Back in early 2010 I wrote about my favorite spot to find prospective tenants.  Can you tell I am not very creative in finding them?

I am still renting 80% of my properties via the For Rent sign in the front yard.

But the important question is, once you an application or applications how do you decide if you should rent to the tenant or not?

We are flexible with most aspects, but here are the most important factors:

1. Income Qualifications

If monthly rent is $1,200 and the tenant only makes $2,000 per month, the process is over.  They are never going to be able to pay.  Their credit score or the rest of the story doesn’t really matter.  As a general rule of thumb, we hope for 3x rent (which would be $3,600) but will settle for 2.5x.  I do take into account all income for this calculation.

2. Criminal Background / Eviction Check

I always prepare a criminal check and eviction check (the criminal charge is called an unlawful detainer).  San Bernardino County, where most of my rentals are in, offer this search for free.    Evictions, hard drugs and theft usually will completely eliminate the tenant.  If we see domestic disputes and other crimes this is a red-flag and we usually discuss them with the tenant.

3. Security Deposit

Our typical deposit is $100 above rent.  Again, if rent is $1,200 our requested deposit would be $1,300.  Very rarely are we flexible on the deposit.

 Other Factors to Consider

• Length of Previous Residency: we are looking for tenants to stay at our house for a long time, if they move every year that is a red-flag
• Rental History: we are looking tenants that have experience renting/owning a house before versus apartment
• Length of Employment: the longer the better
• Ready to Move in Quickly: a tenant that is willing to move-in within two weeks is a definite positive
• Pets: we prefer no pets, we do take them and charge a bigger deposit
• Previous Rent Amount: if a tenant is currently paying $800 and applying for $1,200 that is a concern we usually discuss
• Number of Occupants: many of our houses have quite a few occupants, our max is 2 per bedroom, but we like fewer

As you may have noticed a high credit score is not on this list.  We rarely check credit… typically only when something else on the application seems fishy.  Most of our tenants have credit scores in the 500′s anyways, how does knowing that help us?

What we do if we see Red Flags

Many tenants meet criteria 1 through 3 but the one or multiple other factors bring up some red flags.  We will still extend an offer to rent to the tenant but we will ask for an increased deposit.  By California Law you can collect a maximum of 2x rent for a security deposit.  This has worked out with great success for us, if the tenant is unsure about their ability to pay the rent they probably won’t be willing to hand over additional funds.

If you’ve been reading the blog for a while you know I like stats.  I thought I would compile some stats for what 2011 looked like as landlords for us.

New Purchases

• 26 new rental properties
• 22 are single family houses
• 2 are duplexes
• 1 two houses on a lot
• 1 commercial building
• The most affordable purchase was 40,000 and is rented for $800
• The most expensive purchase was 110,000

Property Management Stats

• 16 tenants still remain from 2009 and 2010
• 35 lease ups
• 8 tenants moved out in 2011
• 5 properties are under repairs or for rent (all new purchases)
• Average time to fill a vacancy took 18 days, longest 32 days, shortest 1 day
• No evictions, but two moved out without getting their deposit back
• Average repairs on move-out $700.  Some we paid, some tenants paid, some split, depending on circumstances
• One $100/per month rent decrease to keep a good tenant
• One $50/per month rent increase for a tenant with rent too low

Landlord Goals for 2012

• December 2012 gross rent collected to be $83,334 or more
• Add 20+ new properties
• Buy 1+ apartment or commercial building
• Convert all tenants to pay online ACH, deposit at the bank directly or pay by mail

Summary

We are very satisfied with how 2012 turned out from a landlord perspective.  It is still my business partner and myself that manage all these properties, if 2012 stays on track we are planning to hire an assistant and one of their primary responsibilities will be property management and lease ups.  Most of the work comes from the new lease ups and phone calls of the properties advertised for rent, if we stopped growing our portfolio more aggressively it would be easily manageable by one person at 10-20 hrs per week.

Why We Haven’t Raised the Rents

We have thought a lot about if it is time to start raising the rents and for 2011 we made the decision that when we are adding 20+ properties a year we don’t want to create more work for ourselves by pushing paying tenants out by increasing the rent.  I doubt many would leave, but even if we lose a couple, it is not worth it.  We had one property that took a while to rent, so we ended up way under market.  So we sent her a rental increase notice for 1/1/2012 which she just paid, but I wouldn’t expect to see a lot of rental increase notices from us in 2012 either.

