Investing Architect

Category: Getting Started

3 Smart Strategies to beat Analysis Paralysis for new real estate investors
If you have thought about getting started in real estate investing but haven’t taken action yet, you are in good and plentiful company. Most everyone knows that real estate investing can help you achieve all your major financial goals often with less risk and volatility than other alternative options (i.e. stock market). You probably already know that if you succeed in building a solid real estate portfolio you can create a stream of passive income that can serve as retirement income you can enjoy much earlier than your typical industrial revolution retirement age of 65. Or, that quality real estate investments can help you build a seven-figure net worth over the next 15-25 years. Last but not least, you’ve probably heard that investment properties can serve as a hedge against the eroding effects of inflation while they help you diversify your investments and lower the risk across the board.

The main reason behind the lack of action rarely has anything to do with doubts about the benefits of investing in real estate. Instead, there is one main reason that holds people back from real estate investing. Today, I will give you an overview as well as offer mental models, mindset shifts and strategies you can use to keep it at bay so you can finally take action.

The Obsessive Research Loop

By far, the main reason that holds real estate investors back from taking action is Paralysis by Analysis. This reason typically holds back investors who are otherwise ready to go: The capital has been saved and ready to deploy and financing pre-approval is in place. The main questions that paralyze you are:
1. What’s the best real estate investing strategy
2. Which market(s) you should invest in?
In a way, this is a sign of the times. We live in an era where new investors have unprecedented access to incredible amounts of real estate investing information. The good news is that there’s never been a better time for information-hungry prospective investors. It’s an all-you-can-eat buffet of blog posts, articles, podcasts, youtube clips, books, classes, forums, social networks and everything in between. The bad news is the same as the good news. When we’re presented with endless choices, humans tend to freeze and do absolutely nothing.

After all, how are you supposed to know what’s the absolute best strategy for you? One day you read an article by a very bright and experienced investor that tells you that you’re crazy if you invest in anything but single-family homes. The very next day you watch a video that professes the exact opposite is true. Does this sound familiar: “Single-family homes are from amateurs and multi-family is everything”? Then that weekend, you go down the rabbit hole in a forum full of investment horror stories that make you question the whole investing thing.

Reframe your questions

The main reason why you find your main questions difficult to answer and enter a vicious circle of never-ending research is that they’re the wrong questions in the first place.

The first thing you want to do to get unstuck is to reframe the questions. Instead of asking what’s the best investment strategy, try asking what’s the best investment strategy for my goals

It might seem like semantics at first glance but stay with me. There is no one-size-fits-all best strategy because strategies are just tools meant to solve a certain problem. Different problems call for different tools. A saw is a fantastic tool if you’re trying to cut a piece of wood but it’s a very poor tool if you used it to drive nails into it.

The strategy you use to create a passive income stream of $50,000 per year would probably not work if your goal is to build a real estate empire that owns 1000 apartment units. You must start with your goals and then fashion the appropriate strategy for those goals.

Simplify with Occam’s Razor

What’s the appropriate strategy? This is the time to bring in Occam’s Razor principle: Among competing hypotheses, the one with the fewest assumptions should be selected. Or in simpler language, Occam’s razor states that the simplest solution is usually correct. In other words, if you build an empire of 1000 apartment units you will also create a passive income stream of $50,000 per year in the process but that’s not the best strategy to achieve that goal. A simpler strategy of acquiring four to five single-family homes and paying them off would be a better option.

Then, once you’ve decided on the simplest strategy for your goals, you can ask: Which markets offer the types of assets prescribed by your strategy? Keep it simple here as well. If your local market does offer a reasonable supply of your target properties, then keep your investments local. If not, then you can expand the range and look at other markets.

Broad, then Narrow

The second thing you can do to get unstuck and take action is the following mental model: Broad Then Narrow. This model is very effective especially if you are the analytical type (as I am). Let’s put it this way: If you’re the type of person that likes to analyze all the possible what-if scenarios that could ever happen from now until eternity then this mental model is for you.

