If you’ve been following me for a while, you know my distaste for “rules.” As I mentioned in one of the earlier articles, I think that rules in real estate investing exist in order to simplify the thought process for new investors, of which there are lots today. As in: Just do this in your head real quick, and it’ll tell you whether the deal is good enough to look into.
I’ve disproved and cautioned you guys against using this type of thinking many times before, and it’s not what I want to do now. Indeed, what I want to do now is break my own rule and tell you about my rule–the only high level item I look at and discard a deal based upon nothing more than this item.
But before I tell you my rule, let me tell you about some of the things I “want” in a real estate transaction:
The Big Picture
Simply put, I want my acquisitions to accomplish two things:
- I want them to make money, and
- I want them to do so as passively and as easily as possible.
The thing is, in many ways both of the above items are a function of the quality of your tenant. Let’s break this down some more. Here’s my wish-list explained:
I want passive cash flow.
There is a very significant distinction between cash flow and passive cash flow. Passive, as it relates to rental income, is a function of minimal involvement. Since small assets simply do not have the spread to accommodate professional management, which means you must manage them yourself, passive becomes crucial.
I am not sure why you buy (or want to buy) income-producing property, but I do it because the income from rentals alleviates the need for gainful employment. In other words, this type of income decouples money from time–my time is better spent doing something other than working for money–at least in a traditional sense.
Well, with that being so, it does me no good to have to work for cash flow; it does me no good to have to babysit cash flow to make sure that it comes in. Several hours per month, sure. But I am not chasing tenants for rent because this would be no different than having a 9 to 5, and I’ll pass on that.
With this in mind, the question I have to ask myself is: What type of tenant (at what price-point) is more likely to facilitate passivity of cash flow for me?
Now that we’ve discussed the “passive” component of passive income, let’s talk about income itself, or to be more precise, some of the forces at work against your income.
There are a lot of costs associated with running income property. While most people are aware of physical vacancy, which is the down time when a unit sits vacant while you look for a suitable tenant, there are the less known items that belong to the category of economic losses, or economic vacancy.
Economic losses can be thought of as all of the money you should have made but didn’t make due to tenants not honoring their end of the bargain; they are essentially losses incurred due to vacancy that are not vacancy itself. Think of it this way: If your unit is vacant because you’ve had to evict a tenant, then aside from losing money due to vacancy in and of itself, you also have other costs, such as:
- Attorney and court fees
- Bad debt (your tenant’s non-payment, which caused the eviction)
- Excessive clean-up costs (we call them turn costs)
- Longer time off-line in order to complete rehab, costing more rent
- Marketing costs to re-rent the unit
- Discounts (concessions we call them) in order to fill the unit quickly
All of the above and more are real negatives impacting your bottom line. And naturally, all of this was brought on by the fact that you had a tenant who left sooner than they were supposed to or one who did not renew.
So, because things are what they are, the question you have to ask yourself is: What type of tenant (and at what rental price-point) is least likely to cause economic losses?
This rationale and conversation could unfold almost indefinitely, but as you can see, this all comes down to the type of tenant you attract. And guess what? The price point of your unit does as much as anything to naturally qualify your tenant base.
In that you want responsible people–who are economically stable and will make their rent payment every month, and who wouldn’t think about trashing your unit, burning it, or skipping on you in the middle of the night–you must analyze your marketplace and establish in your own mind a price-point that opens up your unit to the widest cross-section of population and yet only attracts the type of tenants you really want to deal with.
Do you have your own personal “rule” that helps you determine whether a deal is worth a second glance?
Let me know with a comment.