The Lease

While it may seem overly obvious, you absolutely must have a written lease when renting. It amazes me how many people rent without a lease (I see them in court later, and they are very frustrated landlords at that point). If you don't have a written agreement, then most states have minimum standards that are established by law, and those tend to err on the side of the tenant, not the landlord. For example, in my state you can write in the lease a period as short as seven days to give notice of breach (like not paying the rent). Less than seven days is considered "unreasonable" by the courts. However, if you don't spell that out in the lease, the state establishes 30 days as the period of notice. I have seen many times when a landlord was in court trying to get a tenant evicted who was already a month or two behind on the rent (letting them get that far behind is a mistake in itself) and didn't have a written lease. They usually have heard about "seven days" somewhere, but then when the judge finds out there isn't a written lease they have to give the landlord the bad news that they have to give them 30 days notice, and then file again. The deadbeat tenant is laughing at that point - they've already gotten away with a month or two of free rent and now know they can steal at least another month from the hapless landlord. The landlord can't even think about retaliatory actions like removing the doors - nearly all states have adopted very harsh penalties for doing those types of things.

You really don't want the state establishing the rules for your rentals, trust me. It's also amazing though, how many very, very poorly done leases I've seen (in nearly every case where I've purchased properties and had existing tenants the leases were not very good), and I confess that my early leases weren't the best. It took a while to develop a solid lease. Most landlords realize they need a written lease, but they do it almost as an afterthought, or they get a canned one from an office supply or off the internet. These are usually mediocre at best (though better than nothing), and fail to address many, many things that have to be addressed in good lease. Keep in mind that if there is an area of ambiguity where it could be interpreted more than one way, the courts will normally interpret in the way most favorable to the tenant, because you presented the lease. The courts consider that because it was your lease, you had an advantage in the time to prepare it to say what you wanted. That's a big pitfall of boilerplate leases.

Some landlords will at least get an attorney to put something together, but even then some attorneys are just going to give you something that is pretty boilerplate, while some have real experience at what needs to go into a lease (and what your state laws are). Even if you go to the trouble of getting a good attorney, you will still discover things as you go along that you will want to add to your lease to address specific situations, and you can't just forget it once you have a standard lease. You need to review your lease at least once a year keeping in mind situations that have come up and changes in law. If you are serious about your real estate empire, your lease is one of your most important tools - and will be your best friend when you end up in court (which you will frequently) with a bad tenant. It is possible for you to write your own lease that is a good one (or adapt a boilerplate one), if you are willing to take the time to study all the aspects of what a good lease requires. It is also possible for you to get a poor lease from an attorney if you don't study what is required in a good lease and just leave everything to the attorney. Either way, you need some familiarity with the tools needed for a lease that does what you need.

This series on putting together a lease will be a long one - because a short lease probably is a bad one. The purpose of the lease isn't for you to trip up your tenants later; it is to establish all the necessary aspects of your relationship in a way agreeable to both of you. When you both agree on all these aspects, you've created the basis for a win-win deal. Of course, if things do go sour, it's also to insure that you are protected as much as possible from bad actions by the tenant.

In general, the lease should use straightforward language. Yes, it will have to have some legal terms in it, but it can still be reasonably understandable rather than legal gobbledygook. You should read through the lease with the tenant at signing, explaining legal terms, emphasizing key points (like how much the rent is, when it is due, etc.), and asking if they have any questions.

Having said that, you are going to be absolutely flabbergasted by what tenants will later claim the lease says or think it says. This will happen no matter how thorough you are in going over the lease, explaining terms and answering any questions. There is some aspect of the human psyche which can literally change our memories to the opposite of what actually happened if we need it to fit our actions later. I once had a tenant angrily write complaining that we had breached the lease because the smoke alarms hadn't been inspected. We had to write back pointing out that the lease said the tenant must inspect the smoke alarms monthly and report any problems immediately and that the tenant had initialed that page of the lease right after we read that page to them. Her memory got bad (and obviously she didn't want to challenge her memory by looking at her copy of the lease) because she had wanted out of the lease and we had said no. She then was convinced that we had been a "bad" landlord all along and "remembered" us breaching the lease on a number of points (this wasn't her only faulty memory). The fact that we had actually lived up to our obligations didn't suit what she wanted, so she created things in her mind. Despite the fact that tenants will do this, you still need to make sure the tenant understands what they are signing at the time the lease is executed, but then your job in that department is over.

