Risk vs. Reward, How To Predict Profits

signs-108062_1280-PDPredict profits for your rental property.  

Let’s assume that your property is renting for $1000 per month.  Let’s also assume you collect a $1000 security deposit. 

If you have average expenses, you will be spending, or allocating to a reserve account, 45% of that.  If you have significantly higher expenses, it’s time to look your costs.  If you have significantly lower expenses, you are probably missing something.  Either way, that’s about $450 going to expenses. 

These are amounts for taxes, insurances, association dues, vacancy expenses, management fees, utilities, maintenance (actual and deferred), etc.  It doesn’t matter if you manage the property yourself or not; you need to get paid to do it.

If you are like most investors or homeowners, you also have a mortgage that has to be paid.  Even an $80K mortgage at 5%, would have a payment around $430.  The net result is that you have $1,000 – ($430 + $450) or $120 every month to put in your pocket.

After a year-long tenant, you will have accumulated some money for deferred maintenance, saved some money for the next vacancy, paid yourself to manage the property, and a $1,440 expected profit.

How does credit score factor in?  It’s pretty easy to find credit score delinquency rates.  A simple Google search will do that.  A score of 550 to 599 will have a 51% delinquency rate.  So, that means that ~50% of the time, a person with this low credit score will default.

If you are renting to a person in that credit score range, it means your $120 per month profit, will be considerable less.  It does not mean your $120 will be $60 per month.  When a renter defaults, they do not pay the rent, but they also do not contribute money towards all of your other expenses.  If you incur any legal expenses, those are an additional expense that you did not figure on.

What does a renter default cost?  If you are lucky, you can get 50% of the last month’s rent, have an amicable move out, and keep enough of the Security Deposit to come current on the account.  Most often, it does not happen that way.  Most often, a renter delinquency results in an eviction, and additional damages.  Assume for this example, you have collected the median six months worth of rent before the renter misses a payment.

An eviction will cost the equivalent of about five months in rent for most landlords in MN.  That is two months rent lost from the first missed rent payment to the end of the eviction and the renter is actually out.  Another month of down time while you are repairing the unit.  Another month’s worth of rent while you are marketing your unit and waiting for a move in.  And a month’s worth of expenses for Court costs, legal fees, repairs, etc.

It could be considerably more, if you waited to evict and damages are more severe.  Or, if you evict faster, and can turn and market your property faster, you could be less.  Either way, the formula still applies.

So, you have the potential for $1,440 in profits for a good renter vs. a loss of $3,280 ((6 months * $120 profit) – $5,000 expenses + $1,000 damage deposit) for a bad renter.

So the profitability can be calculated by a formula.  [((100% – Delinquency rate) x expected profit) less ((delinquency rate x eviction expenses) + damage deposit)].  If you have a 50% delinquency rate on a one-year tenant, it is (50% x 1,440) – ((50% x $5,000) + 1000).  $720 – 1640.  Or a loss of $920.

If you get a slightly higher credit score, or a longer term tenant, you fare much better.  A larger security deposit for renters with lower credit scores mitigates some risk.  Even lower rents helps, as your vacancy expenses are lower.

A higher credit score helps considerably.  A 650 credit score person only has a 15% default rate.  With that higher rate, the formula on the same rental goes like this.

[(85% x 1,440) – (15% x $3,280)].  Or $1,224 – $492.  A profit of $732.

So, you can take your chances on a lower credit score, or you can calculate your risk and make a decision based on profitability.  Higher credit scores mean higher profitability.  Can a low credit score tenant be good?  Sure.  Can a high credit score person be bad?  That can happen too.  But when a renter has applied for your unit, you are looking at probabilities, not hindsight.

If you continually take renters with a sub-600 credit score, you need to ask yourself why you look for the bottom 10% of the populace.

Hopefully the math makes sense. Have you ever calculated the risk into the calculations of your landlording?

2 Replies to “Risk vs. Reward, How To Predict Profits”

  1. Eric,

    Great points, as usual. I don’t have the experience you do, but I am very much inclined to agree that a high caliber tenant is the way to go. Right now, I have tenants that fall on both sides of the spectrum. I am learning first hand what comes with that…

    In the long run, I am going to focus on building the majority of my portfolio based on high quality, professional tenants. I have two so far and they have been excellent renters.

    1. The high quality is a better profit, in the long run. Low quality is OK, but you need a 12%+ rate of return. It is a common mistake to think most people are decent folks and will pay rent and return the place in great shape. I have seen properties that after one year, all the doors had holes in them due to punches. Then you have to ask yourself, “In my own house, how many doors do I have to replace every year due to them having holes punches in them?”. Normally, the answer is typically “never had I had to replace a door…”

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