You’ve been watching reruns of HGTV’s “Income property” show and wondering if now is the right time to buy an investment home and become the landlord of your dreams.
With a recent increase in inflation as well as historically low interest rates and the desire of the millennial generation to rent instead of buying their own property has been on the rise in recent years.
In fact, the real estate market is currently the preferred long-term investment for Americans, according to a recent World Bank study. Real estate investment has been consistently named one of the best investments since Bank rate began the study in 2012.
Should you take the plunge into a rental property? Experts say yes, if you do your research first. Here are 10 things you need to know before you commit to the possibility of investing in real estate.
1- Find out if investing in rental property is the right choice for you.
Don’t fall victim to the TV show stereotypes of uninformed landlords. To get the most out of the income property you own, you need an accountant’s eye, a lawyer’s knowledge of landlord-tenant laws, a psychic’s insight and, if you choose to manage your own property, an affable but firm landlord.
“People who try to become landlords fail because they don’t understand all the effort involved,” says Diana George, principal of DG Design Group.
Before you jump in, ask yourself if you have the patience, time and ability to commit to managing the rental. Although rental properties are classified as a passive investment, that doesn’t mean you are completely dependent on them.
Over the long term, real estate investments can outperform other long-term investments, such as stocks, but the results vary considerably depending on the specific circumstances of the area and property in question. You need to consider whether you are able to increase the rent over time and whether the market surrounding the property is able to support it, among other things. How you finance the property and the financing terms can have a significant impact on how much you earn.
If managing an investment property seems too difficult, but real estate interests you, you should consider investing in a Real Estate Investment Trust (REIT). REITs are publicly traded securities that invest in real estate. They typically pay a significant portion of their profits back to investors in the form of dividends. This is an opportunity to gain exposure to real estate investing without the hassle of property management.
2. Financing or buying? Find out what’s best for you.
Some financial experts say you shouldn’t buy an apartment unless you can afford the cash price. Jeremy Kisner, senior wealth advisor at Surevest Wealth Management in Phoenix, isn’t convinced.
“Leverage (i.e., mortgages) generally increases returns, both on the positive and negative side,” says Kisner, who owns two rental properties located in Las Vegas.
Imagine, for example, buying a rental home for $100,000 cash. The home earns $12,000 in annual rent after all costs such as maintenance and insurance, which is taxed at 1,000. With an amortization rate of 27.5 years and an average tax rate of 20%, the investor could earn just under $9,500 in cash per year. Thus, the annual cash flow is about 9.5%. That’s not bad at all.
Here’s how the investor using leverage did, taking the same house. The investor holds an 80% mortgage on the house. The yield increases to 4%. After deducting operating and other interest expenses, the investor earns $5,580 per year in cash. With a $20,000 investment, the annual cash return is approximately 27.9%.
In reality, the leveraged homeowner is slightly better off than these numbers suggest. That’s because a portion of the rental proceeds are used to cover the principal of the mortgage. Therefore, even though the investor didn’t keep the money since they used it to finance the loan, the lender made money (and was taxed) on it.
This is the power of leverage to change the direction of an investor’s return.
George agrees: “I’m all for taking a conventional (mortgage) loan. It’s a great way to get the most out of your money.”
If you decide to finance your purchase, note that you will need to make a larger down payment than is typically required for a mortgage. Most lenders require a down payment of at least 15% for the purchase of an investment property. You will also need enough money to cover closing costs, as well as homeowner’s insurance, maintenance costs and taxes that may apply to the property.
3. Find the right address
The old real estate agent mantra about the importance of location can take an interesting twist when it comes to rental properties.
“The most desirable locations, where appreciation is highest, are in areas where the cash flow from a rental is the most negative,” Kisner says.
Why? Investors can make money by getting appreciation and cash flow. In some areas, investors may need more cash flow to offset slower appreciation. If investors anticipate that a particular area will appreciate significantly, they may be willing to sacrifice some cash flow to take advantage of that appreciation. This means that housing appreciation outpaces rent increases and the units appreciate and bring in extremely little cash flow.
“The result is that property must appreciate in order to be competitive for investment opportunities with properties in less desirable areas,” Kisner explains.
The answer: Get the appreciation wrong. That’s exactly what he’s doing with the two rental properties that, in a normal month, barely make any money. “But when I hold them until I reach 60] and they’re paid off, even after property taxes and insurance costs, they can double the earnings on Social Security,” he says.
4. The road to success is one that requires a long-term vision
The property Mr. Kisner has owned for 13 years has two tenants and requires little maintenance. The other three tenants are more than four years old, the most recent being an expensive eviction.
He follows the same guidelines he provides to his clients.
“The way people end up having problems with almost all investments is that they don’t keep things long enough,” Kisner says. “With rentals, when you break even on a cash flow basis, it’s a very good thing since you’re paying down capital while creating equity that way. At the end of the day, hopefully you’ll like it.”
If you’re trying to make money with real estate, you need to think long-term. If you can pay down or eliminate the principal over time, it is possible to increase cash flow.
