What’s more important: choosing the right property or choosing the right tenants?
If you ask any experienced landlord, you’ll get the same answer every time:
Choosing the right tenants.
Yes, choosing the right property is important. Of course, you need a property that will attract the right kind of tenants.
But, selecting the property is a one-time decision during the acquisition process.
As a landlord, choosing the right tenants is something you need to do constantly.
When you choose your tenants wisely, your experience as a landlord can be very rewarding.
When you fail to choose your tenants wisely, life as a landlord can be very difficult.
Let’s dive in.
Choosing the right property is just the first step as a real estate investor.
When my wife and I bought our first rental property, we were fortunate that our real estate broker took the time to mentor us.
He was a fellow investor and landlord and had learned a lot over the years.
He has helped us in countless ways, including putting together a list of features we look for in every rental property.
Here are some of the most important factors we evaluate when considering rental properties in Chicago:
- Location, location, location. In Chicago, proximity to the L and social life (coffee shops, restaurants, bars, etc.) are crucial. Most of the young professionals we rent to are still in the “going out” phase of life. They want to live in fun neighborhoods so they can enjoy themselves when they’re not working. They typically stay in our apartments for 2-3 years, oftentimes before buying a place of their own and “settling down.”
- Taxes. Property taxes can eat away your cash flow. We have high property taxes in Chicago across the board, but taxes vary widely from neighborhood to neighborhood. I look for properties in areas that have more attractive taxes.
- Big bedrooms. One of the most common questions I get when I do apartment showings is, “Can I fit a king size bed in here?” People love big beds these days. This can be a challenge considering Chicago’s standard 25-foot wide lot. I look for properties with a minimum bedroom size of 10 x 10.
- Outdoor space. Young professionals want to have outdoor space, even if they never use it. When I was a renter, I always wanted an apartment with a balcony for my grill. It didn’t matter to me that I only used it a handful of times each year. Maybe having outdoor space made me feel more grown up?
- Parking. Even though Chicago is a very public transit-friendly city, people still like having cars. Because most young professionals aren’t using their cars every day, they want to keep it safe in a dedicated parking space.
There are certainly other factors we consider, but these are some of the first things we look for thanks to the guidance of our real estate broker.
Once you choose the right property, the hard part begins.
If you are going to be a landlord, selecting the right property is just the first step.
An equally important decision soon follows, one that you will need to repeat every time you turnover an apartment.
Of all the lessons our mentor taught us, this is probably the most important one:
Choose your tenants wisely.
You can have the best property in the world in the best location with the best amenities.
If you have lousy tenants, managing that property will be a total nightmare.
Not only will the experience be miserable, your bottom line will likely suffer.
I know a number of landlords who have had such bad experiences with tenants that they sold their properties.
I’ve known other landlords who stopped offering up their homes for short-term rentals because of difficult guests.
When you’re forced to sell your rental property too soon or stop earning rental income, you’re missing out on the four main reasons to invest in real estate.
If you don’t choose your tenants wisely, you’ll miss out on the four main reasons to invest in rental properties.
Here are the four main reasons to invest in real estate:
When these benefits combine, real estate investors can generate significant wealth over the long run.
Below is a quick breakdown of each of the four main benefits.
For a more detailed description of each benefit, you can read my series on investing in real estate here.
1. Rental property cash flow is king.
With cash flow, you can cover your immediate life expenses. For anybody hoping to reach financial freedom, it is essential to have income to pay for your present day life expenses.
For my money, cash flow from rental properties is the best way to pay for those immediate expenses.
If your present day expenses are already covered, you can use your cash flow to fund additional investments.
That might mean buying another rental property or investing in another asset class, like stocks.
If you don’t choose your tenants wisely, you might not be able to collect the rent on time.
You may have to evict a tenant or ask a tenant to part ways.
Or, you may have costly maintenance and repairs that eat away all your profits.
