By: Eveline H. Brownstein (c)
The real estate market is at a low for prices and a high for inventory. This is, according to many, the “perfect time” to invest in income-generating real estate. Many articles are encouraging people to invest in income real estate, like this Wall Street Journal report which suggests that retirees can benefit from become landlords in owner-occupied rental properties; or this MSN article with five tips to get you started. In all of the articles I have recently read, few have detailed the dangers that may lurk in not carefully planning your strategy.
At the very height of our recent real estate boom, before the start of what is now being referred to as “the Great Recession,” many people looked at the speedy accumulation of equity in their homes as a handy “cash register” for investing. Sadly, many of those same people not only now find themselves without equity in their homes, but many of them find themselves also without those homes. The bursting bubble was predictable if you were someone like me with four generations of real estate professionals in her family and a history of great investments by generations that came before; but it is easy to see how people with very little real estate experience might have failed to see what experience had taught me was coming.
Despite many articles being written, to the contrary, now is not the best time for everyone to buy rental income properties and, for some, it may never be appropriate. There are, nevertheless, some smart strategies for buying rental properties. Here are my strategies:
- Start with a plan. As mundane as it sounds, having a written plan for purchasing rental income property is essential. Your written plan should detail your strategy for acquiring the property, renting it and paying all of its expenses. It is (and it will become) a business, like any other. All good businesses start with a business plan and rental income real estate is no different.
- Purchasing rental income property is not the same as flipping houses. Some people decide to buy distressed properties, renovate them and then instead of selling them, decide to rent them out. This is not a plan to own rental income property. A plan to own rental income property should include the realization that even in the best of circumstances, the return on such an investment will not be realized for at least ten years or more. You will be committing yourself to owning a rental property for a minimum of ten years and to managing and maintaining it for this period of time, or longer.
- Don’t use the equity in your home to buy a rental income property. Assuming you are fortunate in this real estate climate to still have equity in your home, that equity is part of your good credit. Actually, it always has been; however in the recent real estate boom, lenders seemed quite uninterested in credit worthiness and some were lending without proof of income or ability to pay. I believe that the equity in your home is better used as a short-term loan, that you can quickly and easily pay off, should you need it for emergency repairs to a property, or to cover a mortgage payment or two in the event your rental is vacant for a couple of months. Read the terms of your home equity loan very carefully for restrictions regarding what is possible and seek the advice of a loan specialist.
- Don’t buy rental homes in wealthy neighborhoods. There are two reasons why this is a poor decision for the average rental property buyer.
- Most people who live in wealthy neighborhoods own their homes. Neighborhoods where there are a majority of owners are highly desirable and, as a result, the price of these homes is usually high. Therefore, the price of the home you will be buying will be very high, in relation to the monthly rental that you will be able to charge. Two fairly-priced homes in a middle-class neighborhood, when combined, will often generate the same (and sometimes more) income than the single home in the wealthy neighborhood. Always keep in mind the risk of vacancies which will result in you needing to come up with the mortgage payment. While it is possible, it is less likely that both homes will be simultaneously vacant, meaning you will only have to come up with 50% of what a more expensive home will require.
- Higher rental homes can stay vacant longer due to the high cost of moving into them (first month’s rent plus security deposit can run tens of thousands), forcing you to come up with a very high mortgage payment to cover payments due during vacancies. Once again, purchasing two homes in a less expensive neighborhood will spread your risk and help minimize the length of your vacancies.
- Buy income properties in family-oriented neighborhoods. It has been my experience that family-oriented neighborhoods offer amenities that appeal to the widest variety of renters, regardless of whether they have families or not. The populations in these neighborhoods also appear to be much less transitional, leading to community continuity and some predictability regarding neighborhood desirability over the long-term.
- Buy properties in neighborhoods with lots of opportunities for work. If I had to choose ONE tip for where to buy rentals, this would be it. A few years ago, someone suggested to me that I invest in a neighborhood, “because it is growing.” Never one to pass up the chance for a new investment opportunity, I traveled to the area to take a look for myself. I spent a number of days there, speaking to the locals, visiting the neighboring areas, speaking to realtors and looking at houses. Finally, in bewilderment, I asked the realtor what jobs there were in the area. All I had seen were a number of service-related jobs and lots of restaurants. The realtor responded that there was a university nearby. Needless to say, despite the growth that was going on, this community did not fit my requirements for a good place to purchase rental income real estate. People will always move into an area where there are jobs and no more so than right now, when our unemployment rate is so high. You want to rent to gainfully employed individuals and they are where the jobs are. A university is a great place to work, but I don’t know of any university that can employ everyone in a neighborhood. A desirable neighborhood has many different industries represented in it and offers job opportunities to people in all strata of the worker population, not just one or two.
