Saturday, June 7, 2008

You Cannot Manage What You Cannot Measure

When owning a rental property you need to manage your tenants, the actual house and your return on investment. You may cede much of this to your property manager, but now you are managing your manager. You could, like a stock owner, simply be measuring your overall financial return. As an investor property owner, your role may include doing everything from collecting rents, fixing toilets, and trying to stay abreast of all current and changing eviction and fair housing laws or you may simply work from a spreadsheet analyzing when the equity you have in a home may be better shifted to something else.

The title of this post is a line attributed to Phil Murphy of Forrester Research. Its relevance to rental properties is the importance of being able to remove some of the emotion from this very emotional business. Here are some of the metrics we use for measuring.

Is this a good tenant? This is for tenants who are currently living in a home and here we use a three step evaluator.
  1. Do the pay their rent on time?
  2. Do they take care of the house?
  3. Do they report any potential problem?
This is pretty simple and straightforward. We preach this to the tenant from before they move in. If they fall short in any of these areas, we need to decide if it makes sense to continue to have them as a tenant. Since there is a cost associated with tenant replacement, we have to weigh their shortcomings against the cost to replace them.

Is this a good house? This is the question we ask to decide if we want to buy this house/keep this house as an investment property and it is used to compare with other houses. Again we have a basic three step evaluator.
  1. What is the expected "rent/value ratio"?
  2. What is the "expected appreciation"?
  3. What are the expected "repair/tenant replacement costs" over the next 10 year period?
These measures are more complex and with questions 2 & 3 and these measures are more subjective since they involve forecasting an unknown. Rent/value ratio is a measure which provides your initial indication of cash flow, but it is also valuable when deciding if you should divest and reinvest in a different house after you have owned the home for a period of years. The "holy grail" of rent/value is to receive 1% of the value in monthly rent. If you can get this number you can generally afford to maintain the property out of incoming receipts. Expected appreciation is important when making a decision to keep a rental property which may be in a negative cash flow situation. You may be willing to accept a less attractive cash flow if there is a big payout at the end. The last item of repair/tenant replacement costs is more important when you move into lower priced properties in economically stressed areas. You may get a 2% rent value ratio in these neighborhoods for homes and small multi-family products, but the turnover rate, repair costs, legal costs and bad debt costs eat into this projected performance to the point that you may get no better financial performance over time, but you definitely will get more heartache.

The last item I am constantly measuring is how does the performance of this asset measure against other types of investments. People often question the value of real estate against simply investing in an S&P index fund. Real estate can be as dynamic as growth stocks or gold investments or as boring as corporate bonds. The type of real estate you buy should depend on your risk tolerance. The big mistake many make when investing in real estate is they measure the growth of the asset, which may be a meager 3%/year over time, instead of measuring the growth of their actual investment. If I invest $20,000 in a $100,000 home (converting a cash asset into real estate) and the home appreciates 3%/year over a 10 year period I end up with a $60,000-$70,000 asset. I end up with this large number because of appreciation of the asset and the tenants paying down my mortgage. My friends told how great the performance of their stock portfolio is, but it is rare for anyone but extremely wealthy people and their hedge fund managers to outperform my modest rental property, if you remember to measure the performance based on the actual money you invested. Just tell your friends "My lowly real estate only grew at 3%/year over the past ten years", but watch your personal balance sheet grow faster then your friends.

I hope this helps you keep your wits while you are a landlord. I am part mercenary; financial returns are my measure of whether to stay in this game. I am proud to provide a quality home to the renting public, but I am not a total mercenary. If I had to offer a quality product and lose money, then I would run from this business as fast as I could. If I had to be an unethical slumlord in order to make money I would run from this business as fast as I could. I think this is the best of all worlds, I get to add value and get a higher then average return by participating!

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