Pssst - Wanna Be a Real Estate Millionaire? (Part 9)

Chapter 9: Investor versus Landlord?

Only you know yourself well enough to decide whether or not you are suited to be a landlord. When I started buying apartment buildings in 1960, I was a slide rule-engineer meaning I had very few people skills (probably closer to none). It was a rude awakening for me to now have to deal with real people. Tenants come from another planet. They have a completely different mindset from what I would call rational. It takes a particular talent to be able to successfully deal with tenants. Do you have that talent?

I had the good fortune to be able to correspond with- and personally meet with Bill Nickerson in the early 1960s. In his book, he advocated a person start at whatever level his current finances permitted. I argued that if a person had no prior landlord experience, he should start at the bottom regardless of how much money he had to invest. It got to the point where we’d both grin at each other when our eyes would first meet because we knew we had this ongoing disagreement. Bill was probably in his 70s when I knew him; having started when he was age 25. I concluded he was too far removed from his beginning days to remember what it was like. You heard me admonish you at the beginning of this book to start at the bottom regardless of how much money you may have to invest. I still mean this. I’m now in my 70s but I still remember. Don’t allow yourself to be overwhelmed by tenant problems when you first start investing. Think of the steps a baby goes through learning to walk. You need to grant yourself the same leeway while learning to deal with aliens – I mean tenants.

In all fairness, many tenants are genuine people. However, there are enough weird tenants out there to ruin the entire gene pool. Additionally, state laws have been twisted over the years to favor tenants at the expense of landlords. Yes, there are some nasty landlords that give the rest a bad name, but it has been my observation that very few landlords are stupid enough to ruin their own investment programs by being slumlords. Tenants, however, get reinforcement from favorable laws that allow them to act- and behave horribly. You just need to be aware of what’s involved and be prepared to handle these kinds of people.

Fortunately, there is help – professional help. I advocate you start at the beginning with perhaps a rental house or duplex where you might live in one unit and rent the other. This will give you a taste as to what you’re up against. As you expand and acquire more units, you will be able to decide for yourself whether or not you’re suited to be a landlord. If you’re a natural people-person, the chances are you’ll do fine. If you’re not a natural people-person, you can learn as I did. If it just isn’t working for you, you can hire professional management services. Or, you can arrange your affairs to only include investment positions without being a landlord on a daily basis. Let’s see how this might work.

This discussion and review also falls into the other category of active versus passive participation. If you’re a landlord, you’re definitely in the active camp. If you hire professional property management, you’re more of a passive investor who oversees employees. I do recommend that you start out trying to be your own landlord. No one will have as high a proprietary interest in your property as you do. If you’ve given it a fair test and you still don’t feel you’re cutout to be a landlord, either quit owing investments that require active management or hire professional management to work on your behalf.

Whether or not you directly participate in the management of your properties, you must be the one who sets the tone – the standard as to how your business is to be operated. Certain documents are required to protect yourself when dealing with tenants. The first document is the Application-to-Rent form. Some states have specific forms and procedures that you must use. Other states leave it up to the individual owner. Regardless, you must screen each and every applicant before you make any commitment to them. Discrimination laws being what they are today, you dare not overlook this step. The last thing you need is for some disgruntled wanabe tenant claiming you unfairly discriminated against them.

Over the years, I’ve used forms that I compiled from sample forms I obtained from others. Lately, I’ve been using a state Association of Realtors’ Application for Rental form. It’s a two-page form that asks the same information about each applicant and co-applicant regarding identification numbers, residences for the prior two years and employment for the past two jobs. Then it goes on to ask about others who might also be occupying the property (e.g. children), use of waterbeds, smokers, list of all vehicles, description of any pets, questions regarding prior bankruptcy or evictions or credit problems. It also covers armed forces personnel and whom to notify in case of emergency. These are all pretty standard questions a landlord would want to know in advance. You are required to use the same screening procedure on all prospective tenants and then select the acceptable tenant in accordance within stated guidelines. Failure to operate in this manner could subject you to fines and lawsuits in today’s litigious world. In other words, have your procedures already set-up in advance before you begin dealing with would-be tenants. Keep these applications in a permanent file for several years after the fact.