- Research the neighborhood diligently. With the internet being a primary source of information, it is very easy to research a neighborhood before you buy. Know what the neighborhood offers to residents, but also know what might make it undesirable. Know what the market rate is for rents in the area. Make sure that the property you buy is properly priced so that the rent you receive represents a good return. There are several formulas for determining this. Most involve figuring out how many years it would take for you to realize a break-even return on your investment. Sperling’s BestPlaces.net is one of the sites I frequently use to research a neighborhood, but don’t forget that a visit in person can tell you what an online website cannot.
- Two homes are better than one, and three is even better. All investors and their advisers will tell you to spread your risk among investment opportunities. The same can be said for real estate. I am not an investment adviser, so I am not able to give investment advice, but spreading your risk when buying residential real estate makes sense. If you are able to buy two properties, instead of just one, then two will spread your risk. The odds of both being simultaneously vacant are lower than if you have a single home. The strategy that worked for me was to buy one home free and clear and take out a small mortgage on a second home. The first home covered the deficits created by vacancies in the second and had the ability to save for itself, should it have a vacancy.
- Don’t be afraid to buy in affordable areas outside of the state you live in. Conventional wisdom has always been that if you are going to buy property for rental income, you should live nearby. This does not take into account the fact that the best places to buy may not be in your neighborhood, or even in your county. They may indeed be in another state. Of course it is unrealistic to expect you to manage a property from a distance, but that’s where really good property managers can be your best tool for getting the most out of your rental.
- Be committed to maintaining your property in tip-top shape. So you’ve bought a property and you have a renter. Now you just collect rents and pay the bills? No. A rental income property must have the same attention from you as the home you live in does. It must be properly maintained and not be permitted to go into a state of disrepair. A home loses its equity and its value quickly, when it is not well taken care of. To me, collecting rents from tenants obligates a landlord to maintain the home. When I was a realtor I often heard other realtors say, “You can tell this was a rental.” It meant that clearly rentals were not as well looked after as owned homes. It didn’t need to be a truth. Rentals can be looked after just as well as owned homes and can command the same price if the time ever comes to sell or finance it. Don’t lose valuable equity in your rental home by not taking care of repairs and maintenance, freshly painting it, keeping a pretty garden for great curb-appeal and tending to repairs promptly.
- Research your property thoroughly. The realtor you are working with may not know everything about the property that you will find important. Always verify what the realtor tells you (the contracts you sign with the realtor say as much) by doing your own research. Tax rolls and home values are available online on websites such as Zillow.com. You can also get a lot of information from the local City, either in person or online. Most of this information is publicly available. Spend the money to get a thorough home inspection done . Knowing what repairs will have to be made now, or in the future, will help determine if the purchase is a wise one. Look at the local flood map. Research the weather patterns for hurricanes, tornadoes, earthquakes, etc.
- Don’t forget to diligently do the math. There is more to rental real estate than just paying the mortgage and collecting the rents. Don’t forget the other expenses that will be incurred:
- Insurance. Rental properties must be insured, especially if you have a mortgage (the mortgagee will require it). A good policy will cover the loss of rents in the case of damage to the property and other unforeseen disasters. Set up the payments online to come out of your rental property account each month to ensure the policies stay in force.
- Repairs and maintenance. Depending on the age of your property, this will vary. Setting aside ten percent of your collected rents for repairs is a good policy. Don’t forget to add in the cost of normal maintenance for the property, for example, gardening (if the tenant is not responsible for it).
- Utilities. Renters typically pay for utilities, BUT don’t forget that you will need to pay for the utilities during the times that the property is vacant and being shown. Utility companies generally require a deposit from you to maintain an account in your name as the landlord for the property. When a tenant moves into the property, a utility will transfer the service to your tenant, but when the property is vacated, you will once again have to turn the utilities on in your name. Besides water and electricity, there are sometimes city expenses, like sewer and trash pick up charges. A diligent realtor will be able to get this information from the prior owner, so that you can properly plan.
- Property Taxes. Know your obligation BEFORE you buy. Understand the tax collection policy for the neighborhood, when taxes are due, how and when they are billed. When I lived in Los Angeles, taxes were billed April 1 and December 1. They were due in full, December 1. They were very easy to forget. In Arkansas, my taxes are billed once a year and are due the month of the anniversary of when I purchased the homes. They are also easy to forget, if I am not diligently putting the money aside for them. In New Jersey, they are billed yearly and due quarterly…not so easy to forget. Make plans to set the taxes aside from the collected rents from every collected rent payment. I have found that the best way to handle this is to set up a separate bank account from where the taxes are paid and into which anticipated tax monies are regularly deposited.
Buying rental income real estate can be very rewarding and for many it is a passion and a full-time job that they love. Careful planning and attention to some of the more frequently overlooked details can make it a successful business venture, as well.