Investing in rental real estate looks like a great idea on paper. You just buy a place in a nice area, find tenants and let the cash roll in. However, there are some matters you have to consider before buying a property and putting a “for rent” ad in the newspaper. Here is a rundown of the pros and cons of owning rental property and a few tips on how to turn a profit as a landlord.
Advantages of Rental Real Estate
The advantages of rental real estate are quite substantial. One that is not listed below is the fact that when you own rental real estate, you own a tangible asset. You can paint it when you’re happy with it and throw rocks at it when you’re not.
Many people who feel uncomfortable investing in financial instruments have no qualms about investing in real estate. This is a psychological distinction, as a bad stock and a bad rental property are equally capable of losing money, forcing you to sell for a loss. That said, here are the advantages that show up on paper:
Current Income – This refers to the rent money that is left over after the mortgage and related expenses have been paid. Current income is basically monthly cash that you did not have to work for – your property produces it for you.
Appreciation – This is the increase in value that properties generally experience as time passes. Appreciation is not guaranteed. However, if you own a property in a stable area (cities like Santa Barbara), the property will likely increase in value over the years. Even properties in sparsely populated and less desirable areas may appreciate due to general inflation.
Leverage – Rental properties can be purchased with borrowed funds. This means that you can purchase a rental property by putting down only a percentage of the total value. Essentially, you can control the whole property and the equity it holds while only paying a fraction of its total cost. Also, the property you purchase secures the debt rather than your other assets. You may lose the rental property, but you shouldn’t lose your own home.
Tax Advantages – Your rental income may be tax free if you do not receive net cash flow after expenses are deducted. This means that your mortgage is being paid down and you own more of the total value of the property (rather than just controlling it), but you do not pay taxes on the money that is doing this for you. In addition to this, you can also pull out tax-free money by refinancing your loan if the property appreciates and the interest rates have fallen. Lastly, you may be able to avoid paying taxes on the sale of a rental property if you sell it and reinvest the money in another property (called switching or tax-free exchange).
Disadvantages of Rental Real Estate
For every upside, there is a downside, and rental real estate is no different. Rental real estate may expose you to the following:
Liability – What happens if a stair breaks under your tenant’s feet? With the increase in frivolous lawsuits and the unquantifiable nature of “emotional distress”, liability can be a scary thing. Providing someone with shelter in return for money puts you and the tenant in a relationship where both parties bear responsibility. You have to be certain that the property you are renting out meets all government codes.
Unexpected Expenses – What do you do when you pull up the basement carpet and find a crack that opens onto the abyss? It is impossible to prepare for every expense related to owning rental property, so there are bound to be some unexpected ones. Things such as boilers, plumbing and fixtures often need to be replaced and are not prohibitively expensive. However, faulty wiring, bad foundations, compromised roofing and the like can be very expensive to repair. If you can’t find a way to pay for repairs, you will be left without a tenant and with the grim prospect of selling the property at a significant discount. Also, as building codes evolve over time, lead paint, asbestos, cedar roofing tiles and other materials that passed inspection in the past may be reevaluated to your disadvantage.
Bad Tenants – No one wants to have to use a collection agency to collect overdue rent. Unfortunately, almost every landlord has a story that involves police cars escorting his or her tenant out of the property – erasing all hopes of getting the five months’ worth of overdue rent. Bad tenants can also increase your unexpected expenses and even hit you with a lawsuit.
Vacancy – No money coming in means that you have to make the payments out of your own pocket. If you have an emergency fund for the rental property, you will be able to survive long vacancies with little trouble. If you don’t have one, you may find yourself scrambling to pay the rent to the harshest landlord of all – the bank.
Minimizing the disadvantages of owning real estate is actually quite simple. While you won’t be able to eliminate the pitfalls completely, following these guidelines will take the teeth out of their bite.
Keep Your Expectations Reasonable – Have the goal of positive cash flow, but don’t expect to be purchasing a new yacht at year’s end. If you keep your expectations in check, you won’t be tempted to jack up the rent and push out good tenants.
Find a Balance between Earnings and Effort – Are you “hands on”, or should you work with a property management firm? Current income doesn’t seem so great if you are putting in another full-time shift working on your rental property. There are property management firms that will run your rental property for a percentage of the rental income.
Know the Rules – Federal and state laws outline your responsibilities and liabilities, so you can’t claim ignorance when something happens. You will have to do some reading; nevertheless, it is better to spend 20 hours in the library than in the courtroom.
Have the Property Inspected – One of the best ways to avoid unexpected expenses is to have the property inspected by a professional before you buy it.
Make Sure Your Leases Are Legal – If you make a mistake on the lease, you will find it more difficult to litigate if a tenant violates the terms.
Take the Time To Call References and Run Credit Checks – Too many landlords rush to fill a vacancy rather than taking the time to make sure the prospective tenant is a better option than an empty property. If you have time, you may want to drive by a prospective tenant’s current living space – that is what your property will probably look like when that tenant lives there.
Join the Landlords’ Association in Your Area – Joining an association will provide you with a wealth of experience as well as sample leases, copies of laws and regulations, and lists of decent lawyers, contractors and inspectors. Some associations may even allow you to join before you buy a rental property.
Make Friends with a Lawyer, a Tax Professional and a Banker – If you find that you like owning rental properties, a network including these three professionals will be essential if you want to increase your holdings.
Make Sure You Have the Right Kind of Insurance – After learning the rules, you will need to buy insurance to cover your liability. You will need the help of an insurance professional to select the proper package for your type of rental property.
Create an Emergency Fund – This is essentially money earmarked for unexpected expenses that are not covered by insurance. There is no set amount for an emergency fund, some say 20% of the value of the property, but anything is better than nothing. If you are getting current income from a property, you can pool that money into an emergency fund.
Investing in a rental property can be an excellent decision if you go into it informed. Consider these words from Donald Trump: “It’s tangible. It’s solid. It’s beautiful. It’s artistic … I just love real estate.”
Director, Luxury Homes Division
Professional Financial Planner
Keller Williams, Santa Barbara