I have recently been asked to elaborate on my rental property purchase criteria.  You would think I have an elaborate set of guidelines, must haves and must want but it is not that simple. If you have been following this blog for a while you might remember that we started in the house buy-sell business (flipping) and it took a year before we decided we wanted to start keeping some properties. That means we have taken a different approach to the business.

Like the buy-sell business one of the main criteria is EQUITY today!  For rentals we are looking to pay 75% of ARV value less repairs for any purchase.   So if the property will be worth $100,000 once it is fixed up and requires $10,000 in repairs the most we would pay is $65,000 ($100,000 * 75% = $75,000 – $10,000 in repairs).

The second requirement is CASH-FLOW.  The property must generate a positive cash-flow after all expenses and factoring in 10% on the entire purchase and rehab.  We cannot get traditional financing any more, so we are paying private and hard money rates.  This pretty much means that the max investment on a deal is going to be about 120,000 or so, or else it will not achieve positive cash flow.

So the goal is to buy a property at a discount, collect the cash-flow, leverage some of the investment out and sell or trade when the right substitute investment comes along.  I am hoping to see some appreciation in California at some point, but with our model it really doesn’t matter if it happens or not.  We could sell everything rental we own for a profit in today’s market.

Our criteria is pretty flexible if it can meet the above two goals.  For example many investors don’t like to buy 2 bedroom, 1 bathroom houses, I have no problem with these as long as I can get them for 75% or less of what other 2 bedroom, 1 bathrooms are selling for.

There are some items that are deal breakers:

• If I am afraid to get out of my car in the neighborhood, day or night, I don’t want it.
• If it is over a 45 minute drive from my office, that is probably too far.
• Dirt Roads.

Things I don’t like and would want to pay less:

• Flat or gravel roofs.
• No garage.
• Really busy streets or other major location problems.
• A really old house (1940 or less)

I know I probably didn’t provide anything revolutionary or an exact criteria to follow: instant equity + positive cash-flow + good location is really the formula…

Often I visit a great real estate social network called Bigger Pockets.  Recently a new member at the site, Daniel, outlined his investment strategy that was focused on buying properties cash, re-investing all cash and salary and building a portfolio slowly and safely.   See the thread here.

I am not going to knock his strategy, but I wanted to sit down and run the actual numbers to see what the actual difference in return is.

For our hypothetical situations we will compare three scenarios:

• No financing
• Financing 50% of your total investment at 8% interest only
• Financing 80% of your total investment at 8% interest only

Assumptions we are going to make in all scenarios:

• The non-interest expenses ratio will be 40% (this will include ALL expenses taxes, insurance, vacancies, maintenance).  This is conservative in my opinion; a vigilant California landlord should be able to beat this for single family rentals.
• The owner of the property will manage the tenant at no additional cost.

I decided to run three real rental properties I purchased in 2009.

The results are more or less what I expected.  Clearly the more financing you get the higher your ROI is but for the benefits of financing to pay off your ALL CASH yearly ROI needs to be less than your cost of funds.  So if you are borrowing money at 12% instead of 8% on Prop A and you finance it to 80% you will be breaking-even and it is really a lot worse than that because you have 20% of your money invested in the deal, earning $0 return and your managing a property for free.

Now for the fun part of the project, let’s make some wild assumptions and assume 10 years from the purchase the property will return to the previous 2006 peak value.  I have no idea if the market will ever get there again and as long as I am cash-flowing I don’t really care if it ever gets there.  But what does it hurt to run the numbers.

The assumptions I made for this are:

• You sell the property at peak value
• You incur 8% of the sales price in disposition costs (real estate fees, escrow, closing costs, etc)
• The property gets back to the peak valuation 10 years from the purchase
• Rent stays flat

Again, I am not saying I think this is what is going to happen.

Essentially this really shows where the power of leverage can really spice things up.

And for my last point, leverage can go both ways.  If rents drop significantly, major disasters or any number of events happen your losses will grow to a level that might be unbearable if you use too much leverage. I read the book on the founder of In-N-Out and he bought almost all of his restaurants cash and in the beginning he rarely used borrowed money to grow.

I don’t think anything is wrong with owning properties free and clear (in fact it is part of my long-term strategy), but when properties can be purchased at these prices leverage can really be a great tool for investors to take full advantage of the market.

About 10 days ago Zillow released an interesting addition to their software, they now offer a Zestimate on the amount of rents a property will fetch.  For specifics see Zillow’s Official Blog Post about it. If you have been following the blog for a while you may remember a previous post on how I feel about Zillow’s Property Value accuracy.