Here’s how it works. When we work with a client on strategy, we first go broad. We start with your income goal and the amount of time in which you want to achieve it and work backward to the present day. What’s the simplest solution to solve that problem and the most appropriate asset type (single vs multi-family, residential vs commercial) to solve it? Then, we determine how many of those assets you need to purchase to create that income stream, how much capital and how long it will take given your current capital and savings rate. As a result, we lay out a broad plan for the next 10-20 years.

This is the critical point where analytical real estate investors usually get stuck. They start thinking about what if the interest rates change or the economy goes into a recession or I lose my job etc. Therefore, they analyze infinite possible scenarios to death and never take any action at all.

The key concept to understand is that once you go broad with your planning, you have to go narrow with your execution. In other words, when the time comes to execute your plan, you can’t worry about what might happen 3, 5 or 10 years down the line. Instead, you narrow your focus to what you want to accomplish this year and in order to do that what you must do this quarter or this month. If your plan calls for two acquisitions this year, all your focus should be on completing one acquisition over the next 6 months. If you narrow your focus to each step you must take now and take it, the 15-year plan takes care of itself, doesn’t it?

In Conclusion

Most real estate investors fail to take action on their real estate investing strategy the enter the never-ending research loop in an era where there’s an incredible supply of real estate investing information. In this environment, it becomes difficult to know what’s the best investment strategy and which markets you should focus on. Planning and research are prudent and necessary activities to the success of your investment strategy but they can paralyze you when that’s all you do. Therefore, in order to get unstuck, you can stop trying to find the perfect real estate investment strategy and Apply Occam’s Razor principle to determine the simplest real estate strategy that’s suitable to your unique goals. Once you’ve determined your strategy, go broad and plan out your course. Geek out by working backward from your goals in the far future to the actions you must take each year to accomplish them. But then, go narrow and focus only on the action you must take this month or this quarter to make those big goals happen and EXECUTE. There’s definitely a prominent place in your real estate investing journey for planning and research but not while you’re in execution mode.
January 24, 2019
Real Estate Investing Rules of Thumb are Dumb

You can’t escape it. Everywhere you look – in online forums, blog posts even books – you will run into real estate investing rules of thumb that promise you an escape from doing boring, old-fashioned analysis.

There’s the “world famous” 2% rule: The monthly rent on a good investment property should be at least 2% of the purchase price. As long as the rent is 2% of the purchase price, your analysis is done. You set out on your quest to find these unicorn properties that abide by this golden rule. Single-family properties that sell for $150,000 and rent for $3,000 a month? Got it. Small multifamily properties that sell for $380,000 and bring in $7,600 per month in rent? Sure. I have some good news and some bad news about the 2% rule. The good news is that should you find such a deal you should jump on it because it is an absolute steal! The bad news is that such deals are at best, fossilized remnants of decades past and at worst, pure fantasy.

Then we have the reformed 1% rule: The monthly rent on a property should be at least 1% of the purchase price. Not as radical to be sure but you keep looking for properties that fit into that box and you find yourself being pushed to lower and lower quality neighborhoods. Properties in these neighborhoods attract more problematic tenants that lead to evictions and turnover and expenses. In the end, you have a terrible investment experience and your actual returns aren’t that good when it’s time to face your accountant and year-end.

Last but not least, the 50% rule: You can safely assume that operating expenses on your property will be 50% of your gross rent. No need to figure out actual expenses or put boots on the ground. The magical 50% has you covered. Then you realize that it’s much more complicated than that. Are you managing the property yourself or do you have a property management company? Is it an older property that requires lots of capital expenditures or a newer property that needs very little? Is the owner responsible for any utilities or are they all covered by the Tenants?

Look, I get it. There’s an allure to the simplicity of these shortcut rules. They offer an escape from the boring analysis, the mind-numbing figures, and the time-consuming due diligence. Furthermore, they can provide a template lens through which to view potential investment opportunities.

But in the end, real estate investing rules of thumb are the realm of amateurs and they’re a poor replacement for solid analysis. There’s no shortcut to actually looking at operating expenses and estimating vacancy and repairs. There’s no getting around learning the market and figuring out what price to rent ratios it offers for each type of property at this point in time.

Even worse yet, rules of thumb can provide an arbitrary filter that can keep you out of the investing game when the opposite is the preferred course of action. Rules of thumb can establish rigid anchors in your thinking and ultimately prevent you from achieving your goals.

