The Only Real Estate “Rule” That Helps Me Determine Whether to Buy a Deal

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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:

  1. I want them to make money, and
  2. 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.

Related: Put to the Test: Are the 2%, 50% & 70% Rules REALLY Useful to Investors?

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?

Economic Losses

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?

Related: The 2% Rule Should Die a Horrible Death

Conclusion

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.

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

31 Comments

  1. Great Article Ben!

    I agree with your premise that the higher the price point, the higher the probability that you will get a better quality tenant. Nothing is “fool proof” but as you point out regularly, you get what you pay for. Thanks!!

  2. Eric Reichelt

    Love it, could it be any simpler. I live in Berkley MI, right around the corner from our hospital. My wife had the idea of looking at 2bd brick houses designed ideally for residents of the hospital. I love the ideaidea, and see it both as an easier entry point and a more predictable pass investment. I’ve been trying to find more on the topic of niche sub markets, but so far nothing. Would appreciate your quick thoughts if find the time. Thanks for a great read.

  3. Eric Reichelt

    Thanks. I see the a big positive in tenant turnover. No problem of offering discounts for the resident to get another resident in. It also deliveries to me a reliable source of employment, of course humans are nuts, but it’s a positive to day the least.

  4. Judy Ritsema

    I think there is another facet to this topic. I have seen and do believe that what the landlord accepts in his complex will dictate the mutual respect from the tenant. If the owner/landlord/management condones negatives such as too much noise, clutter, etc., then he can expect it. If he maintains and enforces the rules, then it can be a win win for landlord and tenant, attracting, and keeping quality tenants. I have seen it and heard it from landlords and tenants.
    There are, of course, exceptions to the rule. Just another aspect. I do agree with the comments in general.

  5. Luka Milicevic

    Good article, Ben.

    “The price point of your unit does as much as anything to naturally qualify your tenant base”

    Very good point! This was my number one take from the post.

    I don’t particularly have rules that are written out as I am still developing my systems and criteria for my investments. (I am still new). My only rule/criteria so far is that my cash flow needs to be high enough to provide a solid buffer for future maintenance/ improvements without costing me anything from my personal funds. The property has to cash flow enough to 100% pay for itself.

    I have to tell you that after listening to you on the podcast, I now read all of your blog posts and forum comments in your accent! I can’t help it, you are the Morgan Freeman of Bigger Pockets.

  6. Fay Chen

    I totally agree!!!! Someone just recently asked me if I would accept below-market rent from a good tenant or raise the rent taking a chance with a new tenant. My response was “If I have to give up $100-$200 a month to keep a good tenant, then I’m in the wrong market.”

      • Fay Chen

        Really? Please elaborate. I have seen many landlords taking $200-$400 below market rent. And I never understood it. I understand giving a $50 discount for a 2-year lease. But I’ve seen 2 cases now that both landlords are getting $400 below market because they were afraid to raise rent on a 5+year tenant. That to me means: 1. the property is below-market; or 2. management is below-market; or 3. the market is soft. If it’s not 1 or 2, then I wouldn’t enter the market. Your thoughts?

  7. Tom Smith

    This article was very clarifying for my own mental processes. I’m saving for the first rental and torn between two strategies: convert a C property into a B in a lower tax C+ neighborhood or convert a C property into a B in a higher tax B neighborhood. The somewhat higher rents wouldn’t quite make up for the extra tax or the slightly higher entry costs in the B neighborhood but the tenant baseline would be much more stable and enjoyable to deal with.

    Fortunately, if I decide I should have been in neighborhood C instead of B, I’ll just save up and buy another one over there.

  8. Christopher Leon

    @BenLeybovich – great article, sir. All BP members MUST read this article, because I truly believe in my soul, this IS in fact the only “rule” to consider. It’s how I’ve built my business, and have had the luxury of truly having passive income. I appreciate your ability to boil points down like this; I lack that ability. I think it was brilliant that you identified the difference between cash flow and passive cash flow. Also, the breakdown of economic losses – as it is all about the net, and, very rarely do some investors understand that. Thanks again.

  9. Timothy meuse

    My wife and I just purchased our first multi as of right now we occupy half of it. Finding the right tenants for the first floor was not an easy task. We had about 30 people interested the 1st week it was listed, the amount of unqualified possible nightmare tenants was shocking. The unit was listed for $1750 we found the right tenants an older couple that there current landlord offered them quite a few incentives to stay put. In the end I feel like doing your homework and finding the most qualified tenants is better then just getting it rented. I hope my future investments will have passive cash flow like our current tenants. (Not that we are cash flowing since we live there as well but we only put 3.5% down and the tenants cover our mortage, which leaves us with taxes, insurance, water, and repair/maintenance. Once we move out and rent our half we should be cash flowing about $800 a month.)

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