Since I have a small sample size of raw data I figured I would compare 20 of my rentals, actual rent to Zillow’s estimated rent.

As you can see some results seem to be pretty close, and others have a huge gap.  Pricing rentals is more of an art then a science.  Tenants do not do “appraisals” before they rent a house and some situations will cause price gaps (eg: if a tenant has been in a property for 10+ years, it is safe to say they are probably paying under market rent).

Like in property values, Zillow does a bad job of estimating the rent on some of the funky properties:

• The duplex I own that gets $1,000/mo and $650/mo for a total of $1,650.  Zillow did acknowledge the property was a duplex but still estimated rent to be $1,156.  I assume they are basing this on what they think a similar sized single family residence will fetch.
• The property that I rent for $725 is a condo in a pretty rough complex (I think this is the only property I might not have bought if I could get a ‘do-over’).  Zillow estimated rent to be $905.  I am probably a bit under market because I wanted a good tenant on this one, but I assume they are basing rent on other condos in nicer complexes.
• Lastly, the property I rent for $2,000 has some additions, although they are permitted on and on title.  I have no clue why Zillow came up with only $1,337 for rent for this property?

What they could do to improve the service?

• I would prefer if they provided more of a range, market rent is $1,150 – $1,250.
• It would be great if they could provide comps with actual addresses that explain how they are determining the value.  The reason I like this feature is I can eliminate the houses that don’t match mine.  The 1990 built that is rented for $1,750 is not comparable to my 1950′s built house.

In conclusion, this will probably be another value I take into account when doing my pricing procedure (see my blog post on, How I Price My Rentals).  The values they provide seem to be lower then actual market value, 14/20 of the properties Zillow provided a lower value.  None of these fancy services beat actually driving the neighborhoods and doing a little old fashion hard-work.

This has always been an interesting question that I have spent a lot of time thinking about.  What class of properties should you buy and focus on?  Is it worth it to spend your time in the war zones chasing huge cash-flow?  Or work on the consistent returns and easy management of the Class A pile of rentals.

Class A properties – These are the properties that you have extreme pride of ownership over, when you are showing your friends what you do for a living these are the ones you go to.  The cash-flow isn’t as good as the other classes, but they are generally newer, require less maintenance, in better areas, easier to finance and easier to rent.  The theory is these properties will appreciate more (if we ever get appreciation again).

Class B properties – These are the middle of the road properties.  They may be a bit older or in not quite as desirable of a neighborhood.

Class C properties – These are usually the properties you will be bragging about the cash-flow instead of showing all your friends the property.  The appreciation might not be as good and they will usually be more of a challenge to find/manage good tenants and finance.

We did an interesting exercise about two months ago: I printed two copies of our rental portfolio and my partner and I ranked every property as an A, B, or C.  It was a very interesting thing to discuss, we answered the same grade on everything except about 5 of them.  The funny thing is, I found myself defending some of the lowest end properties saying, the tenant in that one is so good I don’t want them ever to leave.

Every investor probably has a different definition of what a Class A and Class C property is.  My definition is, if you are not comfortable getting out of the car during the day, that property is probably Class D to you.  The more properties you look at though, the less intimidating a group of gawking neighbors is.

I did an analysis to compare one property we own in each class.  I tried to pick our average deals, as we have a couple ‘great deals’  in each category that would throw things off.

First I want to explain how I quickly compare rentals.

The Simple Formula

Rental Income per Month / Total Acquisition & Repairs

eg: $1,100 / ($65,000 purchase + $10,000 repairs)

$1,100 / $75,000 = 1.4667%

Our ideal rental should show a 1.5%/monthly return or more.  This formula is similar but a bit more simple than the Gross Rent Multiplier.

Class A Property

Total Acquisition & Repairs: 124,000
Rent: $1,495
Peak Value: 345,000
Total Cost versus Peak Value: 35.9% ($221,000)
Rent Ratio: 1.2%
* we have a very hard time finding Class A properties that are at 1.5%

Class B Property

Total Acquisition & Repairs: 74,000
Rent: $1,100
Peak Value: 285,000
Total Cost versus Peak Value: 25.9% ($211,000)
Rent Ratio: 1.5%

Class C Property

Total Acquisition & Repairs: 58,000
Rent: $950
Peak Value: 192,500
Total Cost versus Peak Value: 30.1% ($123,500)
Rent Ratio: 1.6%

* I am not really counting on us getting back to Peak Value, I am just using it as a comparison for appreciation across the levels.