If you don’t know how to do due diligence on a prospective property that should be the first thing on your agenda to learn. Skip the analysis and due diligence at the peril of your investing results.

April 23, 2018
The Fermi Technique: How to analyze investment properties in under 5 minutes

Over the last decade, I have worked with many successful long term real estate investors. They have different personalities, different professions and often employ different strategies. But they all have one critical thing in common:

Successful long term real estate investors possess the ability to quickly and accurately “size up” a potential deal.

If someone were to call you on the phone to offer you a potential real estate deal, would you know how to evaluate it quickly and accurately within 5 minutes?

If not, the technique I will share with you today will change that. It will allow you to analyze any long term real estate deal in 5 easy steps that fit in the back of an envelope.

The technique was developed by world-renowned Italian physicist Enrico Fermi. He created the world’s first nuclear reactor, has been called the “architect of the atomic bomb” and had a substantial role on the Manhattan project. So, in a nutshell a brilliant fellow. Fermi was known to use his technique to get quick and accurate answers to very complex physics problems on the back of an envelope. Today, I’ll show you how to use the same methodology, to solve a much easier problem: How to analyze a real estate deal in under 5 minutes on the back of an envelope.

Let’s dive right in. Someone calls you and tells you about a potential investment opportunity.

It’s a single family home that would make a great investment property – according to the caller. Here’s how you can run a back of the envelope analysis within 5 minutes.

Collect Information and/or Make Assumptions

To get started with the analysis you need 5 numbers that you can easily get by asking or making simple assumptions: A) Purchase price B) Monthly Rent C) Down Payment D) Loan Amount and terms and E) Monthly Payment. Let’s say you determine that the property is being sold for $170,000, would rent for $1700, you’d put 20% down, borrow $136,000 at 4.5% for 30 years and pay $689/mo.

Calculate key data

• Step 1: Calculate the annual rent – Monthly Rent x 12

• Step 2: Calculate cashflow before financing – Annual rent from Step 1 multiplied by 0.54 (operating expenses typically run about 46%)

• Step 3: Calculate the annual cost of financing – Monthly payment x 12

• Step 4: Calculate cashflow after financing – Cashflow before financing (Step 2) less Cost of Financing (Step 3)

Final Step – calculate critical metrics

There are three critical metrics that will tell you everything you need to determine if this is a good deal: Return on Assets, Cost of Financing and Return on Equity.

Return on Assets is calculated as the cashflow before financing (Step 2) divided by the price of the property. Another term for this metric is Capitalization or Cap Rate. It simply tells you the rate of return the property would produce if you owned it free and clear.

Cost of Financing is calculated as the annual cost of financing (Step 3) divided by the loan amount (your Assumptions). You would calculate this metric so you can compare it to the return on assets figure. If your return on assets is higher than your cost of financing that means you have positive leverage. Put a different way, you using the bank’s money to generate higher returns than what it cost you to obtain that money. You should avoid the opposite at all costs.

Finally, Return on Equity is calculated as the cashflow after financing (Step 4) divided by your down payment (your Assumptions). This metric tells you what your invested capital is earning. When you achieve positive leverage, your return on equity will be higher than your return on assets. Or put a different way, you are earning a higher return by using the bank’s money to finance part of the purchase.

The first time you do this analysis, it will take a little longer to complete until you get used to it. Afterward, it becomes second nature and a powerful skill to make you a better investor.

The technique is especially powerful, after you’ve run the initial analysis because it allows you to quickly evaluate potential scenarios (i.e sensitivity analysis). What if you paid $160,000 for the property instead – how would that impact your returns? What if the property rented for just $1600 instead? What if you could secure financing at lower interest rates?

Run the Fermi Technique and within 5 minutes you have critical information to make better investing decisions and make more money in the long term.

Closing Note

The Fermi Technique is an approximation method that provides some insight whether you should pursue any further, deeper analysis. It is NOT a substitute for the full fledged analysis that we discuss in How to property calculate the return on a long term investment.

January 7, 2016
How to avoid “getting married” to a rate of return and a pyramid scheme story

The year was 1997 and the country was on the brink of civil war.

