The other day I was flipping through a couple of online articles when I came across an interesting piece that discussed Moral Hazards. A moral hazard is an economist's term for a situation where a person who has to make a decision doesn't have to bear the weight of the consequences. In the author's example, he didn't mind parking in a bad part of town because if something happened to his car the insurance company would be the one who wrote the check. In other words "It's not my problem".
How does that pertain to Real Estate? Well in any business you have to deal with people and you can't always trust those people to do what's best by your company. One of your goals should be to remove as many moral hazards from these people as possible, because very moral hazard is an opportunity for someone to make a decision that you'll end up paying for. Let's identify some of the people who may be facing moral hazards:
Property Managers: This is the Big Mama of all moral hazards. A property management (PM) group literally takes over most of your decisions without the incentive to protect your interests. Amongst the moral hazards faced by this group:
- Unnecessary repairs - you are paying for them, not the company.
- Shoddy repairs - the PM group makes no money from the sale of property, just the leasing. They only need to keep the property in working order. Long term problems that affect resale aren't of concern to them.
- Choosing contractors - the PM group often will select contractor to do the work that you are paying for. When dealing with PM groups, contractors will often include a "kickback" in their estimate (if the PM group chooses them, they'll overcharge you and give some of it to the PM group)
- Choosing tenants - as long as the tenants are paying rent, the PM group gets their cut. It doesn't matter if the tenants are destructive, you'll pay those costs.
How can you remove a PM groups moral hazards? The obvious method is simply to not use one. But if you are things can get difficult. Most likely the PM group will be a larger company than you and so you will be dealing with them on their terms. They will draft the agreements and binding documentation that you will have to sign, which leaves you precious little room to protect yourself or remove their incentives.
One thought I had, back when I wanted to invest in my alma mater's college town, was to develop a relationship with some professors who taught property management, and to suggest a program where their students manage the properties for some real-life experience. We changed our business plan before I really worked that idea out, but it might have worked (I can find some obvious kinks in the idea though). Likewise if you want your property to be managed, you'll need to think outside the box or work with a brand new management company who's willing to bend to get your business.
Tenants - Unlike PM groups, these are often an unavoidable group in real estate investing. They'll be on your property 24/7 making every day decisions on how to treat your things. They are, in fact, paying for the right to do this. A few of the moral hazards posed by tenants are:
- Causing damage - tenants will often take small risks (like drinking red wine on a white carpet) that can lead to damage, since it's not their problem.
- Maintenance - tenants (unless they are very long term) will tend to care less about the day-to-day maintenance of the property. They will let things go unreported unless it is interfering with their daily lives.
- Following housing rules - breaking the rules of a Home Owners Association (parking in the wrong spots, leaving clutter in the yard) is less of a problem because the HOA isn't going to go after them, they'll go after you.
Another way to deal with these problems is to beef up your tenant selection criteria. If they have to be faced with moral hazards, wouldn't you prefer that they be the best possible people to make those decisions?
Contractors - Contractors are yet another group that get to make decisions affecting the health of the house without you. With that comes the temptation to cut corners and other things that you might end up paying for. Amongst those hazards:
- Overly expensive materials - sometimes contractors will push you to use certain materials that will allow them to charge you more
- Shoddy materials - other times contractors will use sub-standard materials on a job to cut their costs
- Delays - an hour worked today earns them as much as an hour worked next week. But if you are between tenants, every day costs you money.
As we've seen there are two ways to deal with another person's moral hazards. Either take the decision out of their hands or add incentives. But before you run off feeling high and righteous about how all these people are capable of screwing you over, remember that you too face moral hazards every day. A possibly the worst hazard you will face:
- Delaying repairs - you might be getting a great deal by waiting until next Thursday for the AC repairman to come out, but your tenants living without AC in 100 degree weather might not appreciate it.