The interesting comparison is the Total Cost compared to Peak Value is actually a lot better on the lower end properties.  If you are using all cash, you can essentially buy two Class C properties or one Class A property.  For the Class A you would be collecting $1,495 rent, and for two Class C’s you would be collecting $1,900 rent.  But for the extra $400 you have two tenants, two roofs and two lawns.  You also have to find two good Class C deals, for every good Class A deal.

Our focus has been finding the biggest discounts compared to ARV first and worrying and focusing less on the Class of the property.  Right now we classify about 50% of our properties as B’s while A’s and C’s share about 25% each.  The other thing I like to do is ‘go after’ properties in neighborhoods we already own properties in that we really like (no matter the class).

If you are not wanting to be involved in the management process very heavily I would focus on Class A’s.  Otherwise, I think you should buy a little bit of everything.

Here are two of the rental houses we picked up January.

Both of these houses are the same model, built in the 1980′s, 3 bedrooms, 1 bathroom and should make fine rentals.

The one on the  left we rented this weekend to someone who drove past the house and talked to one of our workers who was fixing up the property.  That is always nice as we haven’t even owned the property for 4 weeks yet.

We are working on renting the one of the right at this time.

We just closed on House #73 about a week ago.  It is a 2 bedroom, 1 bathroom house where the single car garage is converted into a third bedroom.  The house is just under 1,000 square feet and a pretty solid rental in a good neigbhorhood.

The house is actually in pretty good shape compared to what we normally buy.  It has ugly linoleum flooring throughout that we are going to end up replacing, it is in mediocre shape, but just not worth saving.  The kitchen is pretty good shape, the cabinets need a bit of paint, we are going to be adding counter-tops, a range, and a microwave.

Our crew should be in and out of this house is under two weeks, so we are hoping to have a tenant moved in for March 1st.

Here are some more pictures.  I realized I forgot to take a picture of the front today… maybe because it was raining?

When I first started as a landlord it is pretty hard to determine what to rent properties for, as you have no idea what the market is like.

There are some really easy ways to get the job done.

Call Local For Rent Signs

This method is too easy.  Drive the neighborhood and call 3 or 4 of the for rent signs.  You can honest with who you are or you can pretend to be a renter if you want.

Finest Expert (formally Ziply)

Finest Expert is pretty good because you can enter the bedrooms/bathroom configuration of your house and it factors that into the search.  I took a screenshot of a search on a property I know about.

RentoMeter

This site appears to have been recently re-done… it doesn’t list the properties bedroom/bathroom in detail like Finest Expert does.

How to determine the final price?

So now that you have a price range, how do you determine what to list the property for?  All the landlords I know do it a little different.  Some landlords like to keep their prices about 10% under market so they keep tenants longer, other landlords like to maximize cash-flow and price at or above market.

We typically fix our properties up quite nicely (mostly because we buy them in such poor condition to start), so we try to price them right at market for the area (hoping that our property being in good condition will get good caliber renters).  We also use the retail pricing tricks and try to price properties, for example, we might price the above referenced property at $995 or $1095 just to give people the impression that it is under $1,000 or under $1,100.

If you cannot rent the place in 30 days you should lower the price.  We always rent the rent amount, the number of bedrooms and bathrooms on the sign and try to do 3 signs per property.  Two on the yard and one in the window.

As we started renting properties I had to search for solutions for phone calls.  I had a two major requirements:

• I wanted a local number versus a 1-800 number… I am sure a 1-800 number would work, but I think people are less likely to call it.
• I didn’t want to give out my cell phone number to tenants, but I wanted to be able to forward calls to any number I picked

After a lot of searching I ended up picking a service called Toktumi (pronounced Talk to Me) and I have been really happy with the service provided.

They have a web interface where I can add/remove extensions, see my call log, listen to voicemails, etc.  Another awesome feature is they have an app for my Blackberry and iPad that allows me to make calls, text messages and listen to voicemails.  It really makes life easy and I can easily forward the number to someone else if I am out of town or busy in meetings all day.

My only complaint is I wish they had an easier way to dial outgoing numbers.  Maybe they do and I don’t know about it.  But basically I have to first dial my number, hit 2 and then dial whatever number I want for the Caller ID to come up as my rental number.  It is kind of a pain to do from my car.

Check it out, Toktumi.