Just under two years prior, several “investment” firms had appeared offering a very enticing opportunity: Invest a sum of money and in 90 days receive three times the amount. People could smell that something wasn’t right but they felt drawn to the easy profit nevertheless. So they started investing small amounts: $100 at first that became $300 in three months time. And the word started to spread as more and more people decided to dip their toes in cautiously (at first).

Then came the rise. Emboldened by the capital that kept coming, many of the firms started making public investments, sponsoring sports teams and the arts, and in one occasion even became an official sponsor of Formula 1. By now the phenomenon had gone national. Only a few “stubborn skeptics” remained out of the “investment of the century” and they were under constant pressure from friends and family members to join in. For a brief six month period, a poor, previously communist country experienced what it was like to live in an affluent society. Everyone had money, jobs were plentiful and the good times had smiled upon us again.

The missing piece from that story is that while euforia overcame common sense, people’s comfort zone had expanded to the point that many were selling their homes and investing their life savings in these companies. Of course, none of it was real. The companies tried to reduce the amounts they paid out per quarter at first to 15% and finally to 8% but there were simply no people left to feed the pyramid. It was all a facade – all of it. Even the large and public investments were simply a show to lend credibility to a pure and simple Ponzi scheme.

Unlike most Ponzi schemes that typically unravel after 6 months, Albania’s pyramid firms lasted 18 months fueled by large across the board participation as well as large sums of laundered illicit money.

When it was all said and done, widespread devastation drove the country to the brink of civil war.

I told you that extreme story from my teenage years to make this, more understated but equally crucial point.

Every asset class has its own “normal” level of performance in relation to the quality of the asset. Well diversified blue chip stocks usually rise 6-8% over the long term with heavy cyclical volatility in between. High quality real estate investments usually offer cap rates of 5.0-8.5% depending on the asset in addition to conservative long term appreciation of 4-5%. Add to that the fact that debt is being paid off using rents and owners of real estate enjoy exclusive tax benefits not available to investors in other asset classes.

Now, there are times when “the elements” come together just right and real estate investors are able to obtain higher cap rates, appreciation and debt paydown than normal. This usually happens at the bottom of a recession, after a correction in values, when the economy is in distress and interest rates are low. That’s what happened between 2008-2012.

If you had the courage to overcome the negative mood of the country and the widespread fear that the world was going to hell in a handbasket by next Thursday, you could purchase high quality real estate investments with 20-25% down, borrowing money at rates as ridiculous as 3.75% and enjoying cash on cash yields of 15-20%. But let’s be clear about one thing. The principal reason why courageous investors were able to get those type of returns was because of risk. Values were depressed because most people were fearful – they were staying away from the market, in squirrel mode stashing away as much cash as possible to last them through the impending Apocalypse. Now that we know how the movie turned out, their risk taking was vindicated. But let’s not forget that instead of the path of Houston, your market could have also taken the path of Detroit, too. And the risk would have cleaned out most investors under that scenario.

Now, all is well in our world (as for the rest of the world, that’s another matter). The fear is gone and hey, look at all this money we stashed away. Time to put it to work. So demand rises as do rents and eventually prices. And before you know it, returns are back to their “normal” levels as a reflection of greatly reduced risk. But now, we might miss those double digit returns to the point that we doubt the strength of current investments.

Just like we will wish we had invested back when rates were under 5% for investment properties when rates will rise in the following years.

The fact is we can’t control the elements. Prices, rates, economy, overall confidence aren’t up to us.

However, what we can control is this: We can control our strategy and we can make sure it contains clear standards for the assets we acquire. We can control our discipline and execute our strategy. We can reach our financial goals regardless of the element mix.

What we should never do is “get married” to and feel entitled to a certain level of return and in that process compromise our property standards to fit “minimum” returns we feel we must get. That’s where most investors go on the wrong path.

You will never hear the story of the investor that went broke when he only got 8% cash on cash return on high quality real estate investments (instead of 12%) because it just doesn’t happen. Instead, you are far more likely to hear the story of someone chasing too good to be true returns and ending up burned.

Play the hand you are dealt with a consistent, well thought out strategy and it’s a matter of time before your financial goals become your financial accomplishments.

