Worlds Worst Tenants: The 1 Secret To Making Money With Rental Property

The siding is cracked and window screens are busted out and sitting in the lawn.  As my brother approaches my rental property, I can see blinds through the windows thrashed and hanging like modern art mobiles.  “It’s not good,” he says over the face time video as he opens the door.  There is so much garbage and random junk on the floors that he stumbles and hops around as he makes his way through the house.  Empty booze bottles, a few bongs, and smelly clothing strewn about.  Broken furniture, rusty razor blades and crusted food in the kitchen sink.  Sadly there is also kids toys mixed in with the mess: 

The doors and faces of the kitchen cabinets are torn off with many busted into 3 or 4 pieces.  All I can do is laugh as a defense mechanism from other emotions.  I did a full rehab and new appliances on this property only 3 years ago.  The stove looks like it is 10 years old and the fridge is entirely missing. What happened to the fridge? 

In the bathroom, tiles are ripped off the wall, the toilet seat is gone, and then my brother’s phone pans up to reveal a ceiling covered in mold.  I would later find out that the exhaust fan broke and my tenant had about a dozen adults showering and living in the place off lease.  “I found the fridge,” my brother tells me now out back in the garage.  It’s unplugged with the words “DO NOT OPEN” written in sharpie across the front.  Apparently they let food rot in the fridge.  When the smell got too bad, they simply moved the fridge to the garage and lived without one.

Tenant Destroyed Rental Property, Is it Still Worth it to Rent Property?

I have written in the past about how my path in real estate investing started out digging in the dirt for pennies until a money tree grows.  I have also shared why I prefer buying properties rather than investing in REITs.  However, this is easy to say when things are going well.  Today I am going to share what it looks like when the *&%$ totally hits the fan.  Will my opinion on buying properties over REITs change after I made a huge mistake?  I will also share the most important thing in making money with rental properties (and no it is not location, location, location).

Money Comes Easily From It: How to Create a Profitable Rental Property

Finding a Profitable Rental Property

I rehabbed this property in the midwest 3 years ago.  I knew that I could wall off the dining room creating an extra bedroom (adding value).  The purchase price was $78K and I rehabbed it for $19.9K ($97.9K total).  My estimated rent was my actual rent at $1250 per month.  This beats the 1% rule and would even cashflow 7.6% very conservatively under the 50% rule.   

The first year, I managed it myself to understand the house’s quirks and expenses.  By quirks I mean, how often do the toilets clog?  How often does the line need to be cleared?  How much on average are heating, water, electric, etc.  Does the basement get seasonally damp?  Are there breakers that often go off (possible electrical issues)?  Knowing the house like this helps keep renters happy.  It also sets a baseline so that you will know if something is abnormal with the place or with the tenants in the future.   

Filling a Profitable Rental Property

I placed a great listing and found responsible and respectful tenants.  They had good credit and rental history.  I talked with them respectfully about how the deposit is their money and my goal is to return it to them.  Their goal should be to treat the place as they would their own.  Any damage or repairs beyond normal wear and tear is their responsibility.  For the first year and change I earned $1250 per month on the place and had just one service call to the house to recharge the AC unit fluid.  When the tenants wanted to leave to buy their own house, I congratulated them on the purchase.  They cleaned the house and shampooed the carpets.  I returned their full deposit and was able to re-rent within the same week. 

This sounds obvious but respecting tenants and being clear and firm with people works.  In the past, I have even rented to those with horrible credit or past felonies when they were straight with me up front and showed substantial recent evidence of having changed their lives.  In all cases I have been able to return deposits and provide references at the end.  I sound like a great landlord with great tenants but then I made a big huge mistake…

How To Totally *$%# up Your Rental Property and Lose Money.

For this property I had been helped by my brother’s friend.  He had helped me find this rental property.  I even used his wife as my realtor.  I had also used a crew that he worked with to rehab. the property.  Both of these went great.  However, after running the property with a nice 12%+ cap rate for awhile I decided to turn it over to his company for property management as well.  Because my prior experience had been so great with his people and because he was a friend of sorts, I trusted his company to take over property management.  I signed their boiler plate management agreement and waited for checks to roll in.  This is where I violated the most important thing in making money on rental properties.

