Charles:
Bad debt. Justin just hurt your rental income and NOI it weakens your entire investment. Over the past nearly 20 years, I’ve been buying multi-family properties and seen how bad debt can be a massive drag on any property’s performance. Welcome to Strategy Saturday, I’m Charles carillo, and today we’re talking about something every real estate investor needs to understand bad debt. So let’s get started. So bad debt is a common term in real estate lending and lending in general, but in this episode I’m discussing bad debt as it pertains to rental properties and delinquencies. And understanding this concept will help you become a more informed real estate investor. So let’s start by breaking down what delinquencies and bad debt are. So delinquencies refer to late tenant rent payments. Usually after two months of missed rent payments, the rent and the tenant become delinquent. Bad debt happens when those delinquent rent payments are considered uncollectible.
Charles:
Now this usually occurs after multiple rent payments have been missed and a collection efforts have all been exhausted. Now, bad debt is calculated by dividing the uncollected rent by annual income and multiplying by a hundred. For example, if a property collected $100,000 in gross rents and had $1,000 of bad debt, it would have a bad debt ratio of 1%. Now, I’ve read recently that the national bad debt average is 0.7%, but you want to see this at or under 2%. Properties with a bad debt ratio of 2% to 5% might be acceptable investments with higher reserves, but would be considered higher risk investments in most instances. Now, some investors might also see higher bad debt ratios as opportunities that can be corrected with better property management. Either way, rental properties are valued by their income streams, their tenants, and the less reliable they are, the weaker the property is financially.
Charles:
Now, when you’re underwriting a property, a higher bad debt ratio may signal a few different scenarios present on the property. Number one is poor tenant screening. Now this is the first thing I will assume. When I see a high bad debt ratio, the managers have not been conducting thorough due diligence on new tenants. Number two, it’s poor property management. Now this doesn’t always mean the property managers are bad, but they may not understand how to manage the properties class. For example, if the property management firm managers a portfolio of new class A properties built in the last 10 to 20 years while also managing one 50-year-old class C property, there lies the problem. They do not know how to manage the asset class effectively. Number three is inefficient rent collection and or poor communication. So when people owe you money, you must maintain a regular communication with them.
Charles:
Once that communication goes dark, the chances of you getting paid drop dramatically. And one of the reasons why c and d class properties are more management intensive than say A and B class properties is because the time required to collect rents in addition to them being older properties that have more maintenance issues. Still, it is entirely different from a new class A property where 90% or more of your tenants pay rent online and on time versus AC and D class asset where tenants regularly pay late paying face to face with money orders or sometimes even cash. And when I self-manage my own C-Class properties for years, most of my tenants paid me in cash on those rental due dates, and I should have required money orders for the safety of carrying around all that cash. Still, I knew 100% that a cash rental payment would not bounce, and it always seems safer to take cash than trust that they would deposit the cash and write me a check or go down the street, get a money order and come back.
Charles:
Number four is the location in the market. The lower income areas are usually going to have higher bad debt than higher income areas. If that is where you’re investing, this is what is involved. So how do we minimize bad debt at a property? Well, number one is in-depth tenant screening, and I always talk about this on the show, but it all starts with tenant screening. Verify tenants make three x the rental rate set and stick to the required minimum credit scores. Verify the tenant’s employment to avoid fraud and contact employers to make sure they actually work there and they have the required criminal background checks. Now also another thing with this is that years back, we didn’t have to do this, but right around COVID, since this type of fraud with people saying where they workplaces, the income portion of the tenant screening has become difficult.
Charles:
But that’s where a lot of fraud has set in. So make sure that people do that. Also, make sure when you’re buying a property, just as a side note, if you’re trying to raise rents, do some research and make sure that in that area the people can afford the rent in the area where you’re buying it. If you’re gonna try to make it three x. For example, if people are making 25,000 or $30,000 a year in an area and you’re trying to raise rents to $1,500 a month, it’s just not gonna work, right? That area does not sustain those rents. So you’re gonna make sure that everything down the line with your business plan of buying a property, but also when you’re managing a property, that everything starts with the in-depth tenant screening. Number two is solid security deposits set and stick to specific security deposit amounts and increase them if you accept tenants who fall short in the credit score income requirements.
Charles:
Now, you know you have this set guidelines and you don’t wanna deviate too much from it, but also we’ve done it before and the way of doing it is like really solid security deposits, maybe additional co-signers, but I’d rather have money than additional co-signers because in especially in like C class, people might have someone else co-sign for it that don’t really care what happens or something like this. Getting the security deposit, the cash in hand is gonna be more important when you’re having people that are dip below and slightly dip below what you require for guidelines. Number three is effective rent collection. So set up an online rent collection portal with preset rent collection, email reminders, text reminders, and the portal allows people to schedule and pay their rent easily. Now, once rent is late, make sure managers contact the tenant daily, and if you do not hear from the tenant, file a three day notice to pay rent or quit at the earliest date possible by law in your area.
Charles:
Now most times tenants will tell you they need another few days or a week to pay and make sure to charge them a late fee and follow up when they do not pay. If they need more than a couple of days, request some sort of payment right now, even if it’s just a hundred dollars. And I would always laugh to myself when I encounter landlords who will not accept partial rent, but they’ll only accept full rent payments. You know, tenants at our properties can pay us any amount at any time. If you don’t pay in full by the due date, you’ll be charged a lay fee, but we’ll never turn down away any partial payment. Number four is excellent customer service. So we’re talking about before about what we need from tenants. Now, this is what the tenant needs from us, the landlord, excellent customer service.
Charles:
Just like any other industry, when there are issues, address them immediately and when repairs are to be made, have them fixed immediately. Uphold your end of the lease and agreement, and if there’s any delay in repairs, communicate this to your tenants with an estimated timeframe. It’s the same way if you wanna keep open lines of communication when they owe you rent, you do that. You wanna keep open lines of communication when you owe something like a repair, right? And they will appreciate that delinquency and bad debt are important metrics to be aware of. With your current rentals and properties you are underwriting and in certain some markets, bad debt will be more prevalent than others, but understanding the underlying issues for the bad debt will help you become a more knowledgeable investor. So I hope you enjoyed. Please remember to rate, review, subscribe, so make comments to potential show topics globalinvestorspodcast.com. If you’re interested in actively investing at real estate, please check out our courses and mentoring programs at syndicationsuperstars.com. That is syndicationsuperstars.com. Look forward to two more episodes next week. See you then.
