Your Finish Rich Plan - A Personal Finance Blog

Why I Still Love Real Estate Investing: Being A Landlord

Today, the financial website TheStreet.com published a short article titled Read This Before Becoming A Landlord. They offer the following facts and tips for the wannabe landlord:

• Your expenses: mortgage, property taxes, insurance, homeowner’s association fees (if any) and maintenance, should be at least 5% below the going rate for a comparable rental property in your neighborhood.
• The average landlord earns about $2,000 profit per unit each year, before tax.
• When looking for tenants, try the inexpensive, easy search methods first like Craigslist, as well as targeted word-of-mouth marketing (local schools, precincts, temples and churches)
• Request IDs and ask for references of previous landlords from prospective tenants and check them.
• Familiarize yourself with landlord/tenant laws, and make sure your lease forms are correct for your state. Be careful of tenants who bring their own agreement for you to sign in lieu of a standard landlord/tenant lease
• Keep the property well maintained. It’s the best way to ensure a good relationship with your renters
• Make sure your insurer knows that a tenant will be occupying the home. Change your coverage so you’re protected from injuries tenants may receive on the property as well as legal disputes from serving as a landlord.
• Hiring the services of a property manager to take care of the dirty work for you is an option, but make sure the manager is a good one. If he or she is involved in a crime on your property or if they steal from the tenants, your renters could take you to court
• Think twice before renting to people you know. Countless friendships have been lost because of missed rent payments or misunderstandings over repairs or lease agreements

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I’m a sucker for passive income. My idea of financial freedom is that of rental and dividend income totaling roughly twice my expenses, leaving me free to pursue other interests (which may very well be other money-making ventures). That’s why despite everything that happened in the real estate market the past couple of years (or maybe because of it), I want to be a real estate investor, and more specifically, a landlord. Historically, real estate has been a good long-term investment. I actually feel bad not being able to buy now, with prices being low.

Now I’ll agree that my father would have probably had a heart attack had I told him “I wanna be a landlord when I grow up”, but the fact of the matter is that many people have turned this real estate investing method into a full-time profession and many of them have achieved very comfortable lifestyles by doing this. For people who are looking for a second income source, becoming a landlord might be a worthwhile option. Investing in real estate, especially as a landlord, can bring very interesting returns.

As with any undertaking, there are risks and benefits. It is a good idea to analyze both before buying a property that can be rented out. Below is my list of pros and cons to keep in mind.

1. Constant income stream. You will receive your income month after month like clockwork as long as someone is renting your properties. That income can be used to make the rental property mortgage payment (unless it is paid for already). If the property has been paid in full, monthly rental payments can be applied to other uses, such as a college savings account, home repair fund, or a long-term investment for the future. The property also may provide tax deductions under certain conditions. Depending on where and how you bought the rental home, you may be eligible for city funds to pay back taxes or make sizable repairs before renting it out. A rental property is a good investment for the future, as it will appreciate in value over time and allow you to make a profit if you eventually sell it. Many investors start out with only one or two properties, and then improve their portfolio. Eventually, they have several properties that are all working for them simultaneously. In short, they derive a modest income stream on each property. That allows you to diversify your portfolio with investments other than stocks.
2. Freedom of time and work. Being a landlord is not like working in an office, you do not have as much work as a 9 to 5 would require. Even your upkeep responsibilities on the rental units can be handled by management companies who complete the maintenance work for you in exchange for a fee or generally 10% of collected rental income.
3. Leverage. You buy a property for $400,000, by putting $80,000 down. Should the price go up by 5% in a year, you benefit from a $20,000 appreciation while your investment was only $80,000, for a 25% return. Of course, leverage works both ways. If the price falls by 5% in a year, you will have lost 25% of your investment. Historically though, the trend has been upwards.
4. Due Diligence. Owning a rental property forces you to become knowledgeable about property upkeep and home repairs. No matter where you live or how involved you may be (or not) in caring for your own home, when you rent to others, you will have to understand something about repairs and maintenance, even if you hire the work out to be done by others. You may notice that you are more diligent about ensuring a good job is done and that you are charged fairly for the work.
5. Collateral. A rental property can be used for collateral if you ever need to take out a substantial loan. Hopefully you can use the rental income to pay for large purchases when you save it over a period of time. But if you must apply for a loan to pay for medical expenses, college, or another need or goal, a rental home can become the security for borrowing the money. It’s better to use the second home rather than your primary residence in case you should happen to default on the loan
6. Tax Advantage. Becoming a landlord can brings some considerable tax advantages. Favorable IRS rules are one big reason why so many fortunes have been made in real estate. There are generous tax breaks offered to landlord who rent out their properties. As a landlord, you can deduct mortgage interest and real estate taxes on rental properties. If you pay mortgage points, you must amortize them over the term of the loan (unlike points on a mortgage to purchase a principal residence, which can be deducted immediately). You can also write off all other operating expenses such as repairs and maintenance, utilities, yard care, homeowner association fees, insurance and so forth. The best part is that you can depreciate the cost of residential buildings over 27.5 years, even while they are increasing in value.
7. “Recoupment“. You also can let non-profit individuals, like missionaries on furlough live in the home for free and write off the rental value on your taxes.

