Managing for Value – A Guide for the First-Time Landlord

Most of our articles have dealt with the analysis, development and acquisition of income property. It is easy to get wrapped up in the metrics of this process and to forget that eventually you’ll have to engage in the human and sometimes demanding business of actually managing the property you buy.

How you fulfill that task can go a long way toward determining the financial success of your investment. Property management is a complex subject, but if you observe some basic principles you can maximize your long-term profit and minimize some of the burden.

It’s business, nothing personal

Existing tenants will naturally harbor some suspicion about a new owner. Ignore it. Eventually you won’t be the New Guy or they won’t be the tenants, so it doesn’t really matter. Conduct yourself in a businesslike manner starting on day one. Treat your lease agreements like the business contracts they really are. Don’t simply ask a new tenant to sign the lease. Explain the terms and translate the legalese. Doing so establishes the fact that the lease terms matter and you expect both sides to observe them.

The Aretha Franklin Principle

In more than 30 years of owning rental property (and watching others do the same), I have found one principle that has proved consistently valid: Don’t expect your tenants to treat your property with respect unless you treat it with respect. As I urge in my book, Insider Secrets…, “If something is broken, fix it. If something is dirty, clean it up. If something is dangerous, make it safe. You can be certain that very few tenants will put forward any special effort to take care of the property if your attitude is one of neglect.” The converse of this principle is also true. If you behave like a slumlord, you’ll get what you deserve.

Not only does this principle occupy the ethical high ground, it also makes very good business sense. Deferred maintenance is ultimately more expensive than aggressive maintenance and it will eat away at your investment return from several sides. The postponed repair will typically ring up a larger bill later. Consider the small plumbing leak you ignore today versus the additional damage you must repair when you finally fix the leak a few months hence.

A property with deferred maintenance also diminishes the amount of rent you can expect to collect. First, because few tenants will pay top dollar to occupy a poorly maintained property. And second because those who do, but feel they are not getting what they bargained for, are more likely to default in their payments.

Finally, on what should be your big payday – the day you sell the property for a handsome profit – you’ll find yourself making price concessions because of the property’s poor condition and its below-market revenue stream. By operating on the cheap you’ve bought your way into a lose-lose-lose trifecta.

Managing for Maximum Return

Buy Right

Your goal should be to manage the property for the greatest long-term gain. If you’ve read some of our earlier articles about Net Operating Income, capitalization rates and Internal Rate of Return, you understand that an income-property’s value is directly related to its income stream. Hence, your best chance to maximize that gain is to grow the property’s Net Operating Income. Doing so translates into at least two benefits: It’s likely to help your year-to-year cash flow, but even more important, NOI is fundamental to the valuation of the property. Hence, by increasing the NOI you create equity.

One way to optimize the growth of the property’s NOI is to buy it right. That’s not code for “look for properties you can steal.” It is not at all uncommon to find properties that earn below-market rents. This may happen because they have the kind of deferred maintenance discussed above, but it can also occur because the owner has simply not kept pace with the current market. Some landlords, especially those for whom real estate is a sideline, find it easier to renew the leases of good tenants at a nominal increase rather than demand market rents and take on the work and risk of finding new tenants.

When you locate such a property, you must not lose sight of the fact that you should purchase only if you can do so at a price that is very close to what its current income justifies. The seller will tell you that it should rent for more and therefore it is worth more. You could rephrase the seller’s position as, “Do my job and assume my risk, but pay me as if I had done it myself.” If you purchase a property with below-market rents at a price consistent with those rents and then proceed to bring them up to market, you will almost always create additional equity.

Implement Management Improvements

Unless the property you buy is a text-book case of managerial perfection, you can almost enhance it revenue stream (and therefore its value) by making management improvements. Not to beat a fallen horse further, start by cleaning up the previous owner’s deferred maintenance. After that, begin looking for ways to make the property more appealing to your pool of potential tenants. For example…

Common Area – For apartment and office properties, make sure the hallways and stairways are clean and well-lighted. Some artwork on the walls and furniture or other decorative items in the halls creates a more welcoming and less institutional atmosphere. They convey that the owner cares about creating a quality environment.

Security – For better or worse, we’ve become a very security-conscious society. Don’t take that concern for granted, but rather deal with it in a way that distinguishes your property from other with which it competes. The appropriate level of security varies a great deal from one type property of to another, but look for ways to improve whatever you have now. Exterior lighting, higher quality doors and door locks, controlled access to parking, and monitored fire and smoke detectors are just a few of the steps you can take.

Amenities – What do tenants really want? Can you wire the building for high-speed Internet access? Provide pooled secretarial and reception services for small office tenants? Pay for a series of newspaper ads promoting the businesses in your strip shopping center? Your goal is to maximum your income stream and to do so you need to distinguish yourself and your property from your competition. The numbers will add up quickly. Do the math:

Value = Net Operating Income / Capitalization Rate

Let’s say that, in your market, the prevailing cap rate is 10% (that is, if investors are buying properties for 10 times the NOI). You purchase such a property, make some of the management improvements suggested here and increase the Net Operating Income by $1,000 per month, or $12,000 per year.

Increase in Value = 12,000 / 0.10 = $120,000

By making management improvements, you created $120,000 in additional equity. Did you spend some time accomplishing this? Yes. Did you spend some money to make those improvements? Certainly. Did you spend $120,000? Not likely, probably not even close.

People who buy single-family homes with intention of “flipping” them quickly for a profit in a hot market are relying on economic forces beyond their control to create that profit. Those who invest in equities are also relying on outside economic forces as well as the competence and integrity of company management.

The bottom line with income-producing real estate is this: If you manage your property intelligently, ethically and responsibly with an eye toward providing the kind of quality environment that can command optimal rent, you can do something that you could never accomplish with a stock or bond investment or even with a flip. You can use your own initiative and skill to create value. In the most literal of terms, you can make money.

Copyright 2010, RealData® Inc. All Rights Reserved