Who is Your Customer?
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In 2005, I decided to start an investor services business. I reviewed all the popular investing literature. What I found were self-professed experts offering opinions and no processes. As an engineer, opinions hold little value for me.
I shifted my research focus to the commercial sector, where I found rigorous processes that resonated with me. I discovered that retail store location selection and stocking methodologies are excellent guides to systematic residential investing.
In this post, I will explain how I use methodologies from national retailers to select properties that generate a reliable income.
Don't Reinvent the Wheel
National retailers have spent decades developing and refining processes to choose store locations and inventory. Retailers base all decisions on their financial goals - the location of stores, the layout of stores, the decorations, etc. Retailers do not make decisions based on opinions they read on websites or books. They know the demographic of their customers and do what is needed to maximize returns.
For example, in Hawaii, McDonald's has spam, Portuguese sausage, hot haupia (coconut pudding), and taro pies on the menu. This level of localization was necessary to attract the local people to eat at McDonald's. Once in McDonald's, they order from the full range of standard items. This is an example of using an “attractor,” which I will talk about later.
Who is Your Customer?
Operating a rental property is a business where you provide housing services to your customers, who are your tenants. To maximize profit, it's crucial to understand your customers' needs and what they are willing and capable of renting.
If your goal is a reliable income, you need a reliable tenant to occupy your property. A reliable tenant stays many years, always pays the rent, and takes good care of the property. And, since you will own the property for many years, you will need multiple reliable tenants. However, reliable tenants are the exception, not the norm.
Many people mistakenly believe that all tenants have the same behavior. This is not true. The renter population is comprised of many segments, and each segment has different housing requirements and behaviors.
For example, as illustrated below, there are three primary tenant segments in Las Vegas. Each segment has different behavioral characteristics.
The most crucial segment characteristic is the duration of their stay. If there are frequent turns, vacancy costs can turn what appears to be a cash cow into a money pit. So, if you want a reliable income from your rental property business, targeting a tenant segment that stays many years is critical. Among the three tenant segments, the 'Permanent' segment has the longest average tenant stay. They should be your customer.
How Do You Target a Specific Target Segment?
Each tenant segment has specific housing requirements, and they are unlikely to rent a property that doesn't meet all their requirements. Below is an example of a segment's housing requirements and a property that fulfills these requirements.
The converse is also true; a property typically meets the housing requirements of just one segment. Therefore, when you purchase a property, the tenant segment the property attracts is fixed, and there is little you can do to change this. Only purchase properties that match the housing requirements of the segment you want to occupy your property.
How can you target a specific segment? By using a combination of attractors and detractors.
Attractors and Detractors
Attractors are property characteristics that attract a specific tenant segment. For instance, to target the Permanent segment, invest in properties with rents that match a gross income range of $60,000 to $85,000 (Las Vegas example). Doing so attracts individuals within this income bracket and discourages those who earn more or less.
How do you translate gross income to probable rent? Most people opt to live in the best place within their budget, typically allocating about 30% of their gross monthly income for rent. Therefore, you can calculate the rent range as follows.
- Lower rent range: $60,000/Yr x 1 Yr / 12 Mo/Yr x 30% ≈ $1,500/Mo
- Higher rent range: $85,000/Yr x Yr / 12 Mo/Yr x 30% ≈ $2,125/Mo
So, if you buy properties that rent for between $1,500/Mo and $2,125/Mo, you attract people with a gross annual income between $60,000 and $85,000. At the same time, people who earn more or less than $60,000 to $85,000 are unlikely to rent properties in this range.
However, not everyone in this income range has the right behaviors for a reliable income. Based on our research and experience, only families with elementary school children tend to stay over five years. Singles and couples within this wage range typically stay less than two years, making them less desirable tenants.
How do you attract families with elementary school children? By purchasing properties that match their housing requirements.
For instance, our research indicates that singles and childless couples typically rent condos, townhomes, and small single-family homes. When they opt for a single-family home, it usually has two bedrooms, a one or two-car garage, and a small yard.
Families with elementary school children typically rent single-family homes that have three or four bedrooms, a two-car garage with at least 1,200 square feet of space, and a yard that's over 3,000 square feet (so children can play in the yard).
Another key attractor/detractor is the location. Singles and couples usually want to be near the “action” and are not likely to rent in suburban areas popular with families with children.
How can you identify attractors and detractors for your target tenant segment? Through property manager interviews.
Property Profile
Once you identify the attractors and detractors for your target tenant segment (your customer), you can create what I call a property profile. A property profile is a physical description of properties that will attract your target subsegment and deter others. Your property profile consists of at least four characteristics:
- Location - The locations where significant percentages of the target segment rent today.
- Property type - The type of properties they rent today. Condo, high rise, multi-family, single family, the type does not matter. Only a reliable tenant matters.
- Rent range - What the segment is willing and able to pay.
- Configuration - Two bedrooms, three-car garage, large back yard, single-story, two stories, yard size, SF, etc.
Once you have a property profile, you can provide this description to any realtor, and they can find properties that match.
However, property selection involves far more than just the four characteristics listed above. I summarized what you must also consider in the diagram below.
Does This Work?
Below is a map showing where the majority of our client's properties are located. Note that I did not choose the locations, property types, configurations, or rent ranges. I found the tenant segment with the right behavioral characteristics for reliable income and bought what they were willing and able to rent. It really is this simple, and the process will work anywhere.
Below are the results of over 16+ years of using this methodology.
- 2008 crash - Zero decline in rent and zero vacancies.
- COVID - Almost no impact
- Eviction moratorium - Almost no impact
- Our average tenant stays over five years.
- We've had six evictions in the last 16 years with a tenant population of over 1,000 tenants.
- From 2013 through 2023, the annual appreciation and rent growth rates were over 15% and 7%, respectively.
Summary
Retail chains make decisions based on their financial goals, not the opinions of others. These goals dictate store locations, configurations, and the merchandise they stock. If you want a reliable income, follow retailer strategies rather than adhering to others' dogma.