Income Property Management: The 1 Secret To Being Profitable

The most important thing in making money on a rental property is to get really good tenants.  Of course you need to follow local rules and regs in doing so.  A good tenant is worth 5 figures over a year, while a bad tenant can cost you loads of stress while you lose money on the property during the rental and then afterward as well.  Let’s take a look at my example to see how:

My property management company cost me 2 months rent off the bat just to fill and manage the property.  However, the biggest cost of all was in my property manager choosing terrible tenants.  Service expenses went up about $2k over the year.  My tenants treated the place poorly and asked for unreasonable repairs.  The property manager in turn didn’t scrutinize repair requests and simply sent out service calls for every issue.  The biggest cost of all (over $10,000) was rehab costs to a trashed home combined with extra vacancy during repair.  While property management may have cost me a few thousand dollars, it is easy to see how bad tenants can make all the difference.  

The True Cost of Eviction 

It should also be noted that I fortunately did not have to evict in this example.  Evicted tenants get angry and can often inflict even more damage on your property before leaving.  The eviction process takes extra time and expenses as well.  Because of this an eviction may look something like this:

As shown above, the difference between a self managed property with a good tenant versus a bad tenant under a property manager can be the difference between making over $12K per year on your $100K investment or losing around $12K and your mind! 

Property Management is Not All Bad

While bad tenants can really wreak havoc on your rental property, I am not entirely against property management.  However, I understand that one has to be really careful in allowing a property manager to select tenants.  When I turned over management on this property, I verbally set minimum credit limit, specified a criminal background check threshold (no felonies), and income requirements of tenants. However, I did not put this in writing. How could I do this as someone who is generally much more thorough? The answer is that I was acting on my trust and my previous relationship with this company. I was given their word to select quality tenants and was reassured by our history together and their experience. In the future, I will set specifics down in writing.  I will also get copies of the rental file for each tenant from my property manager to see how they are doing in selecting each tenant on paper.  

How To Know You Have Nightmare Tenants and What To Do About It

Check On The Property

It’s easy to spot a problem if a tenant simply doesn’t pay rent.  However, what if rent is paid but the property is just being trashed over time?  How do you know you have nightmare tenants?  If you manage a property yourself, you can check up on the property while doing periodic maintenance like checking central air filters or smoke alarms.  However, what if you live out of state and have a property manager?  

Know The Property

Remember how I managed this property myself for a year and change to understand its quirks?  This is how I knew that the water/sewer bill was over double what it should be.  This was my first clue that something was wrong with this particular property.  When I sent my property manager to check for a cause (like running toilets) they came back with nothing.  I started looking into monthly service calls to the property and they also seemed higher than normal wear and tear.

Monitor Expenses and Service Calls Over Time

The last straw for me was a request for my approval of purchasing a new stove from my property manager.  Since the stove was in perfect condition at start of the lease, it certainly seemed like tenant caused damage.  While getting information on this repair, I asked how many times the management company had been to the house in the last 30 days and was told that there were 8 calls in the last 30 days.  After I had given notice for the tenants to vacate, I received a letter from the sheriff’s department informing me of several police calls to the house over the past year.  There was a warning that my rental license could be in jeopardy if I did not act.  Yikes, I am glad I had already taken action.    

Meet The Neighbors

When I later showed up to rehab this property I apologized in person to the neighbors about my bad tenants and gave them my phone number for future concerns.  I learned that “it looked like a clown car” when the tenants arrived home with a dozen off lease adults living there.  Neighbors recounted how the police had shown up to a brawl on the front lawn.  Neighbors were also appalled that the tenants had put in a kiddy pool in the backyard and left a garden hose running in it 24/7 for several months (high water bills).  In short, make sure neighbors have your personal pone number to call if there are major concerns.

