Managing Tenants: Step 2, Setting the Parameters

Owning Up” – Confessions of a Real Estate Investor

Managing Tenants: Step 2, Setting the Parameters

The first step is selecting the tenants that best fit your property. I discussed this at length in an earlier post – Profiling Prospective Tenants where I look for specific characteristics for my tenants to optimize, not necessarily maximize, my income. I look to balance longer term tenants with optimal rents. In this way, I hope to create a “low hassle” environment.

Low hassle environment means minimal turnover, rents paid on time in full, and harmony between the tenants. To create this environment, I use the RTA (Residential Tenancy Agreement – found on the BC government website – http://www2.gov.bc.ca/gov/content/housing-tenancy/residential-tenancies/forms). The RTA lists the rights and responsibilities of the landlord and the rights and responsibilities of the tenants. I go through the RTA item by item with new tenants so they know what their rights and responsibilities.

Then I go one step further.

Setting the parameters, or stated another way, communicating expectations, is accomplished through an addendum to the RTA. On page 6 of the BC government RTA, it asks if there is an addendum, I check yes and identify the number of pages and items in the addendum. The number of items changes from tenant to tenant due to their specific circumstances but the list continues to grow. It is through the addendum that I further clarify the tenants’ responsibilities.

Addendum Items with Explanations

Listed below are addendum items I include. I have added some discussion after each to provide some background.

  • Who will be living at 990 Johnson Street:

Often there are others than just the tenants of record living at the rental, children for instance. I list all the people who will be residing there. I add that if someone is new is moving in, we can do that but it may require rewriting or amending the RTA.

  • Pets that will be staying at 990 Johnson Street:

I list all the pets that will be there. I also explain that if additional pets are added, this could nullify the RTA. In addition, I add that if you do not have a pet now but acquire one later on, a pet deposit will be paid at that time.

  • All rent payments are due on the first of every month. Payments are to be made using interac e-transfers; cash or cheques are not accepted. Late fees may be charged at $20 per day.

Tenants are already aware of the interac e-transfer rule – this was discussed during the interview stage and they would have already made one e-transfer when giving a deposit. I add that late fees may be charged, I have only charged that once. It is important that tenants give me the heads-up that the rent will be late and we can make arrangements for when it will be paid. I explain – “Don’t duck me, that will just make me angry!”

  • Tenants are responsible for respecting the peace and privacy of their neighbours.

With shared walls, noise from one unit can be heard in the next. It’s amazing how many tenants that they can do whatever they want within the walls of their unit.

  • Guests are limited to 14 cumulative nights stay per year.

With three bedrooms and a mostly finished basement, tenants are tempted allow friends and other family members to move in with them; “Just until they get on their feet” they say!  

 

  • No sleeping in the basement – it is unsafe and illegal to do so.

The furnace is fuelled by natural gas and is located in the basement. Carbon monoxide poisoning is an obvious danger and zoning regulations prohibit sleeping there. I do have smoke detectors and CO detectors but batteries do fail.

  • No alterations or painting without owner’s written authorization.

Through the years, I have had many tenants decide to paint the unit. They paint over switch plates and dab spots on the ceiling. And the colour, some ghastly hue of purple seems to the colour of choice. I have found an off-white colour that I can use on both walls and ceiling. All my units are painted in this colour. It helps when tenants turn over – I don’t have to think about the colour and I can get away with painting only some of the walls.

  • Tenants are responsible for light yard work including snow removal. Tenants are encouraged to plant a garden. A lawn cutting service will mow the lawns but tenants must ensure that any toys or lawn furniture are moved out of the way.

It has happened that letter carriers have refused to deliver mail because the sidewalks have not been clear of snow and ice. I pay for a lawn cutting service because some tenants won’t do it even though I have provided mowers for them – it’s just easier to keep the complex looking its best.

  • Tenants are responsible for reporting any maintenance items. Safety issues will be dealt with immediately. In the case of an emergency, tenants are free to call C.L. – the building maintenance contractor. He is bonded and insured; he has a master key to let himself in if you are not home. His phone number is 555-5555.

I don’t know how often tenants don’t report issues but let them go until they move out.  Then I am faced with a much bigger clean up. Just last month, one tenant had issues with both bathroom sinks but failed to notify me because they were brushing their teeth in the kitchen sink! Another issue is leaky taps or running toilets – a single running toilet can add $200 to my metered water bill.