The Rent to Value Spread: Where Are We Headed? Part II

So, the relationship between the price of houses and the rent that houses generate has deviated from its historic norms - house prices are up much more than rents - and the question is where we are headed from here. Some economists see house prices coming down to correct the imbalance, as much as 3% a year for the next 5 years. Here are the factors that are going affect housing prices and rent:

The median house price can be affected by more sales of lower priced homes, while the actual values of homes may not change as much. The median is simply the number where half the houses sold for more and half sold for less. The low interest rates and too-easy lending practices on owner occupied housing led a lot of people to buy "McMansions" on loans that were doomed. Now those higher-priced homes are difficult to sell in many areas of the country, while their former occupants will be looking for something more affordable. So, we may see the median price fall while values - especially of the lower cost homes - may not.

Lending may dry up: While I think someone - either a stronger hand, perhaps foreign banks/investors or the government, will step in before letting too many mortgage sources fail, it will be harder for marginal borrowers to get loans. Obviously fewer borrowers means potentially fewer buyers, which can mean lower prices. However, those people have to live somewhere, so they will rent (or move in with family for a while and then rent). That's a lot of new renters coming into the market and it seems to me that as they cause vacancy rates to drop, we may finally see rents pop up for the first time in years. This factor may cause both to happen - prices to drop and rents to increase, but I believe it may bring rents up more than bringing prices down (see Loss Resistance below).

Lower interest rates: traditionally this causes house prices to increase and rents to decrease. All indications are that we will continue to see interest rates fall this year. However, I think it will be different for two reasons: 1) Lower interest rates help get marginal buyers into homes, but tighter lending standards that will occur negate that. 2) We've had lower interest rates for years now, and most of the people who would be helped by lower interest rates have already made the leap into home ownership (and many of those are now in trouble on their mortgages).

Foreclosures: more foreclosures means lower prices. However, I think we may have lower foreclosures than expected because the lenders are being forced to renegotiate loans rather than get eaten alive with an overwhelming foreclosure rate. In most states the foreclosure process takes a long time, 6-18 months, and the time can vary. Not all foreclosures are going to hit the market all at once. The foreclosure effect may be less than people think.

Building starts: Builders are going under left and right, and those surviving have finally realized that building more houses that they don't have people lined up to buy isn't helping. December housing starts saw an extreme dropoff. In the normal course of human events, people tend to let the pendulum swing too far in each direction. Buildiers built too much when times were good, I expect them to reach a point where they are building below demand (much as the airlines in recent years have cut available seats to the point where nearly all flights are full or overbooked). All this translates into some degree of price support on houses, though probably not enough for any near-term significant appreciatation. Eventually, builders will get their inventories under control and the incintives will dry up. At that point, existing housing and may start to look more attractive, giving some price support there.

The taken for granted factor: This is an intangible that takes a little to explain, but can be summed up this way: people notice and complain when prices go up, but simply take it for granted with the prices of things get better. The best recent example is the price of gas. It was just a few years ago that we were seeing prices drop towards a dollar a gallon, even after many years of already failing to keep up with inflation. Instead of enjoying and appreciating that bounty, people took it for granted that it would continue and ran out to buy gas guzzlers. Now we're at $3 a gallon. Rents likewise have taken a recent dip in many areas of the country after years of not keeping up with inflation. People have taken that for granted. Could it be that rent - housing being a commodity just like gas - is about to turn up? It seems these things take place when we've reached to point of taking for granted that they'll stay that way and I think we're at that point on rent.