As expected, there are a number of drawbacks of becoming a landlord too. Here are some of them:

1. Your property may generate negative cash flow, i.e. the income generated does not cover the mortgage payment, utilities (unless the tenant pays them), maintenance (like lawn care, painting, replacing broken windows, etc.), insurance, and taxes. Some property owners accept this, knowing that the rental’s value will increase over time, and eventually rental fees can be increased to cover these costs. Ideally, if you’re unable to put together the deal so that you at leas break even, this may not be a good time to consider becoming a landlord. Also, being unable to find a renter and having a property sit vacant means needing to have amount of cash flow to carry the property during times when the mortgage isn’t being paid by a renter. Always anticipate a two- to three-month vacancy when you set out to rent the house.
2. Responsible for the upkeep of the rental units. As a landlord, you can delegate the upkeep on all of the units that you are renting out, but you still have to foot the bill. This could be a major problem especially if you are renting out an old property that barely passing the housing code. Even though it is impossible to avoid every issue that may arise, you can cut back on them by investing and renting out a new property that has quality facilities that do not require constant fixing.
3. Tenant Abuse. Renters do not care for the place like an owner. Typically most rentals are trashed and require more money for upkeep than a comparable residential house. Some tenants carelessly use and abuse a rental property, leaving a mess for the owner to clean up when the tenants move. That’s when it is helpful to know and call into play landlord rights that may allow you to sue the tenant for costs to cover the extra work that will have to be performed because of their negligence. Some tenants get behind with their rental payments or even move out without paying the last few months’ rent. Although a landlord probably is entitled to sue for back rent in court, a tenant who is unemployed or who knows how to work the system may be unable to pay it.
4. Collateral Value Limits. Although a rental property sometimes can be used for collateral, the amount of security it can provide will be based on its current condition and fair market value, which may not add up to the amount of the loan you need. You can try fixing up the home and adding to its value, but the cost of doing so in sweat equity and purchasing supplies as well as paying any assistant helpers may offset the actual dollar value of the property for loan purposes. Also, securing a loan with a rental property means that if anything should go wrong with the loan’s repayment, you could lose the rental property without realizing a cent of profit.
5. Not getting paid on time. Many landlords depend on incoming rent checks to pay the mortgage or to get by each month. If they are not getting paid on time or worst at all, they are put in a bad cash flow position. This means that anytime somebody is late with their rent that you need to hunt them down and try to get the money that is owed. In other words, becoming a landlord also means that you also have to turn into a debt collector. Sometimes, this is as easy to do as making a phone call. In other cases, it may take you weeks or even months to collect your rent.
6. Liable for the safety of the tenants. When becoming a landlord you will be responsible if something happens to them due to your negligence. It is, therefore, important to know what you need to do as a landlord and follow the rules exactly who they are outlined.

My personal research has unearthed a couple more tips:

• You should form an LLC and protect your other assets in case any renter or visitor sues you.
• Before you bid on a property, explore the vicinity. An abundance of other properties for sale or rent could indicate an undesirable location. Regardless, a glut of units could make your search for tenants difficult.
• It’s vital to have some financial reserves for unexpected repairs.
• Should you choose to go it alone, remember that there’s the hassle of managing the paperwork, overseeing contractors, paying the ever-increasing taxes, collecting rents, and looking after the properties
• Even if you plan on having a company handle the management side of the property, it’s recommended to meet prospective tenants. Credit checks and references are always helpful, but a face-to-face meeting is the best way to gauge a person’s character.
• Check the local landlord-tenant court docket before you sign anyone to a lease, to avoid “professional tenants.” Such people persuade a landlord to enter a lease and then don’t pay rent. They know that it can take months to be evicted, so they live rent-free. Then they move on to another house, and the process starts all over again
• Run a thorough inspection of any property you’re considering buying, to avoid structural defects requiring routine repairs and replacements. They can wipe out your profits, and then some.
• Check out www.landlord411.com which has links to all fifty states’ landlord-related laws. Also, invest in a conversation with a real estate attorney who can walk you through your rights and obligations as a landlord. Finally, if there are any landlord associations in your region, seek them out and consider joining; after all, there’s power, strength, and knowledge in numbers.

Obviously, becoming a landlord is no walk in the park. Although it can look great from the outside, owning a second property and overseeing its use by tenants that you probably don’t know very well can lead to stress and possible financial consequences. On the other hand, real estate allows you to benefit from leverage, and offers diversification.

I’ve found that a general rule of thumb is selecting a property which will have a return on investment of at least 8% annually by having a strong positive cash flow. I wouldn’t want to be a landlord if the rent generated by the property did not cover the mortgage, insurance, and 10% maintenance costs. If not, it’s just a big waste of time and money, in which case I would be much better off investing in index mutual funds.

Technorati Tags: investing, landlord, leverage, passive income, real estate, tax

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