  • Tenants are responsible for the behaviour of their guests and for any damage they may cause.

When damage occurs, tenants will claim that it wasn’t them. My point is that they allowed the individuals into their home. If there are repairs bills, then the tenant will have to pay.

I have the tenant initial each item after we have read through it and discussed it. I include a statement at the bottom of the addendum – “I have read and understand all the items of the addendum”. We both sign and date the page.

I try to keep the conversation light, but I want to ensure that the tenant understands what the expectations are and how I will respond to any given situation. My list of items keeps growing as tenants keep finding new ways of bending the rules.

For you, your list might be different. Your rental might be a one-bedroom condo and so some of the items may not apply. Or perhaps, you rental is rural property with a mobile home on it – you might have some additional items.

Closing

Getting off on the right foot is important in all aspects of life and starting right with new tenants leads to low hassle management. There is always going to be maintenance issues and tenant turnover, but it’s the emotional toll that does property owners in. Frustration, anger and even helplessness when tenants don’t return phone calls, fail to pay their rent, damage the property and host loud parties.

Low hassle management starts with identifying the best tenant for the property and continues with setting the parameters of the tenancy. 

 

 

 

   

How much would you pay?

Owning Up” – Confessions of a Real Estate Investor

How much would you pay?

Three years ago, I was approached by a newbie investor about a multi-family property in Prince George. He wanted to either Joint Venture with me or receive a finder’s fee for showing me the property. I was intrigued by the property, especially when I was told the asking price.

The building is a three story walk-up with six units – five two bedroom units and one one bedroom. It was purchased by investors from Vancouver several years earlier for $250,000 and was currently on the market for $219,000. The newbie whispered that this property could be had for $200,000 to $210,000. $35,000 per door, my response – show me the property and show me the numbers.

Before we continue, take a guess, is this a bargain at $210,000? Way too much at this price? Or just about right?

Determining Fair Market Value

Comps: Real estate appraisers look at several methods of determining fair market value. The first approach looks at what comparable properties sold for. The two neighbouring buildings were identical but had been owned for many years and so there was no recent sales data from them. Likewise, there was little data for small multi-family buildings anywhere in the region. The best comps were SXS duplexes with suites found nearby. These ranged in price from $160,000 to $180,000. These provided four rents so a six-unit building at $200,000 was not unrealistic.

Cap Rates: Using the cap rate approach, appraisers look at projected net income and divide by an appropriate cap rate. Several commercial properties had sold in the neighbourhood, most were appraised using 10% to 12% cap rates. These high rates reflect the neighbourhood, across the city cap rates were more in the line of 7 – 8%. Net income was estimated by taking 50% of gross rents and this was divided by the cap rate. $45,600 X 50% / 10% = $228,000.  Once again, this is in the ball park.

NIBDS: Net income before debt service, this is my own approach to determining value. I project gross annual income and then subtract all projected expenses except for financing costs. The difference is the amount available for mortgage payments. Divide by 12 to prorate for monthly mortgage payments.

The Financials

I used my NIBDS approach to determining value.

Start by projecting annual income.

  • 5 @ $650 + 1 @ $550 = $3800 per month
  • $3800 X 12 = $45,600

Then list all annual expenses:

  • Taxes – $3,950
  • Insurance – $2,300
  • City utilities – $2675
  • On-site management – $3,600
  • Hot water heating system – $9,800
  • Yard maintenance and snow removal – $800
  • 10% Vacancy allowance – $4,560
  • 10% Maintenance allowance – $4,560
  • Total Expenses = $32,245

NIBDS – the difference between gross income less all expenses- is $13,355 or prorated monthly is $1,115. This means that the $1,115 is available for servicing debt. Given that $500 will support $100,000, $200,000 could be serviced.

The deal is a little thin, not much extra on case of contingencies and not much positive cash flow for myself. Perhaps there are some savings in the expense side – the hot water heating seems high, and with proper management – could we reduce the vacancy rate; the maintenance allowance – maybe there have been recent repairs and renos.

On the income side, is there a coin laundry, or could we charge for parking? Possibly there are some site features that makes this a desirable holding property – one that will pay for itself now but has the potential for significant capital appreciation in the longer term.

This property is worth a viewing.

