Daily Issues You Will Face While Owning Real Estate
From A/R to maintenance issues to finding tenants
Over the past three weeks we have covered real estate terms, getting organized, and developing your leadership skills.
Now we are going to get into the day to day issues you will face as a real estate investor.
Just as we did in the discussion on due diligence, we are going to use an income statement as our guide.
Revenue
Operating Expenses
Capital Improvements
Leasing Costs
Interest Costs (i.e. debt)
Other Issues Affecting Value
Almost everything you will be faced with could have an impact on the income statement. All other issues will have an impact on sale value and debt options.
I won’t overwhelm you with trying to give every detail of each issue. Think of this as a high level overview. We will dive into the specifics in the rest of the newsletters in this series on operating real estate.
Let’s dig in.
What is an “Issue”?
For this discussion, let’s define an issue as something that comes up that you have the power to take action on. That is not to say that there is a solution for everything, but most of the time there is something you can do.
But let’s make something very clear:
There are many things that will be outside of your control that will affect the performance of your property. Examples of these over the past 10 years include:
A global pandemic
Inflation that impacts both costs and interest rates
War
Political policies and changes in laws
That being said, there are many things within your control. You want to know what those are and what your options are. That is where this newsletter comes in.
Let’s start with revenue.
Revenue
As a reminder, revenue is made up of rent from tenants (and other income like parking) but is offset by vacancy and credit loss (i.e. tenants not paying rent).
Issue #1 - Tenants Not Paying Rent
You have leases in place but the tenants are not paying rent or are paying late.
Your Options: (i) do nothing; maybe you can live with the tenant paying late as long as they pay by the end of the month, (ii) same as previous but also charge a late fee, (iii) talk with the tenant to understand if this is a temporary issue; if so, work out a payment plan, or (iv) evict the tenant.
Future Discussion Newsletter: property management.
Issue #2 - Existing Tenants Causing Problems
Maybe they are loud or leaving trash in the common areas. They are doing something that disrupts others and/or damages the property.
Your Options: (i) do nothing; be a passive landlord, (ii) all bark, no bite - threaten to do something but never do it, or (iii) give the tenant a deadline to resolve the issue and then move to eviction if they don’t.
Future Discussion Newsletter: property management.
Issue #3 - No Tenant
To state the obvious, if you don’t have a tenant in one of your units you will not get rent. Said another way, this is vacancy at your property. It is like an airplane that takes off without a passenger in a seat. You will never get that rent back.
Your Options: (i) find a tenant by working with a motivated broker that knows the local market and/or (ii) expand an existing tenant.
Future Discussion Newsletter: leasing.
Issue #4 - Lease Rate
How aggressive do you want to be in setting your lease rates? Are you willing to give an existing tenant a lower lease rate than you would a new tenant?
Your Options: understand the market conditions and decide on an operational philosophy. Maybe you care more about steady cash flow than driving the rent as high as possible with periods of vacancy.
Future Discussion Newsletter: leasing.
Issue #5 - How a New Tenant Will Use the Space (Commercial Properties Only)
You may have a tenant ready to lease your space at a great lease rate, but you are concerned about how they will use the space. You could be worried they will be disruptive to other tenants and/or be hard on your property.
Your Options: talk with your broker and people your trust. Check with your insurance broker to see if it will affect your insurance rates. Consider a shorter term lease and put strong usage language in the lease.
Future Discussion Newsletter: leasing.
That should be enough to chew on for revenue. Let’s move on to operating expenses.
Operating Expenses
Operating expenses are made up of utilities, repairs and maintenance (“R&M”), insurance, property taxes, and property management fees (“PM Fee”). Some assets will have a more detailed list, but these are the major items.
Issue #6 - R&M: Costs vs. Quality
You will have a number of vendors performing services such as landscaping, pest control, HVAC maintenance, etc. You will need to analyze the trade-offs between frequency, quality, and price.
Your Options: develop your own operating philosophy. What kind of landlord do you want to be? Do you want to operate the property like a top of the line Mercedes, a reliable but basic Honda, or a car that constantly breaks down?
Future Discussion Newsletter: property management.
Issue #7 - Property Manager
This is a similar concept. What are you looking for in your property manager? How proactive do you want them to be? Are you willing to pay more for a property manager with a manageable workload, or do you want the cheapest that has an unrealistic number of other properties?
Your Options: same concept as R&M costs.
Future Discussion Newsletter: property management.
Issue #8 - Insurance
Insurance can get expensive. You will be faced with the choice of having broad coverage or minimal coverage. If you have a loan on the property, the lender will play an active role in determining your coverage requirements. Broad coverage is more expensive than minimal coverage and unfortunately there is no “right” answer to the amount of coverage to have. Additionally, you may have to file an insurance claim at some point.
Your Options: (i) understand your tolerance for risk and (ii) dive in deep and early when you have an insurance claim by actively engaging with your insurance broker and/or claims adjuster.
Future Discussion Newsletter: insurance and property taxes.