Once you’ve selected an acceptable-to-you tenant, you first check out the tenant’s information. That means you check their credit, past landlords, employment history and even marital status. Early in my real estate investment days, I was about to accept a couple whom I thought would be excellent tenants. The husband had worked for the building maintenance department of the office building in which I had my office. I just happened to be on the elevator with the maintenance foreman and I mentioned to him that a former employee of his was about to rent an apartment from me. I immediately saw a concerned look come over his face so I asked him if he thought I was making a mistake. He told me that the man had been let-go due to materials theft. I thanked him for his honesty and saved myself grief by not renting to someone like that.

Today, there are services you can use to verify prospective tenant’s information. You can order credit checks legally if you first get the applicant’s written permission on your application to rent form. There are also fee-for-service screening services that will make an in-depth search of any individual for you including bankruptcies and evictions.

After you are satisfied that your prospective tenant is a desirable tenant, you have the tenant sign a rental agreement or a lease agreement. In this second agreement, the terms of the tenancy are spelled out in great detail. The names of the persons who will be occupying the property are listed. Then there will be a statement that if any other persons live on the premises, the monthly fee will be increased by $X per person. Pets are specifically identified to the exclusion of any other pets and damages are stipulated for any damage caused by that pet. The vehicles on the premises are identified with the stipulation that no additional vehicles will be permitted and that no vehicle repairs are permitted on the property nor will junk cars be left on the premises. Your rental agreement must be complete and specific in every aspect because tenants tend to take advantage of every loophole they can find to avoid just abiding by the rules. Don’t ask me why, they just do.

Another pitfall of being your own landlord is that you can become too friendly with the tenant to the point where the tenant starts taking advantage of that friendship. It’s a very fine line between being businesslike friendly and being a friend. You’re objective is to operate your business in a friendly manner. You are not their beer-drinking buddy. If you can’t maintain this separation, hire professional property management.

If you do hire professional property managers, you still must be exceedingly careful in whom you choose. There is no end to the horror stories of real estate investors being ripped-off by dishonest and incompetent property managers. Once you do find an honest, competent manager, you still must watch them closely and always audit their reports for accuracy. I’ve lost track of how many times I’ve been told about the property manager who hired an electrician at $75 per hour to change a light bulb or hired a plumber to change a faucet washer. It is possible that your selected property manager will have a separate maintenance business to provide these services to you. Probably your best bet would be to separately hire a handyman service to perform these minor repairs independent of the property management. Your rental or lease agreement should also include who will pay for what. If you walk your new tenant through the property and show them that all systems are functioning properly at the time they move in, then when they stop-up the sink or toilet, it’s their nickel to get if fixed. You should only be responsible for equipment and system malfunctions not directly attributable to tenant carelessness or abuse.

You will find yourself being tempted to “hire” a responsible tenant to be your eyes-and-ears at the property. Resist this temptation. If you’re going to hire someone else to manage the property, hire a professional. Either you are the manager or a hired service provides that service. No exceptions. How do you think I know that?

It was not my intention to scare you or dissuade you from being a landlord. You can do it profitably but you must recognize that it will consume your valuable time. If for whatever reason you elect to not own properties that require your supervision, there are still many ways you can invest in real estate in a passive manner. Remember PIGs? In my listing of real estate investment areas of interest in Chapter 1, you will find many passive investments that will give you direct ownership in real estate without the hassle of day-to-day management. These include:

  1. REITs or Real Estate Investment Trusts. Typically, REITs are listed as stocks on some stock exchange and the shares are bought and sold daily. Unlike a stock in a corporation, stock in a REIT is called a “share of beneficial interest” and may have some transferability limitations. Normally, a general manager provides the day-to-day management of the properties and periodically distributes income to the investors on a regular basis (PIG). The type of real estate in the REIT can be whatever is initially specified. Usually, the REIT specializes in either rental units or in commercial/industrial properties. Seldom do they combine rentals and commercial/industrial properties. A few specialize in storage units. You can find out exactly what investments they are permitted to make by reading their prospectus or offering materials.
  2. RELPs or Real Estate Limited Partnerships. RELPs are not liquid so you typically invest as a Limited Partner when the LP is formed and then wait passively until the General Partner liquidates the LP. You do not have any say-so in how the LP is run or managed. Typically, a LP will be formed to operate one property although many do manage multiple properties of the same nature such as apartment buildings. Some specialize in storage units. Unlike the REIT, a RELP is usually organized to create capital gain profits and perhaps tax deductions rather than dividend income. You’re still a passive investor and have no control over the management of the partnership. FYI, I just received a final check from a LP in which I invested in 1967 so it can take quite some time to run the cycle to completion. Even though tax laws have changed to drastically reduce the tax deductions available, some deductions do exist and can be passed through to the investor in a LP. Your liability is limited solely to your initial investment unless you have agreed, in advance, to periodic additional investments.
  3. Special Mutual Funds. Most mutual funds are diversified and they invest in a broad variety of companies. Some funds, however, do concentrate in certain specific areas such as health care, energy, and real estate. Like traditional mutual funds, special funds that concentrate by investing only in real estate are still liquid and may be bought and sold just like a stock. The portfolio will usually be comprised of residential or commercial/industrial properties.

