax on any profits and whatever is left after paying taxes, if sent to stockholders, is taxed again. This double taxation also applies to distribution of sales proceeds; the corporation pays tax on any gain and the sales proceeds sent to stockholders are taxed again. Corporate dividends may be taxed at lower rates than ordinary income; they are taxed at the same rates as capital gains (see Step 5 of Get Rich Slow).
Distributions of cash (dividends) for an S Corporation are, under most conditions, tax-free.

Limited Liability Company (LLC)
Basics A limited liability company (LLC) is a special type of ownership, created under state law, that limits the personal liability of its owners.
Number of owners One or more. Owners are referred to as members.
Income taxes Before doing business, an LLC must get an Employer Identification Number (EIN) and select
how it wishes to be taxed. If the LLC has only one owner, it must be taxed like a sole proprietorship, reporting the income and expenses on Schedule C of their personal income tax return. If the LLC has more than one owner, it can elect to be taxed as either a corporation or partnership.
Personal liability Owners are not personally liable for the debts of the LLC beyond their personal contribution,
except in the case of fraud. As with corporations, LLCs may have a hard time borrowing money unless individuals agree to be personally liable.
Cash distributions Distributions of cash are treated according to how the LLC elected to be taxed.

TIP get professional advice
When organizing the purchase of rental property with partners or setting up a business entity, be sure
to get help from a qualified attorney and tax advisor. Laws that govern forms of ownership are complicated and vary from state to state. People who bring investors into a project must comply with federal and state securities regulations. Keep in mind that tax laws change frequently. Make sure
you get qualified advice so that you can select the best form of ownership for your personal situation.

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Get Rich Slow - Blog 7 (Best Calculators for Evaluating Rental Property?)

 If you are a real estate investor, or thinking about investing in rental real estate, you may wonder which calculator is best for the job.  I will give you my opinion on that.

To properly evaluate a potential investment in rental real estate you will need a calculator that will (1) make time-value-of-money calculations (like calculate a monthly mortgage payment), (2) calculate interest, principal, and remaining balance, by calendar year, on a mortgage loan (this is called amortizing), and (3) calculate an internal rate of return (IRR) on the potential investment.  There are some calculators that will do some of these things, but not all.  Here are the calculators that will do everything:

       Financial Calculators                                                         

      HP 10BII+                                                 

      HP 10B (a predecessor of the HP 10BII+)                          

      HP 10BII (a predecessor of the HP 10BII+)                       

      HP 12C                                                                              

      HP 17BII

      HP 19BII

      TI BAII PLUS

      LeWorld Financial

            Graphing Calculators

      TI 83PLUS

      TI 84PLUS

      HP 30gs

      Casio 9750G PLUS

 Graphing calculators require far more keystrokes than the financial calculators, and are relatively expensive, so unless you already have one of these, I would not buy one.  Of the financial calculators, I recommend either the HP10BII+ or the TI BAII PLUS.  They are very affordable (about $35) and are easy to use.  Here are some basic differences between the two: 

HP 10BII+.  The HP 10BII+ displays more digits than the TI BAII PLUS.  It is easier to change the decimal setting on the HP 10BII+.  And for most problems, the HP 10BII+ requires fewer keystrokes.

 TI BAII PLUS.  It is a bit easier to store numbers.  The TI BAII PLUS uses menus, making it easy to review entries.  And the TI BAII PLUS has some extra applications not available on the HP 10BII+.

 In Get Rich Slow (Your Guide to Producing Income and Building Wealth with Rental Real Estate), by John Webber, we make projections to decide if we should buy a potential investment or walk away from the deal.  Calculators are an instrumental part of the evaluation process.  Step-by-step keystrokes for the HP 10BII+ and TI BAII PLUS are shown right in the book.  Keystrokes for other popular calculators are available through the publisher.  If you want to increase your proficiency with financial calculations, and want to expand your tools in deciding which properties to buy, be sure to get your hands on this valuable resource!