DebtFreeGuru.com's - Tip of the Week - Monday, February 7, 2005
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How
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If
you're cut out for it, life as a landlord can be quite profitable. But
success isn't assured. Here's what you need to know before diving in.
By
Liz Pulliam Weston (as seen on MSN.Com)
The idea of owning rental real
estate seems to be gaining popularity as investors tire of the swoops and
swoons of the stock market. As I pointed out in a separate column,
not everyone has what it takes to be a landlord. But those who do may find
rentals to be a good way to build wealth.
Once you’ve made the decision
to buy rental property, your real work begins. Finding a profitable rental
property usually takes time, connections and plenty of research.
Here’s what you need to know to
get started:
Know your time horizon
As with any other investment, you
should have a good idea how long you plan to own a rental property before
you buy it, says Robert Cain, publisher of the Rental Property Reporter
newsletter.
The longer you plan to own the
property, the more you’ll probably need to invest in maintenance,
repairs and improvements, Cain said.
“If you’re keeping it for 20
years, at some point you’re going to be putting a new roof on that
property. You’re going to be putting in new appliances and doing some
major repairs,” Cain said. If you’re only planning to own a property
for five years, by contrast, you’ll probably want to avoid making any
major improvements unless you’re sure you can recoup the cost with a
higher sale price.
You also may face more investment
risk with a shorter time horizon. Although your rental will almost
certainly appreciate over 20 years, it could easily lose value in the next
five, particularly if you’re buying in an overheated market. You’ll
need a bigger potential annual return to make up for that risk.
For many small investors,
long-term ownership makes the most sense, said Pat Callahan, an attorney,
landlord and founder of the American Association of Small Property Owners.
You’ll have plenty of time to ride out any swings in the market, and
rental income can make a nice supplement to your day job. Find enough
rental properties, and being a landlord may become your day job.
Develop a network
Experienced landlords find their
properties in a variety of ways. Some hunt for foreclosures, making
friends with city hall clerks or bank employees who know which properties
are about to be sold. Some run ads in local newspapers. Others work with
real estate agents who keep their eyes peeled for possible buys.
Several landlords recommended
joining a local landlord or property owner's association to make contacts.
Callahan’s Web site offers links to local groups, as does the National
Real Estate Investors Association. (See the links at left under
"Related Sites.")
“When you begin to own rentals,
all the other investors start coming out of the woodwork,” said Sean
Hoppe, a landlord in
You also can try approaching
landlords directly to see if they’re willing to sell, by calling the
numbers listed on rental ads in the classifieds, by cruising neighborhoods
looking for “for rent” signs or by talking to any landlords you know
personally.
That’s how Bob, who asked that
his last name not be used, bought his rental property near
“We love (the area) and jumped
at the chance to buy it,” Bob said.
So far, Bob and his wife have
been pleased with their purchase. They raised rents and required security
deposits, which caused the property’s less desirable tenants to leave.
He also has a backup plan for the building in case he starts to feel like
the prior owner.
“If being a landlord got to be
too big a hassle,” Bob said, “we would just get rid of the tenants and
make it our own place.”
Get your finances in shape
The better your credit, and the
less credit card and other consumer debt you have, the better your
prospects for getting a decent loan, Callahan said. Lenders usually
require bigger down payments, higher interest rates and generally stronger
finances when you’re buying rental property. That’s because they know
people are more likely to default on investment property than they are on
their own homes.
Landlords say it also pays to
have a substantial cash reserve left over after buying a property. This
can help pay for unexpected repairs and vacancies. Although there are few
rules of thumb, setting aside at least one month’s rent for each unit is
a good start. CPA Paul Berning suggests having a line of credit, secured
either by the property or your own home, to cover larger costs.
You also should make sure you can
save enough for retirement and other goals before investing in rental real
estate. While rental income can supplement your retirement kitty, most
people shouldn’t count on it to replace other investments or allow
themselves to be entirely exposed to the whims of the local real estate
market. Rents and property values can fall as well as rise, and those who
are adequately diversified with investments in stocks, bonds and cash will
be better able to endure the bad times as well as the good.
Avoid overpaying
As one experienced landlord put
it: “You make your profit when you buy a property, not when you sell
it.” Pay too much, and you’ll never recoup as much as you could have
had you driven a better bargain.
The rental real estate market is
generally tougher on investors who overpay than on homeowners who do the
same thing, several landlords said. While a home is often an emotional
purchase, which can lead to “I must have it!” offers and bidding wars,
most landlords look strictly at the numbers to see if their investments
will pay off. If you pay too much for a rental, you can’t count on a
“greater fool” coming along later to bail you out.
Not overpaying can be tough in a
hot market, however. Apartments in
Some landlords use formulas, such
as not paying more than six to eight times the rents they expect to make
the first year. Others try to estimate what the property could be worth
after needed repairs and upgrades are made, and they don’t pay more than
70% of that price, less the cost of those repairs, CPA Berning said.
Every real estate market is
different, however, and these formulas may not work in your area.
What’s key is to make sure your
rental income will cover your out-of-pocket costs, Berning said. That
includes the mortgage payment on the property, as well as taxes,
insurance, maintenance, repairs and a vacancy rate of around 5%. (If you
have five units, for example, you should expect at least one unit to be
empty three months each year. Here’s the math: 5 units times 12 months
equals 60; 60 times .05 is 3.)
If you can at least break even,
you’ll be able to profit from any price appreciation as well as from tax
breaks available to rental property. Cain’s Web site sells $55 software
to help you make these calculations (see link at left).
When crunching the numbers, you
should know that there’s a big difference in how repairs and
improvements are treated for tax purposes. You can typically deduct the
cost of a repair, such as patching a roof or fixing a leaking pipe, on
your tax return for the year in which the repair is made, Berning said.
Replace that roof or those pipes,
however, and it’s typically considered an improvement, which means the
cost can’t be deducted. Instead, it’s added to the amount you paid for
the property to determine your tax basis when you sell. The higher the
basis, the lower your taxable profit. But if you have to wait 20 years
after making a major improvement to recoup any of the cost for tax
purposes, you may think twice about buying a property that needs a lot of
upfront work, Berning said.
To better estimate your costs,
get a thorough inspection before you buy a property. Some landlords have
favorite electricians, plumbers and contractors that they send to any
prospective property, promising them that they can do any repair work they
find. Others use professional inspectors they trust.
Longtime landlords say all this
work pays off in profitable properties that build their net worth while
providing a steady income stream. Callahan, whose family started investing
in rental real estate in the 1940s, says it’s a way of life she
recommends.
“It doesn’t matter if
you’re a professional or a laborer,” Callahan said. “It’s the
equal-opportunity wealth builder.”
DebtFreeGuru.com - Tip of the Week - Monday, February 7, 2005
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