If you don’t want to be an active landlord and you don’t want to invest in mutual funds, REITs or RELPs, there are still other options available that will minimize your daily involvement. Think back to the tax lien house we renovated. We had initial contact with the tenant/buyer but virtually none after that until such time as the tenant elects to exercise his option to purchase. Recall that we placed the ad in the Real Estate For Sale column rather than the For Rent section. It is possible for you to structure your investments to mimic this approach as it minimizes active landlord activities. Other than the Master Equipment Lease arrangement with my industrial tenant, I have no landlord duties other than to receive rent checks monthly. The tenant has agreed to cover all the operating and maintenance costs. My only cost is property tax and fire insurance bills once a year. This is not zero involvement but it is so minimal as to be essentially passive activity.

Still another approach is to flip properties to end-users and just be the middleman facilitating that transfer. This will work for any type of real estate. Usually the flip is associated with the ugly house that needs to be rehabbed. Occasionally it is used to turn over pretty houses. Seldom is it used in commercial/industrial properties. If you’re good at finding a continuing supply of properties, believe me there are numerous investors out there who will want to get to know- and work with you. You’ll never have to deal with a tenant.

We’ve briefly discussed mortgages as being saleable, but this is still another real estate area that qualifies as a passive investment and does not require dealing with tenants, trash, toilets or termites. Typically what happens is that someone sells their home and carries back a second mortgage or trust deed on the property. The buyer of their house would have given the seller some cash as a down payment and then obtained a new first mortgage insufficient to cover the seller’s entire equity. The seller doesn’t want to forfeit this equity so he creates a second mortgage for the remaining difference.

It may be a short term mortgage all due in 5 years or so, or it may be a 15-year mortgage. It may have a balloon payment meaning that when it becomes due and payable, the monthly payments were insufficient over the payment period to completely repay all the interest and principal. Hence, a final amount or balloon is due as a lump sum.

After selling the house, many sellers decide they would really like to have the cash instead of the monthly payments. They offer their second mortgage for sale to a third party. The buyer of the note will demand a discount to the face value of the note as an additional profit for purchasing the note other than just receiving the stated rate of interest on the note. These discounts can range upward of 60% depending upon the collateral securing the note, the creditworthiness of the borrower, the payment history, etc. There is no fixed formula and it basically boils down to what each party is willing to accept.

Your involvement could be tracking down second mortgage holders by looking at the Court House recordings and then contacting these holders to see if they’re interested in selling. Some newspapers have classified sections listing these notes that are available for sale. You would always want to look at the property and talk with the buyer before you finally agreed to purchase the note from the seller. Most likely, you’d then hold this note until it matured and you received the full face value. Your profit is a combination of the interest earned and the difference between the discounted price you paid versus the face amount on the note. Recall that I accepted a second trust deed on the sale of the 28-unit apartment building but that I then used it at full face value (no discount required) as the down payment on another apartment building.

Sometimes the owner of a second only wants a portion of the face value in cash and would like to then keep the balance of the note to maturity. You can work with them on this by simply buying the income stream for a period of months in exchange for a fixed payment from you. Effectively, you still discount the face value, but for only a period of months instead of the entire duration of the note. The seller then continues to collect the balance due after you have received your interim monthly payments. Admittedly this is an advanced concept but it is frequently done.

Hopefully one of these approaches will be acceptable to you and you can then confidently pursue your real estate empire.

NOTE: Stay tuned for forms of R.E. investing Part 10