Editor’s note: If you’re interested in investing in rental real estate, this article offers some insights. I’m not a rental real estate investor, so it’s nice to have some input from someone else on this subject. Let me know what you think in the comments, and whether you invest this way.
With rental prices skyrocketing and vacancy rates dipping across the country, residential real estate investments have become a popular option for savvy investors who want to capitalize on the rental industry’s booming success. In fact, according to the National Association of Realtors investors accounted for 15% of all homes sold in December 2015.
Individuals have found success with income-producing properties where a home is purchased with the intent of renting it out to collect passive income, finance the mortgage payments and build equity. This type of investment produces a substantial pride of ownership and accountability due to the tangibility in owning a physical asset.
Owning a tangible asset in the form of rental real estate is one of the reasons these type of investments have become so popular. Additionally, there are many other advantages and rewards associated with rental real estate. While real estate investments are lucrative opportunities, any landlord will be quick to tell you that rental management takes time and effort to generate a positive cash flow. As with any financial investment and business decision, researching the steps it takes to be a great landlord will set you up for success.
Rewards for Rental Real Estate Investors:
Appreciation – Overtime, real estate investors hope their asset will increase in value, known as appreciation. While you collect rental income to pay off the amount owed on the property, you can also expect the home to become worth more than you originally paid for it, increasing your net worth. Appreciation is not guaranteed, so it is wise to make investment decisions based on cash flow, not appreciation.
Tax Advantages – Nolo notes that rental real estate provides more tax benefits than almost any other investment. Landlords get to deduct items such as insurance, maintenance, and utilities from income, which homeowners do not. Other deductible expenses may include interest, property taxes, and deductions for depreciation.
Passive Income – Owning rental property allows you to collect rental income and use the funds to pay off debt and other expenses associated with the property. After the expenses are paid you can keep the remaining funds as income. Passive income refers to your monthly cash flow that you did not have work for.
Risks for Rental Real Estate Investors:
Like any financial decision, real estate investments come with their fair share of associated risks. Mishandling risky situations could result in bankruptcy, legal proceedings or losing the investment altogether. Often times a rental property owner cannot avoid the following situations, however, with proper planning you can mitigate the risks in order to manage them appropriately.
Bad Tenants – The right tenant can make or break your investment dreams, both emotionally and financially. Terrible tenant stories include renters who don’t pay rent, lie, steal, destroy your property, conduct illegal activities and worse. Unfortunately, evicting a tenant is a lengthy process if you want to do it legally (which should always be your top priority to protect your investment). Even if your tenant is in the wrong, you can significantly delay the process or even end up owing your tenant money if you do not follow the appropriate steps for evicting a tenant. Dealing with bad tenants can be expensive and stressful, causing mismanaged properties to become a negative investment experience.
Maintenance – Landlords who reinvest a portion of their rental income into performing monthly maintenance will can keep their properties in great condition and their tenants happy. Maintenance expenses tend to average out overtime but a smart investor will create an estimated budget in order to prepare a reserve fund to cover unexpected bills.
Property maintenance for rental properties includes seasonal & routine maintenance, emergency maintenance and regular maintenance associated with owning a home and protecting your investment. Landlords are legally required to keep their rental property in a habitual condition for their renters. In most cases this means fixing appliances when they break, replacing roofs, repairing damaged structural features, managing pest invasions, and eliminating mold or other toxins.
Vacancies – Even with record breaking occupancy rates making headlines, there will be times when a rental property sits vacant. Even one month without a tenant, is one month with zero income coming in which could lead to negative cash flow without proper planning. If your property remains vacant for more than a month, your expenses could become unmanageable, as your front the cost for paying the mortgage, property taxes, insurance and other monthly expenses out of pocket.
When a tenant moves out of your rental property, not only do you miss out on monthly rental income from the unoccupied unit, but the costs can continue to add up when you factor in the additional steps it takes to get your newly vacated unit rented again. Stay ahead of expiring leases and start marketing upcoming vacancies before your current tenant moves, so the vacancy period is as short as possible. You should also conduct regular property inspections so you can plan ahead for turnover maintenance and keep costs down.
How to balance it all:
The best way to ensure the rewards outweigh the risks when expanding your investment portfolio with rental real estate is to take the following steps.
Get Familiar with the Numbers – A smart investor understands that the equation for positive cash flow from rental property is more than (rental income) – (mortgage payment) = money in the bank! Your initial investment should include an adequate reserve fund that you keep separate from your rental income and expenses. You need to have enough money to cover the unexpected like broken appliances, property damage, maintenance emergencies, and vacancies. It’s important to familiarize yourself with all the numbers before purchasing as well as throughout owning the property to keep your investment on track.
Learn the Laws – Laws pertaining to rental housing are established to protect both parties of the landlord-tenant relationship. Knowledge of and compliance with federal, state, and local regulations is crucial for both landlords and tenants. You can be sued for not obeying laws and ignorance is not a viable defense.
Nolo provides a great starting point when conducting your own research on state landlord-tenant laws. The U.S. Department of Housing and Urban Development (HUD) is responsible for regulations covering discrimination and other federal issues affecting your tenants. You can also check with your state real estate board or join a local professional agency for property managers or landlords who should be able to provide guidance on state regulations.
Save Money – Prepare for the unexpected and make sure your reserve fund can cover the cost of emergencies, property maintenance, and vacancy. Wells Fargo suggests that “Most homeowners need to spend 1% to 2% of the purchase price of their home every year for routine maintenance projects, such as window replacement and roofing repair.” Another way investors calculate a budget for rentals, involves the 50% rule. Brandon Turner for BiggerPockets explains the 50% rule is simply to allocate 50% of your rental rate for operating expenses.
Screen Your Tenants – The trick is to be selective with your legal tenant approval process, set the right rent amount, and provide a nice property that good tenants want to live in.
Landlords have the legal right to approve tenants based on income, rental history, debt to income ratio, and other factors that are verified in rental applications and tenant screening reports. Tenant screening is designed to help landlords make smart and informed decisions about tenants to protect their investment property.
I always advise landlords to run a credit check to assess an applicant’s bill-paying behavior and to get a good look at their debt to income level. If an applicant has outstanding balances and collections against him, what’s to say he won’t fall behind on his rent too?
Be Ready for a Full-Time Second Job (or to hire someone else to manage it) – DIY landlords will quickly discover self-managing rental properties requires a significant time commitment. Property maintenance, inspections, rent collection, and application processing will take up a big chunk of a landlord’s time.
While a low maintenance tenant can be a breeze to manage, even a rent paying, responsible tenant will have maintenance emergencies that make you get out of bed in the middle of the night.
A majority of landlords have seen tremendous success in self-managing their rentals with helpful tools like property management software that automate administrative tasks. Alternatively, rental property owners can hire a property management company who will handle all of the management duties for a flat fee or percentage of your monthly rent (ranging from 7-15%).