Viewing the Property

The property is located in the ‘hood and is one of three identical buildings in a row. The other two appeared to be well-maintained and both were fully occupied. The subject property looked ok from the street.

Once inside, my opinion changed. This building had only two units occupied. The manager was living in one unit and was receiving a discounted rent for her services as manager; she paid $350. The other unit was occupied by the manager’s druggie daughter who had not paid anything for three or more months.

I only viewed two of the empty units but that was enough. The building was in a state of severe deferred maintenance – meaning that many repairs and updates were required. The roof leaked and there was water damage to the two units I viewed. All of the flooring needed replacing, the kitchens were dated and the appliances needing replacing. There were renos needed to some of the baths as the sub-floor was soft and the tub surrounds were leaking.

My estimates for repairs:

  • Roof – $30,000
  • Flooring per unit $2,000 X 6 = $12,000
  • Bathroom tub surrounds $800 X 6 = $4,800
  • Kitchen cabinets $1800 X 6 = $10,800
  • Fridge and Stove $800 X 6 = $10,800
  • Paint $600 X 6 = $3,600
  • Holding Costs for 3 months = $2,750

Estimated costs to reno and upgrade totalled over $70,000. 

At this point, I decided to walk. If the purchase price was $200,000 and another $70,000 in renos meant an all-in price of $270,000. Present rents would not support the debt.

Others may see an opportunity and perhaps with savvy negotiating, they could arrange a purchase price that made more sense –  something around $160,000 – but this was more hassle than I wanted to take on. My time and money were better spent elsewhere.

Epilogue

Several months after viewing, the subject property was featured in the local newspaper and not in a good way.

http://www.princegeorgecitizen.com/news/local-news/rcmp-hunting-down-troubled-properties-1.1027493

Local law enforcement had identified the property as a troubled building. A prolific offender involved in crack shacks was reported to be squatting there, the lone tenant was moving out, and the windows were boarded up.

I’ll leave you to draw your own conclusions.

Negative Gearing: Taking Advantage of Losses

“Owning Up”- Confessions of a Real Estate Investor

Negative Gearing: Taking Advantage of Losses

Those of us at R.E.N.T.S. preach the Holy Trinity – the three ways to profit through rental properties – mortgage paydown, capital appreciation and monthly cash flow.

But what happens when properties need to be subsidized, and cash flow is not able to cover all the expenses?

This can often be the case when buying a single family home that only generates a single income; new investors don’t account for all the costs of owning rental properties. Beyond mortgage payments are taxes, insurance, water and sewer, garbage collection, and the list continues. Owning a rental property is a business so investors have to start thinking like an business person.

Financial Reports of Businesses

The two main ways of examining the finances of any business are identified in two reports: the income statement and the balance sheet.

The income statement lists all the revenue coming in and all the expenses going out for a given period of time. The bottom line is Net Income; which could be a negative number if expenses exceed income. Some businesses report monthly as they collect GST, PST and other levies which are remitted back to the government. Large corporations listed on stock exchanges provide income statements quarterly, which aligns with the distribution of dividends for those stocks. Everyone creates annual income statement – it’s called filing your income taxes.  

Whereas the income statement covers cash flow over a defined period, the balance sheet is a snapshot of the business’s value at on a specific date. The balance sheet identifies all assets and liabilities, the bottom line is Net Asset Value.

The Holy Trinity and Financial Reporting

Profiting with real estate rentals in reflected in both the income statement and the balance sheet. Bottom line of the income statement, Net Income represents profit through monthly cash flow. Rent received is the income and all the costs are the expenses.

Expenses can sometimes exceed rents which shows a loss on the income statement. This can occur if there is a vacancy and no rent is received for that particular month.  Other times, there may be significant repairs.

But is this cause for alarm?

Not really. If the owner has income from other sources, he can use the losses to his advantage. In fact, the owner may purposely claim legitimate expenses to force a loss to reduce his tax obligations. The reason; the balance sheet shows increasing net asset value.

As an example: Rental property A was both purchased and appraised at $300,000 at the time of purchase. The owner put $25,000 down and was carrying a $275,000 mortgage. At the end of the first year, the income statement shows a net income of ($5,000) for the year – the brackets indicate a loss or negative number.

At the same time, the property value went up 2% and the mortgage was paid down 3%. This means the house would now be worth $306,000, up $6,000 for the year.  The mortgage amount still owing is now $266,750 – a paydown of $8,250.