Let’s move on to the “below the NOI” line items. Reminder: NOI = Revenue minus Operating Expenses.
Capital Improvements (aka Capex)
Issue #9 - Repair or Replace
Things are going to break and deteriorate. That is the reality of owning a property. It might be the HVAC unit, a dishwasher, or a section of the roof. As the landlord, you may need to address this under the terms of the lease.
Your Options: (i) read the lease to determine who is responsible for the issue - landlord or tenant, (ii) review the age of the system - example: if the HVAC unit is 20+ years old, a replacement may make more sense than a repair, (iii) price out both the repair and the replacement, and (iv) get opinions from multiple vendors.
Future Discussion Newsletter: construction.
Issue #10 - Replacement Quality
This is the same concept as R&M vendors and property managers. How high a quality system and work do you want for your property. Are you OK with the cheapest lighting, HVAC, and quality of work that won’t last as long but is less expensive? Or are you willing to pay more for high quality systems and work that will last longer term?
Your Options: (i) develop your own operating philosophy, (ii) be eyes wide open on the trade-offs and the reality of your cash position, and (iii) get multiple bids for the work and talk with the contractors about their work before you sign a contract.
Future Discussion Newsletter: construction.
Leasing Costs: Tenant Improvements (“TI’s”) and Broker Commissions
Issue #11 - Your TI Budget
How much are you willing to spend for the right tenant? What is the reality of your cash situation? Although TI’s are mainly applicable to commercial properties, the same concept applies to residential relative to how much you want to improve the unit for a prospective tenant.
Your Options: (i) develop your own operating philosophy, (ii) be careful of tenants that want specialized TI’s that are unlikely to be re-used by a future tenant, or (iii) try to push the cost of the TI’s onto the tenant in exchange for free rent and/or a lower lease rate.
Future Discussion Newsletter: leasing.
Issue #12 - Leasing Commissions (Commercial Properties)
Brokers play a very active role in leasing commercial properties. Commissions can get expensive and need to be paid at the time the lease is signed (i.e. upfront). This can squeeze you on cash at a time your revenue is down because you have a vacant suite.
Your Options: (i) build up cash prior to a potential vacancy and (ii) understand the time commitment and risks of not using a broker.
Future Discussion Newsletter: leasing.
Let’s move on to debt.
Interest Costs, Debt, and Other Lender Issues
Issue #13 - Rising Interest Costs
You may be tempted by the low interest rate that come with a floating rate, adjustable loan. But if interests rates go up, your monthly interest costs could double. Yikes!
Your Options: there may not be any options if your interest costs go up. This could wipe out your cash flow and/or put you in a situation where you can’t make debt service. Be very careful of floating rate debt. This adds a significant amount of uncontrollable risk.
Future Discussion Newsletter: investor and lender issues.
Issue #14 - Lender Approvals
As discussed in Debt: An Amazing Tool with Strings Attached, your lender may have approval rights on a number of issues and not allow you to do what you believe is best for the property.
Your Options: (i) read and understand the loan documents so you know your rights, (ii) develop a positive working relationship with your lender from day one and be reasonable; this will pay dividends in the future, and (iii) make the case for why you want to do what you want to do.
Future Discussion Newsletter: investor and lender issues.
And finally, let’s quickly address “other issues”.
Other Issues Affecting Value
There are some issues that may not affect your cash flow during ownership, but will be problems when you go to sell or refinance the property. These could include:
Environmental issues
Zoning changes
Challenging neighbors
Challenging tenants
Your Options: (i) conduct annual property reviews to identify issues early, (ii) maintain good relationships with city officials and neighbors, (iii) address problems immediately rather than letting them compound, and (iv) document everything in case issues arise during sale.
The key is to be eyes wide open on the risk to your future sale and/or refinance and then try to resolve the issues as best as you can before you are in the time crunch of a sale or refinance.
That’s the list of 15 or so issues. Are these all the possible issues you will face?
No, but they give you a sense of the type of issues you will face.
What are our key takeaways?
Key Takeaways
Here’s what you need to keep in mind:
Develop your own operating philosophy. Combine this with your niche, and you will have a clear foundation on which you evaluate your decisions. Without a philosophy, you will find yourself over analyzing each decision and not having any consistent approach.
Issues that you need to figure out will come up. Methodically break them down into parts. Do the research. Talk to experts. And then make a decision.
Not all issues are equal. Cash flow problems (non-paying tenants, rising interest costs) demand immediate attention. Quality decisions (Mercedes vs Honda) can be determined over time.
There will be unexpected costs. Keep a cash cushion. Don’t distribute every last dollar.
Life is full of challenges. Think of all the ones you have overcome in your life just to be able to be sitting here reading this newsletter.
Operating real estate is a lot more complicated than owning stock.
It can be time consuming and stressful. There is no sugarcoating it.
If you don’t want this in your life but you still want to be a real estate investor, there is alway the option to invest as an LP and have the GP do all the work (for a fee).
But for those of you willing to do the work, it can be financially lucrative and intellectually rewarding.
You can do it.