How to Boost Cap Rates by Buying Great Tenants

by | BiggerPockets.com

There are always a million things you can look at when you buy a rental property:

  • What is the rent?
  • Is there any water damage?
  • Is the house on a concrete slab?
  • What kind of neighborhood is it in?
  • Do the cabinets need replacing?
  • How many more years does the roof have left?

I could make a list a mile long, and it still wouldn’t cover everything a person could check or all the mistakes I have made.

There is, however, one set of questions that I always ask: How long has the tenant been there? How prompt are they with paying rent? What kind of maintenance do they request?

Why Do I Make This a Priority?

Landlords say tenant screening is one of the most important things to do. There are easily available tools online to get credit score, criminal history, and other applicant information. This processes is necessary to predict how reliable someone will be in paying their rent and how responsible someone may be with your property.

I would suggest that if longevity, reliability, and responsibility are the markers of a desirable tenant, there’s no better way than observing and verifying how someone currently live in their own home. Wouldn’t it be cool if you could visit each applicant before you rent to them? I would certainly have a better quality tenant on average if that were possible.

There is one circumstance where an investor can actually visit a tenant in his or her home: When buy the house they live in! Quality tenants are like neon signs in the jungle on a moonless night. The house is well kept and neat. The lawn is cared for. They do minor maintenance items themselves. They don’t bring up broken items when you are there.

Quality tenants are worth buying. They are worth paying up for. If you are a numbers person, think about it in terms of cap rate. Consider a $100,000 house, financed for 20 years, that rents for $1,200 per month. Here’s how a desirable, high quality tenant could affect your investment:

Longevity

When a tenant turns over, it costs money. A modest $500 in repairs, not covered by a security deposit and one month of lost rent, is $1,700. That’s about $70 a month in terms of month-to-month cash flow. Cap rate drops by just shy of 1 percent. If your property manager charges a re-leasing fee and/or advertising costs, that amount can grow up to 1.5 percent.

Ms. Glenda on California Avenue has rented from me for 15 years. I might talk to her twice a year. What is that worth? No doubt she is an all-star. And sweet to boot. 

Related: The 2% Rule Should Die a Horrible Death

Reliability

Tenants who pay on time every month save collection headaches. If you have to evict a tenant (at least in the markets that I am in) costs can be up to $1,000 per occurrence. If you assume that 20 percent of all slow paying tenants have to be evicted this add another $25 per month, averaged over a person’s rental portfolio. This knocks the cap rate down by .3 percent.

Mr. Willie on Edgewood Street is an elderly tenant of mine. His check is in the mail on the 4th of every month. Like clockwork.

Responsibility

It’s harder to quantify what minor maintenance is worth. If a quality tenant puts up his own ceiling fan or fixes a leaky bathroom faucet, savings can easily get to $50/month on average — for another .3 percent on the cap rate.

Mr. Mike on Mondy Road did everything at the house including running a bulldozer in the front yard to help with drainage. No telling what that would have cost me.

Related: These 3 Simple Steps Will Prepare You For Your First Deal

Figuring out what a new tenant’s longevity, reliability, and responsibility is difficult at best. Sure, you can call their current landlord, but can you be sure you haven’t been given fake numbers to friends or forged references? Sure, you can check a credit score, but does that tell you if a person moves every 18 months? Existing tenants are simply an easier prospect to evaluate.

As we see here, finding properties t0 purchase that already have great tenants can be worth $170 per month or more to an investor. In our example house, this can amount to over 2 percent on the cap rate.  This is easily the difference between profit and loss or a good investment and a great investment

Most markets and most tenants won’t let a landlord raise rents by $170 per month. Look for hidden value in single-family homes by buying great tenants, and reap the benefits for years to come.

What do you think are the most valuable tenant qualities? 

Share below in the comments!

About Author

Jay Strickler

Depending on which day of the week it is, Jay is a 30-year oil and gas project manager and owner of about 160 rental units in three states. He harbors faint hopes of ditching corporate life someday to travel and spend more time with family and friends.

8 Comments

  1. JL Hut

    I agree with you completely. But I do visit their home before renting to them. I have been doing it for 38 years. Do all your due diligence work before you rent to a tenant and you wont have much work to do after they are your tenant.
    JL

  2. Christopher Smith

    Another reason why I have well seasoned PMs that do a superlative job of prospective tenant selection. They can sniff out a potential problem child from a mile away and don’t charge for finding new tenants when necessary.

    In 20 years of PM selected tenants over many properties I’ve only had one substandard tenant and he only became substandard after a number of years of paying timely when he ultimately lost his job.

    This has been huge in keeping my cash flows consistently strong with an aggregate vacancy rate of about 1 percent over the full 20 years. These are SFRs so cap rates aren’t necessarily the ultimaye driving factor in their current valuation, but some of the same concepts apply nonetheless.

    • Jay Strickler

      Hmmmm. Can you be more specific?

      I adjusted net cash flow based on a swag estimates of each “cost” of a bad tenant. Then used the new NOI for a new cap rate.

      Anything that costs an investor negatively affects cap rate.

  3. Dave Rav

    I would be cautious basing future tenant performance on previous tenant history. The X factor worth mentioning here is the *relationship* tenant has with prev landlord. This relationship is unique to those two parties, and from that some behaviors and tenant traits stem.

    For instance, I have one tenant that been at one of our multi units for 10 years. That’s 8 years before my purchase in 2016. This tenant comes off as one who watches out for the property and takes care of some maintenance. In exchange, their rent is lower than others. However, they unit is one of the dingiest and they’ve even been pegged a few times for late rent, and lease rules violations. Perhaps the last LL just let them do whatever they want, that’s why they lasted 8-10 years. Potentially valid point.

    Don’t get me wrong, I want the long-term tenant who I only hear from 1x per year too. (As a matter of fact, I’ve had two of those – with record independence times of 11 and 13 months respectively). What I’m saying is be cautious of the previous relations with the old guard. That may explain some (not all) tenant behaviors and actions.

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