Real Estate Advice: A Bad Tenant Is Worse Than Vacancy

When I started this blog in 2020, my main goal was to share my financial mistakes (here are my top 11 financial mistakes) and how I was fixing them. Well, I have good news and bad news. The bad news is I keep making mistakes. The good news is that means I keep getting to share them and learn from them! So, in this post, I want to share some real estate advice. That I learned the hard way.

The lesson is that a bad tenant is (way) worse than vacancy. But don’t just take this piece of real estate advice because I say so. Let me illustrate.

Let’s set the table…

To begin, I just want to briefly review how Selenid and I invest in real estate. Because this will help inform some of the (bad) decisions that I made in this case study.

We invest in multifamily cash flowing rental investment properties using a Buy, Fix, Rent, and Hold model
To screen investment properties, I use the 1% rule (Monthly rent/Purchase price >/= 1%)
- If it meets criteria, I move forward to more analysis
- If it doesn’t meet criteria, I move on to another property
To analyze investment properties, I use cash-on-cash return (Annual Net Income/Money Out of Your Pocket >/= 10%)
- If it meets criteria, I lock up the property by placing an offer based on your criteria
- If it doesn’t meet criteria, I move on to another property
To valuate investment properties, I use NOI (Annual Income not including financing)
- Estimated Sale Price = NOI/X% (based on local market data, usually 8%)

And I’d like to focus a quick moment on the cash-on-cash return calculation

Cash-on-cash return (CoC) is the percentage of annual cash flow that a property puts in your pocket divided by the amount that you paid out-of-pocket for that property. And a lot of numbers go into figuring out the CoC return of a property.

The CoC Denominator

The easy part is figuring out how much money you are paying out of pocket for the property. That is a simple equation:

Money out of pocket = Down payment + Closing costs + Repairs/Renovation

The down payment and closing costs are easy to estimate by asking your lender. The repairs/renovations estimates can be a bit more tricky. I recommend walking around the property with your contractor to get a sense. You can even bring them to your showing or open house. You can also ask your real estate investor agent if they have a lot of experience but tread carefully (they want to sell to you and some agents may be inclined to underestimate).

Whatever that value is will be your denominator in the CoC equation.

The numerator is a bit more tricky

The first step to figuring out your numerator (AKA the annual money that the property puts in your pocket), is to get an accurate estimate of how much rent you can get.

I already mentioned Rentometer as a good option to get a general sense. But there are 3 other ways that you should confirm that your rent estimate is accurate:

Compare to similar listings on rental websites like Zillow or Apartments.com
Ask your investor real estate agent (make sure that they are actually an investor real estate agent first)
Ask your property manager (or if you are self-managing, just call property management company and ask, they are happy to help. We did this)

Once you have monthly rent, you need to figure out all of the other estimated monthly expenses.

These include:

Mortgage principal and interest
Taxes
Utilities
Insurance
Estimated vacancy and turnover (usually use 5-10%)
Property management fee (if using a property manager – most property managers charge 10% of monthly rent)
Unit turnover fees (if using a property manager for this – most PMs will charge one month’s rent for this service)
Estimated maintenance costs (usually use 5-10%)

Anyway, the basic point here is that anything the reduces our yearly cash flow will result in a lower cash-on-cash return.

What are some things that can reduce our cash flow?

Vacancy
Non-payment of rent by tenants
Property repairs/renovations we need to pay for

Ok, we are up to speed…

The situation

This case study revolves around our second investment property. You can read about its analysis and initial cash flow here.

At this point in the story, we owned the property for about 2.5 years. In that time, we had incredible tenants. They paid on time, kept the place tidy. We barely heard from them in fact. They were ideal.

Then, the family in the lower unit bought a house of their own. We were sad to see them leave. But honestly, that’s a bit point of why we invest the way we do. We want to help families out. We had done that in this case.

Anyway, we found a new tenant who seemed like a good guy and had good financials. He was there about 3 months before he got in a serious car accident and moved back to another city where his family lived.