Whatever the case may be, when you are not receiving timely and consistent rent payments, your cash flow suffers.
This is especially problematic if you depend on monthly cash flow to pay your living expenses.
2. Long-term wealth through appreciation.
Appreciation simply refers to the gradual increase in a property’s value over time.
While cash flow can provide for my immediate expenses, appreciation is all about the long-term benefits.
Like investing in stocks over the long run, real estate tends to go up in value. The key is to hold a property long enough to benefit from that appreciation.
To benefit from appreciation, all I really need to do is make my monthly mortgage payments, keep my property in decent condition, and let the market do the rest.
Appreciation takes time to materialize.
When you don’t choose your tenants wisely, your experience as a landlord may be so miserable that you end up selling prematurely.
If you have lousy tenants and choose not to hold your property long-term, you won’t benefit from his massive wealth-generator.
3. With rental properties, other people pay off my debt.
When I buy a rental property, I take out a mortgage and agree to pay the bank each month until that mortgage is paid off. At all times, I remain responsible for paying back that debt.
However, I do not pay that debt back with my own money.
Instead, I rent out the property to tenants. I do my best to provide my tenants with a nice place to live in exchange for monthly rent payments.
I then use those rent payments to pay back the loan.
As my loan balance shrinks, my equity in the property increases. Equity is just another way of saying ownership interest.
When my equity in a property increases, my net worth increases.
Of course, if your tenants are not paying rent consistently and on-time, you’ll be stuck paying off your own debt.
Depending on your overall financial situation, you might not be able to pay the mortgage without the rental income coming in.
That’s a big problem for obvious reasons.
4. Real estate investors earn massive taxes benefits.
When you earn rental income, you must report this income on your tax return. Rental income is treated the same as ordinary income.
However, the major difference between rental income and W-2 income is that there are a number of completely legal ways to deduct certain expenses from your rental income.
Common rental property expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs. We’ll touch on a few of these deductions below.
With all of these available deductions, the end result is that most savvy real estate investors pay little, or nothing, in taxes on their rental income each year.
Yes, you read that right.
I’ll say it again, just to be clear:
Most savvy real estate investors legally pay nothing in taxes on their rental income each year.
However, if you don’t have rental income coming in because you didn’t choose your tenants wisely, this benefit is not so helpful.
How to choose your tenants wisely.
Now that you understand why it’s so important to choose your tenants wisely, the next question is how to do it.
The first, and most important, rule to remember is that you are not allowed to discriminate when screening potential tenants.
That should go without saying.
For more information, please refer to The Fair Housing Act, which prohibits discrimination based on race, color, national origin, religion, sex, familial status, and disability.
You also need to be aware of any local rules in your area.
Disclaimer: While I am a lawyer, I am not your lawyer and am not providing legal advice. This post is for educational purposes only.
The next most important rule is that you need to personally meet every tenant before you sign a lease.
Forget about credit scores and income sources and references for a minute. You can confirm all of that during the application process.
Before you get to any of that, you need to see what kind of person you may be getting into a relationship with.
You are going to be depending on this person for your livelihood for the next 12 months or more. You can’t afford to get this decision wrong.
Choosing the right tenant is like dating. No, you don’t have to love this person. You don’t even have to like the person. But, you have to do your best to figure out if he’s going to make your life miserable.
Avoid the temptation to sign a lease with the person qualified applicant who walks through the door. Make sure an applicant is a good fit, even if this means saying no to people who otherwise qualify on paper.
Ask yourself these questions when you’re sizing up a potential tenant.
When meeting a potential tenant, ask yourself these questions:
- Is he pleasant to be around?
- Does he seem reasonable?
- Is he a jerk?
- Is he rude?
- Does he seem respectful?
- Is he a complainer?
- Does he give off “party-until-2am” vibes?
- Is he sloppy?
- Does your apartment seem to match what he’s looking for?
By asking yourself these questions, you give yourself a better shot at finding a good tenant for your apartment.