Loss resistance: This is a common, but also intangible, phenomenon in real estate - a seller (whether owner or bank which has taken it through foreclosure) typically becomes fiercely resitant to taking a loss on the sale. This gets to the point that they would rather take a larger loss, but a month at a time, on the mortgage. I've seen banks take huge losses over time insisting on going through the foreclosure and marketing process rather than sell at a small loss to me early on. Eventually sometimes it will dawn on people if their price is completely unrealistic, but from my experience this is a very long time. The effect of this is that if the majority of sellers are holding on to their pricing ideals, it can create a reality of slowing the downward price drift.

When looking at all these factors, while I agree that the median price will drift down, the actual prices of individual houses on the market may not decline as much as the economists predict, whereas the factors that appear to be ready to finally push rents higher seem to be a greater influence: less building, low interest rates having fewer new buyers to attract, and resistance to lower house prices by sellers. It could well be that it is rent pricing that is the next commodity to move up in the post housing/lending bubble world.

Rent to Value Spread: Where are we headed?

This past Summer, people became familiar with the term "crack spread" as gasoline topped $3 a gallon in the U.S. The crack spread is the margin between crude oil prices and the prices of refined gasoline. A large spread means the refiners are making fat profits. In stocks, investors are concerned with the price to earnings ratio. In real estate we also have a ratios to look at; an important one is between the cost of the raw material (the house or building) and the price of the finished product (the rent). This rent-to-price ratio or spread is something that real estate investors should pay attention to. I began noticing about three years ago that the spread was getting out of sorts. We were seeing the prices of houses increase, yet rents were actually decreasing. In our area we've seen rents decrease about 15% over the last three years, while house prices continued to increase at 2-3% a year (no, we're not in one of the hot spots that saw big increases). This spread became so large that it was squeezing profit margins and it made more sense to sell off houses than continue to rent them. So beginning about three years ago I began selling down our single family house inventory and now we just have a few left. Fortunately we got most of them sold before the sub-prime lending crisis threw lending and real estate markets into turmoil.

What created the problem was the overbuilding and over lending which has affected all areas. Rents were falling because people who normally would have rented for a few more years before saving enough to buy a house, and even people who should never have bought a house, were jumping in to home ownership. At one closing recently where we sold a single family home, it turned out to be to an unmarried couple with no money (literally), no credit and no regular jobs. They seemed like nice folks who wanted the American dream, but they just weren't ready for it. This confirmed for me the lending crisis was going to get much worse. Builders compounded the rent problem. As they found themselves sitting on homes without buyers, many turned to renting, creating a temporary over-supply in rental markets. Not having experience with landlording, many builders ended up with the bad tenants that experienced landlords were shunning which just compounded the builder's problems.

There is another spread in real estate, which is the difference between new and existing home sales. I also saw that getting entirely too large beginning about three years ago. People began to pay premiums of nearly 30% more for identical housing that was new rather than existing. This spread told me there were problems coming for new housing, unless existing housing prices were going to jump up to match (they didn't). Now most of the builders in our area are bankrupt, out of business or on the ropes, and they are offering concessions that effectively have lowered the prices of new housing dramatically.

Sure enough, my experiences were backed up this week as some Federal Reserve economists released a study saying that the rents to prices spread had gotten away from the norm. Their study showed that between 1960 and 1995 the rent to price ratio remained fairly steady at 5 to 5.5 percent (I assume they mean annual rent to price, though 5% would be a bad ratio for a savvy investor - that's another post I need to do), but from 1995 on has fallen steadily to a low of 3.5 percent in 2006. When a ratio like this gets away from the norm, the question is which factor will move towards the other (or will they both move towards each other). The economists who did the study concluded that housing prices would have to move down to get back into relationship with rents. They predicted house price declines of 3% a year for the next 5 years, and were factoring in "normal" rent increases continuing at 4% a year.

I would have to disagree somewhat with their assessment. First, most areas have not been seeing rents increase at a rate of 4% annually. Before the recent decline of 15% over the last three years, we saw rents stay flat for about seven years (and we are in an area of population growth and housing demand). I'd love to see rents start increasing 4% a year. But, with the economists' general assumption that it will be prices that fall to return their ratio to the norm, I think they may not have it right. Prognostication is a dangerous game, but I'll take a stab at it in the next post.