And this is where I made my mistake…

At the same time that this unit was vacant, we had another property that we just acquired which also needed two units to be filled. As a result, I was hyper focused on filling vacancies.

Vacancies = empty units = no rent = less cash flow = lower cash-on-cash return

In the process of doing showings for the other apartment, I met a potential tenant who was very interested. She was, as a told Selenid word for word, “rough around the edges.” In retrospect, there were definitely red flags. And I should have done more due diligence calling past landlords.

Ultimately, these red flags were enough that we did not offer her an apartment in the new property. However, I felt her finances were enough to cover the lower rent in the other building. We offered it to her and she took it. She paid security deposit and first month rent right away.

But then the issues began…

Initially the issues were largely behavioral. Her kids were rude to neighbors. The upstairs tenants complained about her smoking inside and littering in the yard.

Ultimately, our amazing upstairs neighbors moved as a result. We found another great tenant for the upper unit but this lower tenant was a constant issue.

And, after a few months, payments became a problem. It was a constant nag to get rent paid. And then, after 8 months, she stopped paying. We still received a small stipend from housing support that came directly to us. However, 80% of the rent was not being paid.

As our social mission within real estate investing, we aim to help those in need have access to high quality housing with affordable pricing. So we tried to work with her for a long time. But promised payments never came and eventually we had to evict her.

The process of eviction cost $1,000 and took about 6 months. Plus, after she moved out, the place was trashed and required extensive work to get it move in ready.

real estate advice — *This is how I found the apartment…*

The total financial damage of this bad decision

Lost rent due to non-payment: $6,213
Lost rent due to vacancy after moving out: $2,600
Repair cost after moving out: $6,000
Eviction: $1,000

Total cost of decision: $15,813

That’s a big number and a lot of cash flow. And this doesn’t even take into consideration the mental energy we expended in dealing with these issues. Of course, real estate investing – like anything else – is never completely passive. But this was way more active than our usual real estate activities.

Cost analysis

Let’s say, in my eagerness to fill vacancies, I had let this one unit sit vacant for one month instead of renting it out ASAP. Our extensive experience shows us that at most, it takes 2-3 weeks to rent out a vacant apartment. Thus, this is the maximum amount of time it would take to fill the unit. I would have stood to lose one month’s rent, or $1275 in this case.

Instead, I made a financial decision that was, literally, 1,240% worse.

The real estate advice that I impart

I am an impatient person at baseline. Many times, that serves me well as I get things done.

In this case, it caused me to skip important steps in vetting this tenant. Even in the vetting I did – including background checks, employment verification, reference screening, and having her mom as a co-signer – I overlooked red flags. All because I wanted to fill a vacancy and reduce lost cash flow.

I lost sight of the forest for the trees.

If I had just been patient (in fact, patience is a good piece of real estate advice just in general), I feel very confident we would have found a great tenant. Our property would be cared for. And our cash flow maintained. Despite perhaps a very temporary reduction in cash flow.

The bottom line is that a good tenant is worth their weight in gold. And a bad tenant is way worse – financially and otherwise – than vacancy, even if it is more prolonged.

The good news

I hope in sharing this piece of real estate advice I didn’t scare anyone away. As of now, Selenid and I have 18 units and this is a rare situation.

And even despite this bad decision and the lost cash flow, overall the property still cash flows 16% for us over the 3+ years we have had it. That well exceeds our goal of 10%. You can see more specifics about this property and its long term cash flow here.

Even when the payments were not coming through, cash flow from the other unit more covered our expenses. Plus we had 16 other units cash flowing as well.

Plus, all of these expenses related to the property were tax deductible from our real estate income. That’s a silver lining at least.

So don’t get discouraged or give up hope on real estate. But be realistic and learn from my mistakes!

In the meantime, here are other posts chock full of real estate advice for doctors looking to accelerate their path to financial freedom:

And if you want to see how real estate investing fits into a plan for financial freedom for physicians, check out my best-selling book, Money Matters in Medicine!

What do you think? Have you made a mistake with a bad tenant? How do you handle vacancies? What real estate advice do you have for us? Let me know in the comments below!