Yes, the income statement showed a loss of $5,000 but this was offset by an increased net asset value of $14,250. Over time, rents will increase, the property will be improved so fewer repairs are required, and ultimately, the income statement will show a positive net income. In the short term, those losses can be used to offset income from other sources.

The bonus is that some of the expenses are not directly created by the property.

Filing the T-776 Statement of Real Estate Rentals

Owners of rental properties must complete Form T-776 Statement of Real Estate Rentals as part of filing their income taxes. All income is reported – rents received, plus any other income from alternate sources such as parking and laundry.

There is an extensive list of allowable deductions. They fall into three categories – operating expenses, capital expenses, and business expenses.

Operating expenses are all those costs resulting from running the rental. These include:

  • The cost of financing – interest on loans and mortgages, appraisals, application fees.
  • Cost of purchasing – inspections, environmental audits.
  • Professional fees – accountants, property management, lawyers
  • Maintenance and repairs

All operating costs are fully deductible.

Capital costs are those charges that are “once in a lifetime” type of charges. These include:

  • Major renovations such as gutting a kitchen or bathroom, additions to floor space
  • Replacing windows, insulation, and siding
  • Upgrading electrical, plumbing and heating systems

Capital costs are not fully deductible. Capital Cost Allowance (CCA) – also referred to as depreciation – regulations and procedures are in effect. These limit the allowable deductions.

Some major renovations are cost intensive but not necessarily once in a lifetime, they have a shelf life. For example, a roof may come with a 20 year guarantee. This roof may have cost $20,000. This cost could be “amortized”; that is the $20,000 deduction is permitted over 20 years – $1,000 per year.

When it comes to capital cost items, CCA, and amortization – check with a tax expert or accountant for the best approach. It may be advisable to forego CCA deductions during the current tax year as it is “recaptured” at the time of sale.

Business Expenses: when first time buyers begin to look at properties, they may be unaware of the benefits, and the tax implications of owning a business. Owning a single rental property qualifies for business expenses.  Legitimate and eligible expenses, those that are allowable include:

  • Home office – All the costs of maintaining a home office including prorated amount of power, heat, water, sewer, etc…
  • Home office operating costs – costs related to purchasing or leasing furniture, computers, software, printers plus all consumables such as paper.
  • Vehicle – All the costs of purchasing and maintaining a vehicle required to owning a rental property –
  • Cell phone – All costs to purchasing and maintaining a data plan / calling plan required to own a rental property.

It may be that the rental property pays its own way, but the business expenses causes the property to show a loss. Below are two links to CRA forms related to tax returns.

Link Address to Form T-776: Statement of Real Estate Rentals

http://www.cra-arc.gc.ca/E/pbg/tf/t776/README.html

Link address to Guide T-4036: Rental Income

http://www.cra-arc.gc.ca/E/pub/tg/t4036/README.html

Negative Gearing

Negative gearing refers to using losses to offset income from other sources such as regular employment income which in turn reduces the taxes owed.

Suppose you are employed and your income paces you in the 40% tax bracket. The net income from the T-776 is negative $2,000. This $2,000 loss translates into $800 tax savings (40% of $2,000). This reduces the overall loss to just $1,200.

Another way of looking at negative gearing – shorter term losses are accepted and planned for, they are called holding costs. Consider the flipper who owns a property for several weeks, no revenue coming in while renovations are being completed, but still has costs relating to financing. Similarly, the developer has to wait for rezoning applications, building permits and construction time before any revenue is realized. The developer not only anticipates negative gearing, but budgets for it.

Closing

Negative gearing is when a loss from rental properties is used to lower tax obligations of income from other sources such as employment income.

Higher income individuals often look for short term tax write-offs, looking to profit longer term.

Losses, or negative net income is acceptable in the shorter term; these losses show up in the income statement. Balance sheets profits generated from mortgage pay down and capital appreciation will exceed losses in the income statement.

Shorter term losses are considered by some to be holding costs, with the expectation of bigger returns in the longer term. Short term pain for long term gain.

Disclaimer: I am not a tax expert or an accountant. Tax laws and rules constantly change. Consult an accountant or tax expert for professional advice.