Dealing With the No-Show Part II

I wish I could tell you that there is an easy magic formula for eliminating costly no-shows who set an appointment with you to see a rental and then bail out, but there isn't. Interestingly, even realtors I have spoken with say they have a high no-show rate. You'd think that people who are claiming to be contemplating such a serious purchase would be serious about keeping the appointment, but the "fantasy" or "window-shopping" syndrome hits there as well. There are some things you can do to cut down on no-shows, though:

1) Try to answer any questions they may have before setting an appointment. For some, school districts or other civic features will automatically rule out some sites. Maybe you think you're a natural salesperson who can talk them into taking it anyway, but in most cases you're wasting time, and sometimes people forget to ask you those screening questions that they had in mind. So just ask them - do you have any questions about school districts, utilities, etc.?

2) Absolutely insist on getting a phone number they can be reached at when making an appointment. Tell them you need it in case something comes up and you can't make the appointment, which is true of course, but the reality of giving out their phone number starts to wake up some of the folks who are just calling on a fantasy.

3) Do a little pre-screening if you get a chance. People who are getting evicted somewhere else will do a lot to seem like a promising prospect to you (like show up for the appointment), which is likely a waste of your time. We're in the courthouse regularly, and it's easy then to check on the eviction suits that have been filed. Check and see if your appointment is on that list. If they are call and cancel the appointment and save yourself some time. We do sometimes offer to continue with someone who is evicted if they can come up with a reasonable co-signer, but most of them can't - probably because family members have already been hit up repeatedly and won't do it again. One time we had an appointment in the afternoon, but were in court earlier and saw the prospect there on an eviction case. We called later to cancel the appointment, telling her that we saw her in court on an eviction. She couldn't understand why that would matter, so we offered to continue if she had anyone who could co-sign. She admitted her family wouldn't do that. If the family doesn't trust you, and you aren't paying the rent where you're at, it saves both of us time to just cancel.

4) Try calling them an hour or half-hour before the appointment to confirm. Many times they will answer and tell you they changed their minds. They weren't going to call and let you know that, of course, but when called personally they will admit to it.

5) If they don't show, try calling again. If you can find out for sure they aren't coming at this point, at least you'll save a few minutes.

6) If you aren't far from the site, there is another approach in this age of cell phones that we have tried when no-shows get out of control: Tell them to call you when they get there, or just before they get there. If they tell you they don't have a cell phone, that's not a good sign, but most will have one. You can tell them that way if they get there a little early, they won't have to wait on you - you'll come right over and are just a few minutes away. If you never get the call, you'll know you've saved yourself a no-show trip. While this is a little bit aggressive, and a few prospects might find it odd, when you're running 50% no-shows and have several showings a week, you have to do something to protect your most valuable asset: time.

7) Double book. Very often prospects have some flexibility in when they can see a property. If you already have a showing set for 2:00 on Monday and someone else calls wanting to look at it Monday afternoon, try to steer them towards 1:45 or 2:15 or 2:30, so you only have to make one trip. You've doubled your chances at least one will actually show up. It also never hurts for a prospect to know that someone else is coming to look at it. We've even triple booked when we can, and almost never do all three show up.

8) This one I've never tried, and have reservations about, but offer it as food for thought. I heard through a friend in the business of a landlord in Florida who had gotten so put out with the no-show problem, he quit doing showings. He would tell prospects to come by his office (so this doesn't work so well if you don't have a public office), and he would take down their driver's license information and then give them a key. He would then tell them to go take a look and bring the key back when they were done. The concerns with handing out keys are obvious, but apparently it did work for this one fellow, and he completely eliminated his no-show problem. I believe that closing the deal and getting an application is much easier, though, if you are there with them looking at the property, answering questions, and they can apply without having to make a trip back to your office.

No-shows are costly. They keep you from getting other things done that keep your real estate operation growing and well managed. Using the methods above that work for you will save you more than you realize.