Dealing with other people

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.
Many real estate investors, including the highly regarded John T. Reed, have concluded that PM groups are far to dangerous to work with. Instead they recommend either managing the properties yourself or hiring an individual as an employee to do it. Others, such as Rich Dad, Poor Dad guru, Robert Kiyosaki, claim they have better things to do than "fix toilets all day". Deal with PM groups at your own risk.

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.
So how do you deal with these moral hazards? Some of them (clutter in the yard) can be dealt with in a very strict leases combined with semi-frequent drive-bys. Others (minor damages) can be dissuaded through a security deposit. Maintenance issues can be dealt with by instituting a semi-annual walkthrough. The goal of which wouldn't be to find problems the tenants are causing (you're not spying on them) but to just check the general health of the house (hot water heater works, AC works, roof isn't leaking). Too many landlords let their tenants report their problems to them.

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.
The best way to deal with contractors is simply to do your research. While you may not be qualified to remodel a bathroom (which is why you brought in the plumber), you certain can go on-line and research the different types of stone flooring possibilities. If possible, it's often nice to acquire the materials yourself, which allows you to avoid the contractor's markup. If you are on a project that is time sensitive (you can't rent out the place until the job is done) offer incentive to the contractor if they are able to meet certain criteria. And never-ever pay in full for a contracting job until you've seen the finished product and you are satisfied.

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.
So there you have it. Running a real estate business is very simple as far as businesses go, which is why it can be so easy and fun to explore the complexities of it.


jldude said...

Excellent post. Very succinctly put about my current situation, and what i need to do for the future.

I was reading another RE journal/blog from a new landlord. He was on the East Coast, too, but he stopped blogging for some reason. I'm out here, all alone, in California.

Anyway, I'm glad I discovered your blog. I just bought a SFR investment in May, got a tenent in fairly quickly. I got into it through John Schaub and John Reed. I'm cash-flow negative but I've got plans to change that.

I've made some classic Landlord mistakes, but I did negotiate a good purchase price, so I have a little cushion.

Do you plan to buy any more houses? My 3-yr plan is to buy one more SFR, then jump to a 4-unit and let a PM handle it, but your post has given me some doubts.

Anyway, I look forward to reading more of your archive posts and getting caught up.

I have a blog, but I haven't posted about my RE activities yet.

Lord of the Land said...

My partner and I currently have two single family homes (we bought our first in March 2005, the other in January of 2006). We've looked into getting a third, but at the moment we think our next goal will be to pay off a piggy back loan that we have on the second property (which will put both properties in the black).

If you are interested in working with a PM don't let me completely dissuade you. Do some homework. I know that John T Reed despises using them, but another blogger at swears by them.

However, given the number of houses Biff and I are dealing with, it wouldn't be worth the loss of income to get a PM, even if they were extremely good.

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