Tenant Pool, the Second Most Important Decision

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The only way to have a dependable passive income is if a “good” tenant continuously occupies the property. A good tenant is someone who:

• Has stable employment in a market segment that is very likely to be stable or improve over time
• Pays all the rent on schedule
• Takes care of the property
• Does not cause problems with neighbors
• Does not engage in illegal activities while on the property
• Stays for many years

Good tenants are the exception, not the norm. Good tenants are the result of:

• Targeting the right tenant pool.
• Selecting properties that your target tenant pool is willing and able to rent.
• A skilled property manager.

Three Major Tenant Pool Segments

Las Vegas has three major tenant pool segments. Below is a result of a study comparing monthly rent vs. length of tenant stay. I named the segments based on the average number of years tenants stay in the property.

Below are typical characteristics of the three tenant pools.

• Transient - This tenant pool is primarily low-paid hourly workers. They are usually cash-based, with no credit cards and no bank account. Since they are cash-based, skips and evictions have no impact. This tenant pool is the first to be laid off and the last to be rehired in times of economic stress. Also, since they have no credit history, so there is no practical way to screen out the bad actors. As one property manager said, "If they have two paycheck stubs and enough money for the first month's rent, they are in." Turn costs are high and frequent.
• Permanent - This tenant pool could be hourly or salaried, but they earn well above minimum wage. They tend to be very stable, stay for several years, pay all the rent on schedule, and take care of the property. This tenant pool's income is very reliable, even during economic stress, because they are direct income producers for their employers. The only time they are laid off is if the business is permanently closing. Other than permanent closure, these people generate the company's income and are never laid off.
• Transitional - This tenant pool has a high enough income that they are typically home buyers. They only rent if there is a major disruptive event in their lives, a divorce, the death of a spouse, etc. Once they sort out the problem, they buy a home. The typical tenant stay is two years. Very few are direct income producers, so they risk being laid off during economic stress.

Apparent vs. Probable Return

When most people evaluate properties, they consider what I call apparent return. Apparent return assumes 100% occupancy, which does not reflect the specific tenant pool's behaviors. Below is an example of apparent return using typical rent and typical property cost. In this example, all three tenant pool segments have approximately the same rate of return. Based on all three having the same return, the Transient tenant pool segment with the much lower acquisition cost is the best investment.

	Typical Property Cost	Typical Rent	Acquisition Cost	Debt Service	Apparent Return
Transient	200000	1000	54000	876	2.8%
Permanent	400000	2000	108000	1751	2.8%
Transitional	600000	3000	162000	2627	2.8%

Assumptions

• Financing - 25% down, 5.75% rate, 30 years.
• Closing costs - 2% of purchase price.
• Acquisition cost - 25% x purchase price + 2% x purchase price for closing costs.
• Return - (Annual Rent - Annual Debt Service) / Acquisition Cost. This is an over simplified return calculation but it is sufficient for this example.
• Other - No renovation cost, no management cost, no maintenance, 100% occupancy.

Below are typical vacancy costs for the three tenant pool segments from another study. In order to keep this post to a reasonable length, I omitted the calculations. If you would like to see how the vacancy cost is calculated, please contact me.

Tenant Pool Segment	Annual Vacancy Cost
Transient	6600
Permanent	400
Transitional	5750

Below is the table you saw earlier with the addition of the annual vacancy cost and the probable return.

	Typical Property Cost	Typical Rent	Acquisition Cost	Debt Service	Apparent Return	Annual Vacancy Cost	Probable Return
Transient	200000	1000	54000	876	2.8%	6600	-9.5%
Permanent	400000	2000	108000	1751	2.8%	400	2.4%
Transitional	600000	3000	162000	2627	2.8%	5750	-0.8%

Once you include vacancy cost, what appears to be the best property is the worst. This demonstrates that vacancy cost, which is tenant pool specific, is a critical consideration when selecting an investment property.

In Conclusion

After location, the most important decision you will make is the tenant pool. Base your tenant pool selection on probable return, not apparent return.