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If you are interested in developing a consistent, well thought out strategy that starts with your income goals and shows you an empirical way to accomplish them, please email me or if you’re reading this from your email just hit reply

November 7, 2014
How to properly calculate the return on a long term real estate investment
This may come as a surprise but in my experience, most real estate investors don’t know how to properly calculate the return on investment on a particular piece of property. Couple that with the fact that ROI is the metric most investors use to make crucial decisions about investing and you have a recipe for disaster. Or at the very least, a recipe for missed opportunities.

First, let’s illustrate how most investors calculate the return on investment by looking at an example. Suppose there’s a property in a good location, zoned to good schools with nice finishes on the market for $160,000. A look at rent comparables in the immediate neighborhood reveals that the property should rent for $1650/mo ($19800/year) within a 30 day timeframe. Operating expenses, vacancy provisions and leasing fees add up to 40% of gross rents. The loan on the property is a 30 year fixed conventional loan at 5% interest for 80% of the purchase price (down payment of 20%) so the annual principal and interest payments add up to $8,244/year. So after covering expenses and mortgage payments, there’s a projected annual cashflow of $3,636. To purchase the property, the investor would have to pay the 20% down payment ($32,000) plus loan closing costs ($3,000) for a total of $35,000.

At this point the investor takes the positive cashflow of $3636 per year and divides it by the invested cash of $35,000 and conclude that the return on investment on the property is 10.36%.

The return calculated by the investor in the example above only reflects the cashflow return on investment or as it’s commonly known “the cash on cash return”. Essentially, this method looks at the real estate investment as a sophisticated CD or dividend stock. You invested X amount in the CD and it paid out Y at the end of the year so therefore your return is X/Y.

The method just described is wrong not because it’s incorrect but because it’s inconclusive.

Here’s why the cash on cash return does not tell the whole story – It does not account for:
1. The principal of the mortgage paid of during that year
2. The fluctuations in rent price during the holding period
3. The fluctuations in property value during the holding period
Let’s take them one at a time. Part of the debt payments on the mortgage goes towards paying down the principal balance of the mortgage. Therefore, ten years from the acquisition point the mortgage balance will not be the same as when you start. The cash on cash return figure completely neglects this very important benefit of investment real estate. That is, the ability to pay off the mortgage using rental income. Second, the cash on cash return calculation may be accurate during the first year of the investment since the rent and expenses are pretty much set. But as time passes and you change tenants, the rents don’t typically stay stagnant and neither do expenses. Rents usually follow an upward trend (they go up over time) but that’s not guaranteed. Sometimes rents go down – for instance, when there’s an oversupply of rentals and not enough tenants to go around. So the cash on cash return does not accurately depict what happens to your investment as rent prices fluctuate. Third, on a similar note, home prices don’t stay stagnant over the long term as the last recession duly reminds us. Remember, there are two returns we have to contend with: Return on investment and return of investment. If you acquire a low priced property in a neighborhood where values are likely to decline over the next 10 years, your cash on cash return is providing an inflated view of what your true return will be in the end. Because when the time comes to exit the investment, you will have to “give back” some of those returns by not being able to recover all the capital invested at the outset due to declining prices.

As a way to illustrate how poor of a measuring stick the cash on cash return can be, suppose for a minute that instead of a 30 year mortgage, the investor went for a 15 year mortgage instead to take advantage of more favorable terms. When the loan term is shortened, loan payments increase by about 40% wiping out any positive cashflow that was there. Does this mean this deal is not worth doing because now the cash on cash return is zero? More importantly, is zero the true return on this investment?

The short answer is absolutely not.

The proper way to calculate the return on a long term real estate investment is the internal rate of return. It’s not perfect, but it accounts for all those deficiencies I just went over. This method looks at an investment during the entire holding period and calculates an annual return. Take a look at the table below:

Internal Rate of Return Calculation

Think of this table as a chronological roadmap of your investment if you held it for 10 years then sold it. In the beginning, there’s your $35,000 investment (a negative number because it’s an outflow of cash) followed by ten years of cashflows and the cash you get back at the exit point if you sold the property for the same price you paid 10 years ago (zero appreciation over 10 years). As you can see, most investors just look at the first two numbers which don’t even cover half of the story.

