You’ve undoubtedly noticed that real estate prices are ridiculously low (in some areas of the United States) as are interest rates. On top of that, people have lost their homes in record numbers. That has been tough on a lot people unfortunately. But it has helped drive prices lower and create a great demand for rental real estate. All this comes together to make it a wonderful time to buy rental property.
I am not an expert in this field but I do own several rental properties and (more important) I’ve worked with clients who own or owned rentals as well. As a result I’ve seen what works and what doesn’t both from a personal and also from a professional standpoint. If you want to own rentals, here are the top 5 tips to maximize your profits and minimize your pain.
1. Smaller is Better
No matter what, do not get in over your head. You must plan for unexpected costs like big repairs and long vacancies. If you are buying distressed properties that have been vacant for a long period of time, things are going to start breaking as soon as people start turning them on. That has absolutely been my experience with my own rentals.
These “unexpected” outlays aren’t a problem if you have a small enough mortgage. But if you have a large mortgage and are suddenly hit with a big negative on the profit and loss statement, you’re going to have to scramble. If that cash squeeze is prolonged, where are you going to find the cash to make that mortgage payment?
Cash flow is the biggest reason why people lose properties to the bank. Don’t let this happen to you. My rule of thumb is that a property must return 7 % at the very least in order to compensate me for the risks described above. If you can’t buy property to return at least 7% on your investment, keep looking.
How Do You Calculate ROI?
First calculate your net income on an annual basis. This is difficult to do exactly because you don’t know what all your costs are going to be. Just make sure to make reasonable estimates for those items you aren’t sure of. Here is a partial list of your expenses:
- Repairs and maintenance
- Vacancy
- Insurance
- Taxes
- Mortgage Payments
- Assessments
- Unexpected
Take a look at this Rental Property ROI Calculation spreadsheet. You can see that on the far left, you have an expensive property and the ROI is only 2%. In the middle, is an example of a property that you paid a little less for. As a result, your mortgage payments are lower and your ROI goes up.
On the far right is a property in a less desirable part of town (or State). The price of the home is much lower. Even though the rent is also lower, your ROI is through the roof. If you are capable of handling a property in a different location and with less pride of ownership, this could be a winner. But properties like these may expose you to more landlord liability so make sure you have the right property insurance.
You can always ask your realtor to run an ROI calculation for you. Even if you aren’t going to buy something right now, they will likely be only too happy to do his for you as a way to make a connection.
2. Careful Screening
The biggest complaint that property owners have is tenants. In fact, many people who are former rental property owners got out of the business precisely because they couldn’t stand dealing with whining tenants. There are three solutions to this problem.
- You can keep your property in tip-top shape and price it a bit higher than the market. Make it a shining jewel that high-quality tenants would want to occupy.
- Your second option is to go the other route. You can rent to Section 8 tenants. This is a government-sponsored program that actually pays the rent for economically challenged families. This program is not hard to get in to as a landlord. For the tenants, once they are accepted into the program they want to stay in it. And the tenants know that if they trash your place, they will be out of the program for good. Because they have so much to lose, they tend to be good tenants.
- The third route is to form a syndication of sorts with a group of friends and buy a bigger property that will generate enough cash flow to pay for good property management. I have participated in programs like this and I love it because all I have to do is cash my check every month. I never get any calls from the tenants. Life is good.
If you buy your own property, make sure you check your prospective renters’ credit score. If you have a property manager, they will do this for you.
3. Partners
Notwithstanding my comments above, be careful about taking on partners. Make sure that you have a written agreement that spells out who is responsible for what. I’ve seen too many business failures precisely because the wrong partners got together.
Unless you are going big-time syndication, get a smaller property and do it yourself.
4. Location
You’ve heard that location is the most important thing in real estate and it’s absolutely true. Don’t be tempted to buy a cheaper property that is off the beaten path. Spend more and get high-demand real estate. Again, go smaller if you have to but don’t buy real estate in areas that have low occupancy rates. Make sure you familiarize yourself with all the vacancy, crime, pricing and school statistics in the neighborhood. No shortcuts.
5. Income, Not Appreciation
This is purely my opinion here, but I believe that real estate is going to be about income rather than appreciation for the next 10 years. I strongly suggest that you refrain from buying a property if you are doing so because you think the prices are going to pop in the next 2 or 3 years. Of course, they might but I don’t think it is a wise wager.
When you are considering a purchase, focus entirely on cash flow and return on investment. If the appreciation comes, so much the better. But you will be much happier if you evaluate the investment on an income basis only.
What has your experience been with rental properties? Are you buying now? What are you looking for? Do you think appreciation is just around the bend? Why?
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Neal Frankle found himself in a financially fragile situation at the age of 17. Both his parents passed away while he was still in high school, leaving behind a small insurance settlement. Neal sought out a financial advisor to help him invest his nest egg so that it would help put him through college. Instead, the advisor charted a self-serving course and was on the verge of burning through the money when Neal realized what was happened and fired him just in time to avoid losing everything.
The experience had a deep impact on Neal and formed in him a lifelong desire to help people learn to make smart financial decisions. Today, with more than twenty-five years of experience in the financial services industry, Neal is an author and avid blogger. To learn more, visit Wealth Pilgrim.
I think the most important thing is to know your local tenant laws. They can vary by city. For example, one of the towns near me requires a $10,000 deposit with the city for each rental. Another one has a $25 inspection fee between each tenant rental. You don’t want to get in trouble or fined by the city.
I think if you can handle the taxes and insurance, go for it. It can lead to a nice side income.
As a former rental property owner, appreciation is income. Rental properties are valued based on income, although a single family house, condo or townhouse is not. Duplex or triplex will be valued based on income.
Location is an extremely important aspect to factor in. All states have different laws, some much harsher than others. A small rental property will be much more difficult to maintain in New York City than in PA given NYC’s very strict rental laws.
Thanks for the helpful insight. We are just starting out. If I could add one thing, it would be to find an honest & wise mentor. We haven’t yet, but are keeping our eyes peeled. I would be interested to get your take on seminars that teach people how to invest in real estate. Their claims about getting rich quick sound too good to be true, but they are very tempting. I have one in mind if you aren’t sure what I am talking about. I won’t post the name here, but feel free to email & ask me for… Read more »
What are your thoughts on buying residences within areas where the Baby Boomer generation already are and will be moving to (i.e. Florida)?
I happen to own property in Florida and I love it!!!
Nice. My parents were looking at buying some properties down there with the thought of providing places for all the snow birds.
Good, comprehensive article. I like the point about investing in a property and keeping the cash flow and ROI aspect in mind. In terms of covering for the unexpected, you could consider taking out insurance to cover for loss of income depending on your individual circumstances.
Real Estate Investing if done right is a great way to increase your returns, and after some years of experience I expect at least 55% on mine. One of the key strategies is to look at the properties from a numerical perspective as opposed to the way you buy a home. I don’t even look at the house until the last step. I also want to clarify the situation to the seller to see how I can be of service to them. If I can’t offer value to them, I won’t be able to buy their house I have put… Read more »