5. Make sure you have the right materials for the owner
If you decide to buy an investment property to rent out, is it better to be the sole owner or to pay 6-10% of the rental income to a management company? There’s no right answer for everyone, George and Kisner prefer to outsource the work.
“They do a background check on your tenant, so make sure the tenant signs the lease and pays the rent on time,” George says. “This allows you to manage your finances rather than your tenant and property.”
Kathy Hertzog, past president of LandlordAssociation.org, based in Erie, Pennsylvania, says being your own landlord can have a significant downside.
“If you’re way too involved with the tenants, and they’re having financial problems, you could be stuck since you don’t want to have to evict their tenants,” the attorney says. “You have to be very professional about it, because if someone doesn’t pay your rent on time, then they are taking money away from you.”
To top it off Are you sure you can make the important choices when managing a property? Do you plan to repair or replace the broken air conditioning unit or the leaky dishwasher? It’s up to you to decide which option is best for you.
6. Prepare for the unexpected
Failure to plan for the many costs of managing an apartment can be the fastest path to disaster.
“As a landlord, you’re looking to keep about 20 to 30 percent of rental income to cover maintenance, upkeep and other emergencies,” Hertzog says.
“You have to make sure you’re not living on the money you make,” she says, “because by the time something bad happens, you won’t have the money to fix it. You’re trapped as the owner of an asset that needs a quick fix, but you don’t have the money.”
Kisner couldn’t be more right: “In my experience, you’re underestimating all the expenses that are coming up, and you’re also overestimating how positive your cash flow is likely to become,” he says.
7. Make sure you renew your lease
If family landlords have a major problem, it’s the inability to renew tenants’ leases on time George says.
“You’d be shocked by the fact that many landlords don’t renew their leases every year, which is why they let their tenants take month-to-month contracts,” she says. “What’s wrong with that? The problem is that the whole idea is, it’s time to let my tenant go, I can’t do it because they’re no longer bound by the lease.”
“They can’t raise the rent either,” George adds. “The only way to change the rent is to have them sign a form to change the lease every year. That’s how you can make sure your tenants are in control. If you let things go like that, it’s really hard to get your tenants back to their normal routine,” George adds.
Depending on the state, county and city where it is located, the landlord can give an eviction notice for a set period of time. In California, George’s home state and the state where the state is located, landlords are required to give 60 days notice to tenants who have lived in the unit for more than one calendar year (or 30 days for less than one year). The landlord could also offer a new lease during the same period.
8. Do you want long-term tenants? Consider Section 8
Sudden tenant vacancy is a nightmare for any landlord.
“Every month when a rental is vacant, you have to pay rent, utilities and other maintenance costs out of your own pocket. Therefore, this is one of the problems you need to be able to address quickly,” Hertzog says.
A popular solution? Try Section 8 tenants.
Section 8, also known as the Department of Housing and Urban development’s Housing Choice Voucher Program, generally caps the rent for low-income Americans eligible for the program at 30 percent of their monthly income. While some landlords are skeptical of the paperwork and potential maintenance issues faced by Section 8 tenants, Hertzog has a favorable view of them.
“The older groups” and people with disabilities are generally excellent tenants. They tend to take great care of the property because it’s the place they call home. It’s where they want to be. Also, if they don’t pay the rent or damage the house, they risk losing their Section 8 voucher,” she adds.
A downside for Section 8 tenants is that it may be more difficult to increase the rent over time, which could affect your ability to pay rising costs by generating more rental income.
9. Don’t forget to include rental properties when filing your taxes
There is a ray of sunshine that shines on property owners with income each spring as they sit down with their accountants to complete your federal tax returns.
“When you own your home, you can deduct the interest and that’s all that matters.” says George.
“But when you have an investment property, the Schedule E tax form allows you to deduct almost everything from painting the house to replacing light bulbs.
“So even though you’re able to report rental income on your return, you can report less than you actually have and also deduct your mortgage and interest while creating equity in the process,” George says.
It’s the powerful combination of tax benefits and investment returns that keeps investors interested in rental properties.
10. Knowing how rental law works
According to Hertzog, state and local laws regarding landlord-tenant relations can be a bit of a drain on landlords who don’t pay attention.
A good example is the tenant security deposit. It’s not as simple as storing and securing the money.
“There’s definitely accounting to be done. You need to set up an account for each tenant, put the money in and keep it,” Hertzog says. “Security deposit laws determine how long you need to return the security deposit at the end of the tenancy and minus the cost of repairs and cleaning, and all of that needs to be accounted for.”
“In some states, if you don’t return it, the tenant can sue the landlord for double the amount of the security deposit if they don’t return it in a timely manner,” she adds.
Of course, this is just one of the rules for rental properties. There are many others that landlords need to be aware of to avoid being in violation of these laws. It is important to become familiar with the laws governing eviction, fair housing and other requirements of the regulatory system.
Renting real estate is an investment worth considering if you do it professionally. However, you need to be aware (as much as possible) of the risk you are taking before you put your money on the line. While the lure of earning passive income each month through real estate is appealing, it’s important to keep in mind that maintaining that income can take a tremendous amount of effort.