Internal Rate of Return with 2% Annual appreciation

Now let’s assume that the property went up in value at the rate of inflation (as most goods do) over the next 10 years. Take a look at the illustration above – your cash on cash return is the exact same but your true return has increased by 25%.

This may seem like a nerdy debate about methods of calculation but it’s much more important than that. The rate of return is usually THE metric most investors use to make decisions on investment opportunities. If you pass up on a worthy investment simply because your numbers aren’t right, that will have a negative impact in your investing results.
March 11, 2014
How to find and screen tenants for your investment property
When you are trying to reach your retirement goals using a long term real estate investing strategy, there is a multitude of factors can make the crucial difference between success and failure. To mention a few, the quality of the location and school district, the price to rent ratios in your portfolio and the terms of your financing are all factors that lead to underwhelming results when compromised.

But if I had to pick one factor that all successful long term real estate investors must get right, one ingredient that is necessary for your portfolio to achieve its full income potential, I’d have to go with the ability to find and keep great tenants. Without great tenants, your dream retirement unravels into a hassle laden, vicious circle of vacancies, evictions and problem calls that typically keep skeptical inventors from investing in real estate in the first place.

With that in mind, I’m convinced that one of the greatest services we provide for our clients on a daily basis is the procurement of great long term tenants. So today, I wanted to share with you some pointers on how to find and screen potential tenants to find the hidden gems that will pay rent on time for a long time and take care of your property like it’s their own.

Before I begin, I want to point out something of outmost importance. The investment properties you buy generally attract (and essentially pick) the type of tenant you will eventually have. If you buy a property in a bad location, with high crime rates and low quality schools your applicant pool will consist of tenants that would want to live in that property. There’s no magic wand that would allow you to find great tenants for a low quality property. So, what follows assumes that the property itself is an investment grade property in a good location that would attract a well qualified tenant.

Now that we got that out of the way, let’s say you just closed on a great investment property and are anxious to find a great tenant (as 100% of investors are). How do you go about finding and screening applicants in a methodical and proven way?

First let’s tackle the “finding part”. At the outset you have to let the market know that you have this great property available for occupancy. Painfully obvious, I know. But you’d be surprised how many investors fail at this stage in a futile quest to save a few hundred bucks. In order accomplish this, your property needs to be listed/advertised/posted where potential tenants look for rental properties. That means your property must be listed on:
1. The MLS – A large percentage of the great tenant pool are relocations into the city where your property is located. These tenants are usually well qualified, have high paying stable jobs and they HAVE to move. So all the ingredients are there in a neatly wrapped package. Now the wide majority of these clients have agents who represent them that were assigned to them by the relocation company. Their agents aren’t going to drive by neighborhoods at random and see your red “For Rent” sign you bought at Lowe’s. If your property isn’t on the MLS, you essentially don’t exist for a large section of the very tenants you are hoping to attract.
2. Every Real Estate Portal – Your listing needs to be on every real estate portal that accepts lease listings: Zillow, Trulia, Hotpads etc. Do all these work all the time? Not really. But you are trying to cast a wide net and see what brings in the haul. The good news is that most MLS these days automatically syndicate to these portals. Or in the event the one in your city doesn’t, there are websites you can use to upload the property once and propagate it to all portals (i.e Postlets)
3. Craigslist – Finally, the godsend for landlords everywhere. After the MLS, Craigslist is the second largest source of tenants we have found. Your listing must be on Craigslist and it must be there as often as they will allow you to be there.
But the fact that your property is listed in these places, is as important as how it’s listed. In order for your property to stand out, you must have well lit, high quality pictures taken. If you don’t have a high quality camera and flash, hire a professional photographer. It will be the best Benjamin you ever spent. Pictures are crucial.

Last but not least, the ad for your rental property needs to resemble the ad for a job. Just like the employer paints a picture of the ideal candidate they would like to hire, so should you describe the exact tenant you are looking for in specific detail. Don’t be afraid to alienate the candidates that don’t meet your criteria (provided your criteria are reasonable and most importantly, legal). You’re not trying to generate interest for interest’s sake. You’re trying to generate targeted prospects that have a high probability of getting approved.

