Investing/Rental properties

Rental properties are a way to have a long-term monthly income as well as build equity, meaning that the property has value in itself that can be recovered upon sale.

Me, a landlord?

You, yes, you, can be a landlord. Well, maybe not *you*, but that other guy over there. Yes, him.

He's got reasonably good credit, some initial cash, plus a moderate amount of time and patience to deal with initial paperwork and projects. He's willing to make his life more complicated now in the hope that he might be exchanging it for greater wealth later. And he lives very near an area where people are looking to rent.

To be a landlord, he will need: a place to rent (fully insured), tenants in that place, and carefully constructed written agreements with the tenants (leases) that talk about how everyone is expected to behave, including how much the tenants will pay. If he doesn't have a place already, he'll need to buy it, which will mean negotiating with the previous owners (or their agents) and bankers.

If the landlord can find a place to buy such that his monthly total of mortgage payments, insurance, taxes, utility, repair and miscellaneous costs are less than the rent he's taking in, he'll be making money. This may not be realistic at the start. A high property cost, low amount of down payment, a less than ideal interest rate, high taxes and critical property repairs could push expenses too high for profit. But he'll never know for sure until he researches his local market and starts making calls.

Choosing a property

Single Family Houses

Houses are a higher risk than apartments and condominiums simply because usually a house costs more and therefore you have a higher risk of negative monthly cash flow if your property is vacant. With a condo, since the overall cost is usually less, your exposure to risk is less. Likewise in an apartment since there are more units to rent if one is vacant there will still be some rent collected every month. For instance if an investor buys a 4 unit building (four-plex), with 2400 total square feet, then rents each 600 square foot unit for $500/month, the total rent collected is $2000 dollars. Lets say this same investor buys a 2400 square foot single family home and rents it for the same $2000 a month. The risk is obvious; the single family tenant could decided to leave, then the investor is stuck with a property with zero dollars collected for rent. While the four-plex only has one unit vacant, the other three are still rented thus the investor has $1500 of rent still coming in. The four-plex is a much smaller risk.

The other negative is a multi-unit investment property usually rents at a higher rate per square foot than a single family house. Lets assume this same investor can get around $0.83 per square foot for a single family house while the four-plex will rent at $1 per square foot. That is $2400 of total potential rent for the four-plex, and $2000 for the single family house. It is obvious multi-family investing is better for maximizing positive cash-flow for a real estate investor.

On a positive note single-family houses have tended to appreciate faster and more steadily than condos, in a steady real estate market, although that's no guarantee of future price changes. For this reason the single family house may equalize the monthly cash flow of a condominium when looking at a long-term investment (5 to 10 years +). It is important to look at the history of the neighborhood and region you are investing in to determine the best strategy that meets your financial goals before investing in single family houses. But remember, history is only a guide - the future may be very different and can't be predicted. Even the nicest area now can become a slum in the future.

Condos

Condos are a great place to start for first time investors, simply because they require very little 'exterior' maintenance. Usually you pay an 'Association Fee' (HOA) that does all the 'Common Area' maintenance. This leaves you free to concentrate on the inside and taking care of the renters.

Be wary, however. In a condo agreement, you are vulnerable to risks associated with the other condos. If another condo owner in the association goes bankrupt, you may be subject to higher HOA fees. Likewise, if another condo falls into disrepair it may become very difficult to rent or sell your unit. The larger fraction of ownership each associate owns, the greater the risk. Condo rules may change without your consent, as they are subject to majority votes; imagine the association deciding the units can no longer be rented!

Buying the property

Financing the purchase

You don't actually need to have a lot of cash on hand to buy a property. All you need is to have access to cash. This can be through equity that you withdraw from your home through a second mortgage or line of credit, or the cash a partner in a joint venture provides. This initial cash - whatever the source - provides your down payment.

When you have a down payment that is sufficiently large (10% of purchase price, 25% or some other amount), a lender can lend you the rest. This lent sum will normally be secured against the value of the property, through a mortgage.

Remember though the interest you are paying on the loan reduces your profit and the level of your risk increases the more you borrow... if your property is empty you still need to pay the mortgage.

Renting the property

Predicting rental income from a property is important because it is your only source of active income from the investment. The property may gain value over time and provide you with return upon sale of the property in the future, but it should not expected. Your rental property investment should be profitable on the rental income alone.

There are several ways to estimate rental income. In rough order of accuracy:

• The property may be currently rented, or have a rental history. Request this information from the seller.
• Ask your real estate agent for a list of rental income statements from properties in the immediate area. Highlight those that are similar to the property of interest (# of beds/baths, sq. ft, general appearance, amenities, etc). This can be very easy if a subdivision has identical homes, or rather difficult if the area is diverse (socioeconomically, and building type). Pay close attention to location nuances; depending on your target renter you may note public school district boundaries, busy streets, parks/stores/entertainment, nearby colleges etc. Try to compare the differences between your potential investment and the similar homes. Keep track of positive and negative characteristics and do your best to estimate rental income.
• Use the 'Rent Zestimate' from Zillow.com. Zillow provides a range for this estimate; the smaller the range, the more certain the Zestimate is. Keep in mind Zillow may not have complete or accurate information about the property. It's up to you verify the statistics Zillow presents. Hint! If the information on Zillow is not current, your seller's agent is inexperienced or an old timer. Either way, the audience of potential buyers for the property is smaller and you may be able to negotiate more aggressively.

Once you have estimated the rental potential, it's time to correct the figure for vacancy and management costs. If you plan to manage the property yourself, do not correct for management. Management costs range from 8 to 12% of rental income on average. Skimping here may result in unruly tenants, more vacancy, and unchecked maintenance. Paying a premium may save you in the vacancy and maintenance department. 10% is a good rule of thumb for initial calculations. Vacancy should be expected and projected as well. Rule of thumb: 7% (about 1 month a year). Therefore, if you estimate rent to be $1,000 a month, multiply by .9 and then by .93 to obtain $837. Sobering, but if you calculate conservatively your risk will be mitigated.