Forcing Appreciation, 5 Actions to Increase Value

“Owning Up”- Confessions of a Real Estate Investor

Forcing Appreciation: 5 Actions to Increase Value

A property appreciates when its value goes up. A property will naturally appreciate over time as inflation causes prices of all goods and wages to rise. Given market ups and downs, it may take years for any significant gains to be realized; however, there are other market factors that cause the appreciation.

Events within the community may be instrumental in bringing outside workers and families to the community. A new industry, a new manufacturing plant, a new mine, adding new university programs, as well as expansions to existing employment can all contribute to in-migration of population. These events increase the demand for housing and if the supply does not keep up, prices will rise. These events can speed up the appreciation of property values so that significant added value can be realized within a couple of years.

But investors are impatient and want to accelerate the growth of property values to months or even weeks. They will force appreciation; they will initiate actions that increase the property’s value.

5 Actions To Force Appreciation

Renovate – We have watched many different shows where investors, “flippers”, will buy a house at a low price which will be repaired and renovated. Some renos are extensive where walls are torn down and the space is redefined, some rooms are made larger, others relocated within the space. Other renos are less extensive and require not much more than a new paint job and thorough cleaning – sometimes referred to as “adding lipstick”.

Flippers try to be in and out of a property in a few short weeks.  A more extensive renovation may take three of four months from possession to listing.  A flip requiring only lipstick may take only a week or two from possession to listing.

The profit is realized when the flipper can buy at significant discounts to existing comps and sell when their property is listed at the higher end of the comps.

Add an income suite – Unused or underused space, often the basement but sometimes the attic, is transformed into a separate living space that can be rented out – think Scott McGillivry and his hit tv show “Income Property”. This added dimension of revenue makes the house more desirable and as such buyers will pay more. The timeline on these actions is some what longer as permits are needed, inspections have to scheduled, and the scope of the project is larger than renovating. These projects can take three to six months and more to complete from possession to listing.  

Once again, the flipper profits by buying at a discount or at the lower end of the comp range and then sells at the higher end of the comps.

Add square footage – In years past, houses were built smaller. It was not unusual for a family home to be limited to three bedrooms, one bath and only 800 square feet. In more expensive areas and in highly desirable areas, these houses are typically knocked down; replaced with a new and bigger house. Sometimes the numbers don’t make sense to knock down a perfectly sound and functional house, but it does make sense to add more square footage. One approach to calculating a house’s value is to multiply its square footage by the value per square foot; more square feet equals more value.   

Additions to existing houses increase the square footage as well as making the house more livable by today’s standards. Master bedroom suites complete with ensuite baths, family rooms, enlarged kitchens and dining areas are some of the more common additions to existing small houses.

One variation is adding square footage to include a revenue suite. This suite can be attached to the existing house or a detached suite such as a laneway home.

The flipper or developer profits by buying at the lower end of the comps, but the adding footage allows a different set of comps to be used. The timeline for adding square footage is six months and more.

Rezone – Older houses were constructed at a time when the property would have been zoned for single family residence. But neighbourhoods change over time, politicians can change zoning requirements and Official Community Plans are amended.

“Highest and best use” is the term used during appraisals.  Cities are allowing, even encouraging greater density as housing inventory and tax revenue is increased without incurring additional infrastructure development costs. A house built on a wider lot can benefit by being rezoned for a duplex; a house built on a corner lot can rezoned commercial to allow a gas station or convenience store; several lots can be consolidated to allow multi-family development.

A single family home ranks low on the scale of highest and best use. Investors profit from the change of value from rezoning to another designation that allows for a higher and best use category. The process can take several months as the process involves meeting with city planners, a presentation to city council members, and a public hearing.

Subdivide – This is when a larger property is split into two or more lots. This happens two different ways: Older homes were often built at a time when city services were not provided so a septic field was installed and a larger lot was required. Fast forward a few years and the city has extended their sewer lines to include these homes. Now the extra property is not needed for a septic field allowing the owner to apply to have the extra land split off to form a new lot – sometimes called flagpole lots because of their shape.

Bare land, especially larger plots such as farms can be subdivided into individual lots.  This will require rezoning the property. This is more the domain of developers as roads have to be built, water and sewer lines installed, curb and gutter and so on. This process can take months even a year or more.

Closing

The “buy and hold”approach to investing is a proven approach for inexperienced investors to profit. However, this passive approach often takes years to see any gains in property value. By taking action, investors can speed up capital appreciation so that gains can be seen within months or even weeks.