One of the worst feelings most beginner real estate investors get is that feeling when they start to doubt the projections they made. It happened to me, and I’m sure from talking to others that I am not alone. So, assuming you are already in the property, how can you improve your situation? Sure, you could sell it, but then you are virtually guaranteed to lose money. The good news is there are things you can do to increase therate of return you are seeing on your less than stellar property.
Jumping in, the most fundamental framework through which to approach this problem is evaluating the Net Operating Income (NOI) of your property. Recall that NOI is your gross scheduled income less your operating expenses. The main reason NOI is so vital is that it is agnostic of your financing scenario, as debt service is nowhere to be found in an NOI calculation. Your NOI is what’s left over after rent has been collected and expenses have been paid. There are two ways to make that number grow. You either increase the income or decrease the expenses. First, let’s talk increasing the income side of that equation.
Strategies for Increasing Gross Operating Income
1) Finding Additional Sources of Income
On many properties there are creative sources of untapped income. For example, a colleague of mine recently purchased a large 6-bedroom rental home in a college town in Kansas. Rent on the house is $2,100 a month. The property happens to have a 2-car detached garage with a previously unoccupied single bedroom apartment above it. He now rents out that apartment to a car enthusiast for $400 a month. The previous landlord left $4,800 a year unclaimed due to his lack of initiative! Far more common sources of additional source of revenue includes things vending machines and laundry facilities. Many times, there is some type of income available to those who think outside the box!
2) Improve and Optimize Tenant Screening
Good tenants decrease costs in different ways. They do less damage and takebetter care of your property, lowering your maintaining costs. They stay longer, decreasing turnover. Their checks come on time and don’t bounce. Screeningfor the right tenant can go a long way in decreasing those costs on your bottom-line. Most landlords plan for vacancy with a rule of thumb, but some quickly bring in sub-par tenants as soon as they have vacancy. While that may be a good short-term fix, finding quality tenants is a long term solution for reducingcosts. Marketing will be the tool with which you bring those “ideal” tenants, so define the ideal tenant and then design your marketing strategy to bring them to you. Once you have a prospective tenant, don’t be afraid to implement asolid screening process.
3) Planning For Vacancy
When it comes to vacancy, things won’t be perfect. Some markets will have high vacancy rates and others virtually zero. While rules of thumb may be good for planning or getting into a new market, nothing beats a track record of performance. A friend of mine has a 3-bedroom townhouse near a military base, and it has been vacant for more than two weeks at a time every 18 months. Alternatively, another friend owns a single family near a different military base, and it has been vacant for 3 months, but usually tenants stay about 3 years. The point is, make sure you research historical rent on your property and use the track record under your ownership to update your projected financials. Changingyour vacancy rate projections may help or hurt your bottom-line, but nothing beats theaccuracy in the numbersto help you make decisions.
4) Raise Rents Appropriately
Many landlords are hesitant to raise rents. Cost of living, inflation, and market forcesdrive prices up at fairly predictable rates in America. Whether you have a published schedule of increases, or you raise rent at lease renewal every few years, you need toincrease rent as the market goes up. Remember from number 2 that you want goodquality tenants. Good tenants pay market rates for that type of residence! What I am notsuggesting is that you gouge your tenants or execute any other form of unethical business. Think back to when you rented a living space, did your landlord ever increase rent. If so, were you outraged and determined to leave? Likely, you didn’t like it but you understoodand kept paying. Failing to raise rents uniformly while experiencing the expense creep associated with inflation and the like makes it a mathematical surety that your NOI will go down, lowering your return. The best way to anticipate this is to do research on rental increase rates in your area before you project your numbers into the future. In buy and hold property investing, small changes in these numbers can compound greatly over time and affect your return both positively and negatively.
5) Consult Appropriate Experts
I once heard about an old couple who rented out a family owned home for many years, never actively involved in its operations or finances. When it came time to sell the property, they were aghast when my friend, their CPA, explained the concept of depreciation recapture and the tax bill they were about to receive in their retirement. They were totally blindsided! You don’t have to be an expert in every field, that is why experts exist. Consult appropriately to make sure you are running a healthy property. Use a good quality accountant, establish relationships with different maintenance service providers and lenders, and if you are not 100% certain your projections are wholesome or correct, ask! Don’t be blindsided by things that were preventable and able to be anticipated, you could find yourself going downhill on a black diamond ski run when you were just looking for the bunny hill. Believe me, the cost of those services will pay for themselves when it comes time to deal with these different scenarios if you’ve already taken it all into account. Don’t be afraid to leverage the knowledge and experience of experts, it will ultimately increase your return by landing you only in great properties in which you are confident! Now, let’s discuss the tactic of decreasing operating expenses, and how we can accomplish that.
Strategies for Decreasing Operating Expenses
6) Know When To Spend The Money
It may seem totally backwards, right? Arguably one of the most common mistakes in this arena is being too stingy with maintenance and other property related expenses. Remember to focus on the things that increase your value. In rentals, those things are kitchens and bathrooms! That’s where you don’t want to skimp, that will help you keep raising rents and bringing in quality tenants. You may need new floors in 4 units and go straight to the lowest bidder. When you have to hire another company to fix their work 6 months later, while having to relocate those tenants temporarily, did you really save money? No, you didn’t. That is why relationships are so important. Getting quality work done on your property will, on balance, save you money over the life of your property.
7) Shop Your Property Manager
The most obvious way to decrease expenses is to manage your property yourself and stop paying for property management. That may work for some, but even if you plan to manage a property yourself, your projections should always include property management costs. Your time is valuable, and events may occur in your life that keep you from being able to manage that property. In that event, you want to be confident thatyour NOI remains favorable under management. Assuming that you do have a property manager, make sure you look around your area for others. You may have signed on withthe broker who sold you the property, and they could be charging a few points above market average, let’s say 12%. Recall our previous example of the property bringing in $2,500 a month in gross rent, or $30,000 annually. At 12%, you’re paying $3,600 a year in management fees. When you look around, you find a reputable management companyproviding the same services at 10%. After moving your business to the new company, your NOI increases by $600 per year. Don’t get too comfortable, the market changes around you and you need to keep your finger on the pulse of your market.
8) Shop Your Insurance
The insurance market is incredibly competitive. Disappointingly, those who are “loyal” to one provider tend to see their rates increased over time, as the insurance algorithms tell your company that you are not likely to shop around. Don’t let the small hassle of changing insurance providers stop you from maximizing your NOI. As the market changes, re-assess your needs and rates for insurance and change policies as appropriate. Lowering your insurance bill has a direct effect on your NOI. There are many ways to achieve a better NOI, so get creative! You need to constantly challenge and re-assess the expenses and vacancy rates in your realm. What are the root causes and underlying assumptions? Can those assumptions be challenged and changed? The internet is a great resource, and so is talking to other investors and learning from their knowledge and experience. If you don’t have a great handle on the numbers, have it explained to you. The importance of “the numbers” in this game can’t be overstated or ignored.
Parting Question: What are you doing to increase your return?