How To Monitor Income Properties Under Management;

• Get a copy of the rental file for the tenant (including the application and all checks)
• Observe condition during routine maintenance if possible (change air filters, checking fire alarms). 
• Know the property to understand what baseline expenses are
• Monitor service calls / expenses to look for changes over time
• Give neighbors your phone number

Nightmare Tenants Doing Something About It

The silver lining for my example is that I acted once I started to see the picture of what was happening.  I got rid of my tenants and also my property manager.  On all of my rentals, I use a lease that converts to month to month after the one year term with a 30 day notice to end lease from either tenant or myself.  Since this tenant had been there just over a year, I was able to get rid of them with a 30 day notice and they did leave.  Off lease tenants, unlawful activity, and unauthorized alterations would all have each been grounds for eviction under my lease as well.

There are many reasons I recommend acting quickly with nightmare tenants:

• If there is a pattern of damage and high costs, waiting just adds to losses for the landlord
• Neglect left un addressed can spiral in cost.  For example water damage or mold left untreated.
• Eviction takes time.  Bad tenants often miss final months rent on purpose knowing this.
• Get them out before winter.  Some areas do not allow eviction in winter or require the heat to be paid as a safety concern even if tenant defaults.

World’s Worst Tenants: Can I Recover Damages

Once I got rid of these tenants, my estimate for rehab alone came back at $9000.  Can I recover damages from tenants, my property manager, or my insurance?

Recover Loss from Insurance:

The challenge with insurance is proving that the damage is not normal wear and tear, that it exceeds your deductible, and that it is covered under your policy. For example, a pile of trash left in your house does not in and of itself constitute damage.  In my case, I will likely not to pursue this based on my deductible and coverage.  

Recover Loss from Tenants:

The short answer to this is that tenants can be taken to court for damages.  Small claims court may not require a lawyer but every state has limits on dollar amounts one can pursue in small claims court.  Having a pre-rent property condition checklist and a post check list proving damage is helpful.  Having estimates from independent contractors to substantiate your claim amount is helpful.  Video and pictures of egregious damage is helpful.  If you get a court judgement, you can then file again to have the tenants wages garnished to pay the debt.  The challenge here is that most deadbeat tenants have a list of creditors a mile long.  It can be a lot of work and a low chance of recovering the cash.  In my case, there were some collections notices in the mailbox after the tenant left.  My chances do not look good.

Recover Loss from Property Management Company:

One could sue a property management company for negligence.  In my case, this may be a challenge since I relied on trust and relationship for selecting tenants. Documentation of management is also sparse since I am several states away.

My opinion on all of these avenues is that we all take gains and losses in business.  I often prefer to take a few lumps, learn, and then get back to profitability.  However, if the loss is truly someone else’s doing and it is worth the cost and effort to pursue the recovery of those damages, considering legal action makes sense. I have not entirely ruled out any of these avenues and will post further if I pursue any of them.

Do I Still Prefer Direct Rentals Over REITs?

I obviously made a few mistakes on this property and had some nightmare tenants.  You may be asking why I am not freaking out more about this outcome? I can be hard on myself when I make mistakes. However, it is worth pointing out from the numbers above that at the end of the day this fiasco represents a 1% loss on my investment in this one property over the year.  Stated dis-passionately in this manner, this is not that big of a problem in an overall broader set of properties and a larger investment portfolio. In other words I should be tending to this tree but worrying about the forest. Just to add perspective, the stock market swings more than 1% within a day or two.  More over, from an investment standpoint I am sitting on 20-30% appreciation in this particular investment “tree” which helps cushion the blow. 

This kind of underlying value seems better than the book value of similar asset REIT portfolios I follow.  So yes I still like owning property over REITs but I am not letting myself off the hook.  I could pay someone that $9K to rehab this property and try to forget about my mistake but I’d rather learn from it the hard way… 

If you want to hear about how I renovate this trashed property in 9 steps over 4 days to turn this 1% loss on the year into a gain through sweat equity, subscribe below to read part 2 when it comes out. Ok ok you can also just come back next week and read it but why not subscribe and get awesome articles every week straight from me? If you have any opinions, advice, or questions, please chime in on the comments below.