Why is this so important?
There are going to be times when things go wrong. Dishwashers break. The tenant upstairs will be too loud. The hot water heater stops working.
When these things happen, the last thing you want is to be dealing with a jerk on top of the problem that needs to be fixed.
Trust your gut. Use your common sense.
You won’t be right 100% of the time, but you will be in a much better situation if you put in the effort to personally meet potential tenants before signing a lease.
Does your apartment seem like a good fit for the potential tenant?
Don’t ignore that final question above.
A landlord-tenant relationship is a two-way street. You want to find someone who will be happy in the apartment.
However, landlords oftentimes focus only on whether a potential tenant is a good fit for the landlord.
Yes, that’s important. But, it’s just as important that the apartment seems like a good fit for the tenant.
For example, maybe a potential tenant tells you that outdoor space is on the top of his wish list.
If you convince him that outdoor space is not very common in your area, sure, you may close the deal. But, is closing the deal all that matters?
In this example, you’re stuck with someone for 12 months or more who’s living in an apartment without the number one thing he wanted. That could lead to an unhappy tenant who can’t wait to move on after his lease expires.
Think about it like this: if you end up with a tenant who doesn’t really like the apartment, he could make your life difficult during the lease term.
He might go out of his way to find things to complain about. Or, he might not be cooperative when you need to access his apartment for routine maintenance or future showings.
Plus, he’ll be more likely to move out at the end of his lease instead of renewing for another term.
Because vacancy is a landlord’s worst nightmare, your goal should be to find tenants who might end up renewing their lease at the end of the term.
The point is: part of your job as a landlord is to think about whether your apartment is a good fit for a potential tenant, not just whether a potential tenant can afford the rent.
You won’t always be successful in choosing your tenants wisely.
Despite your best efforts, you may end up in a difficult situation with your tenants. This happened to me recently.
We have an apartment building in a terrific location with units that are in great shape. We’ve never had any trouble finding tenants.
This year was no different.
After three showings and very little effort, we happily signed a lease with new tenants. As a bonus, the former tenants had moved out early, so we were able to fill this unit with zero days of vacancy.
All was well… until it was not.
Let’s just say that after about six weeks, it was apparent that the relationship with our new tenants was not working out. The tenants were not bad people, but it was clear that we could not meet their expectations.
Instead of living through a difficult year with these tenants, we offered them the chance to break their lease, without penalty. They accepted our offer and moved out two weeks later.
We all remained civil and amicably split up. The tenants left the apartment in good shape and we all avoided unwanted confrontation.
We re-listed the apartment and found a wonderful new tenant after one showing.
In the end, we lost out on three weeks of rent between leases but now have a very happy new tenant.
Upon reflection, I’m confident this was the right decision for all parties involved.
The tenants could find a place more to their liking, and we could start over with a new tenant.
If you can’t do the tours yourself, set up a virtual meeting before signing the lease.
Since 2018, my wife and I have done every apartment showing ourselves (except one unexpected occurrence when we were out of town).
This is the best way to truly get a read on what kind of person you may be renting an apartment to.
If you can’t do the tours yourself, the next best thing is to set up a virtual meeting before you enter into a lease.
With apps like Zoom and FaceTime, it’s easy to set up a 15 minute call. At that time, you can find out more about the potential tenant and ask yourself the questions we covered above.
Putting in this extra effort is what separates successful landlords from those who give up and sell their properties prematurely.
Choose your tenants wisely.
Showing apartments and interviewing tenants is not always fun.
It’s time-intensive. It may lead to awkward conversations. You may not love meeting new people.
But, it’s critically important to the success of your rental property business.
Being a landlord takes effort. If you are hoping for completely passive income, opt for index funds, not rental properties.
Choosing the right property is just the first step.
Choosing the right tenants is equally as important.
Landlords: what are things you look for in a potential tenant?
Have you made mistakes in choosing your tenants previously?
Let me know in the comments below.