That brings us to the second part of the discussion: The screening process. Suppose that your marketing efforts have paid off and now you have lease applications from prospective tenants. What are the factors that will determine the eligibility of the tenant or lack thereof? In order of importance:
1. Rental History
2. Sufficiency of Income
3. Employment History
4. Background check
5. Credit Check
6. Pets
7. References
The prior rental history of the applicant is a great indicator of how they are likely to perform during your lease term. So in most cases, serious problems in the applicant’s rental history lead to the rejection of the application. What you are looking for here is at least a two year history of leasing properties with no issues. Any prior evictions, collections from previous landlords, lease breaches etc tend to indicate problems that are likely to repeat themselves so we avoid them every time. Other aspects of the applicants’ rental history that matter are the typical length of their prior leases and the rent amount they’re “used to paying”. If the history reveals a tenant that moves every 3-6 months, that might not be the best fit if you’re looking for a long term tenant. And finally, you want to avoid the effects of rent increase shock. A tenant that has been paying about the same amount of rent over a period of time is less likely to be shocked than a tenant that’s used to paying half the rent you’re asking.

Sufficiency of income is paramount to avoid future defaults, evictions and vacancies. In fact, one of the principal reasons that lead to evictions is the investors’ own carelessness in placing a tenant in a property they can’t afford. This may sound like overkill but what you need to do to determine sufficiency of income is to run a down and dirty budget for your tenant. How much of their gross pay do they take home? How much “disposable income” is left over after they pay your rent, utilities, food, gas, and monthly payments? If the answer is “not much” you’re one car problem away from not getting your rent paid. Why would you do that to yourself on purpose? So, to insure there’s enough income there to support the lease, we require tenants to make 3.5 times the monthly rent in gross income. Essentially, we want the lease payment to be no more than 28.5% of their gross pay. Last but not least, their income has to be reliable (salaried or base, not variable commissions) and documentable through pay stubs or tax documents.

Employment history addresses the probability that the income we’re relying on is likely to continue during the lease term. Typically, we look for at least 2 years in the same line of work (they can be at different companies as long as its the same job and level of income). Of course there are exceptions – for instance a recently graduated college student with a solid job offer letter for a reputable company.

The background check is another go/no go criterion. It must be clean of any issues that show character flaws (theft, violence, fraud, drug related issues and other serious criminal offenses). We look at small misdemeanors on a case by case basis. If its an issue that happened 20 years ago and the tenant has no issues since, that’s looked at differently than something that happened last week.

The credit check is a tricky one because investors tend to simplify the matter down to a credit score. I don’t agree with that approach. More important than the score is the story. Some credit reports tell the story of an applicant that’s always late on all payments. Others, tell you about a rough patch the tenant may have been through a while back due to a job loss or medical issues but also speak of solid payment history since then. The funny thing is, both candidates may have the same exact credit score. And I’d lease to the second (provided all the aforementioned criteria is in order) but not the first.

Pets are another issue that requires a lot of care. If you just purchased a quality property in a great location you might be tempted to categorically disallow pets to prevent damage to your property. The problem is, a large percentage of the “great tenant” pool have pets so by excluding them you’d be missing out on some great candidates. Besides, pets require a lot of care and dedication so in a way, the fact that your tenant may have a pet is a sign of maturity and stability. But on the other hand, some pets can cause a lot of damage to properties. So, it’s important to get this right. Usually, we go with a case by case approach on this. We place weight limits (40lbs) and total number of pets limits (2) as well as exclude breeds considered dangerous to eliminate liability. We also charge non refundable pet deposits for each pet to mitigate the risk.

Finally, you want to make sure that the information on the lease application is true and correct and has not been “enhanced” by the tenant to fit what you’re looking for. You do this by checking references. Check county records to make sure the listed landlord truly owns the property they leased and isn’t a friendly uncle. Then, call all previous landlords listed and ask open questions (not yes/no questions). After you’ve verified the information as correct ask them if they’d lease to the tenant again if given the chance. Repeat the process with their managers at work.

There’s no possible way to avoid all defaults and problems as they’re part of life (even qualified tenants can be laid off) but if you follow the advice I’ve just given you to find and screen great tenants for your investment property, you’ll reduce their occurrence to a minimum.

Juhan Sonin via Compfight
May 31, 2013