Home prices have fallen to multi-year lows, and can be as much as 60% below peak prices. Combine those apparent bargain-basement prices with low fixed-rate financing and the potential returns from becoming a landlord by buying rental properties starts to look mouthwatering.
Consider real estate web site Trulia's recent analysis of renting vs buying, which found that it would be cheaper to buy than rent in about 80% of major cities. Using their figures, you'd find that rents on a two-bedroom unit in Phoenix go for as much as $1,000 a month, but it would cost less than $100,000 to purchase the same unit.
Assuming you put $30,000 down and got a loan for the remaining $70,000 at 5.5%, your monthly mortgage payment amounts to a paltry $397. Add in $100 a month for property taxes, another $100 for insurance and utility costs, and another $100 for maintenance and repairs, and you're still collecting $300 more per month than you spend.
Your average annual return? 12% on the $30,000 in invested capital. Better yet, the renter is paying off the mortgage. If the home appreciates from here, you're really in the gravy. Let's say, for example, that home prices rise a mere 2% on average over the next 30 years. Your home will be worth $181,000 when the mortgage is paid off. Because the rent has more than covered the cost of the loan, your only cost is still the $30,000 you put in. Net profit (not including the income you've received each year): Roughly 500%.
That said, it can be tricky to find the right property and make the numbers pencil out, says Christine Karpinski, author of How to Rent Vacation Properties by Owner.
Here's how you do it, step by step.
Step One: Vacation or long-term rental? Pick one. There are advantages and disadvantages to each. Long-term rentals require less day-to-day management, since you're not constantly seeking new renters. But they also put you at risk of having a long stretch with no income.
Why? If you're unlucky enough to get a bad renter who stops paying and refuses to vacate, it can take up to six months -- more if you misstep -- to evict a tenant, says Adam Leitman Bailey, a New York-based real estate lawyer.
Vacation rentals, on the other hand, don't put you at risk of having an occupied unit with no income, says Karpinski. But they need to be furnished, tended, and must make economic sense when they're only rented for one or two weeks per month. Because they're unoccupied as often as not. The bright side here is that you can vacation in your vacation rental when it's not rented. The flip side: no rent, no income.
Step Two: Choose DIY or buy. If you buy a vacation rental, you'll need to do a lot of tending. These "tending" responsibilities may include buying and occasionally "refreshing" furniture and housewares; deciding on how to advertise your unit and executing that strategy; spending a few hours a week responding to emails and phone calls from potential renters; collecting deposits and rent; and arranging to have the property inspected and cleaned after every use.
There's less tending with a long-term rental, but you still need to screen tenants -- pulling credit reports and criminal records -- and collect rents and handle repairs.
Do you have the time and the disposition manage your own properties -- including getting phone calls in the middle of the night when a pipe breaks? (See related story: Six Signs You Should Never be a Landlord.) If not, you can pay a property manager to do it for you, but you give up a portion of your profit for the convenience. Typically, long-term property management services costs 10-15% of your rent; management of a short-term rental can range from 30% to 50% of the rent collected, Karpinski says.
Step Three: Research the market. Before you buy, you need to find out average rents in the area you're considering; the type of properties that are easy and difficult to rent out; and whether there are rules and regulations about renting that you need to know -- including whether there is a homeowner's association that restricts the ability to rent your unit. Local Realtors and property managers should be able to help, providing information about rental and vacancy rates as well as a condominium or townhouse's CC&Rs, which spell out the rules for shared housing.
If you're considering buying a property in a rent-controlled area, make sure you also talk to a local real estate attorney, Bailey says. Some communities put such tight controls on rents and evictions, that it can be difficult (if not impossible) to pass on rising expenses or evict troublesome tenants. That depresses both the income from your long-term rental and your ability to re-sell the property.
Step Four: Do the math. The monthly cost of a rental, like the cost of a home, will depend on the size of your down payment; how much you need to borrow; the mortgage interest rate; property taxes and insurance. MortgageGrader, a mortgage web site, offers great calculators that help with the monthly expense math.
Ideally, some or all of your monthly costs will be covered by renters, but you need to figure out the worst-case scenario -- not the best, says Bailey. Consider putting together a spread sheet that spells out the costs and returns at various rental rates; and assuming some vacancies.
Do you have the staying power to last for 6 months without getting a dollar in rent on at least one unit -- more if you're buying a building with multiple apartments? If not, you should build up that reserve before you buy. Without an economic cushion, you can lose both your investment and your credit rating at the same time.
Step Five: Factor in repairs & replacements: All household items -- from sofas to dishwashers -- have a limited useful life, Karpinski notes. When you become a landlord, you need to figure that everything from paint to plates will need to be replaced on a semi-regular schedule.
With a vacation rental you'll need to replace or recover sofas every two or three years, just to keep the place looking fresh, she says. Towels, sheets, plates, glasses and cookware are likely to wear out even faster. To be sure, its penny-wise to keep things as long as possible. But if you don't replace things when they're looking tired, you lose repeat business, which is pound-foolish.
What about long-term rentals? Dishwashers, stoves, air conditioners and refrigerators wear out too. Figure all major appliances will need to be replaced in seven-to-10 years. You'll likely need to touch up the paint every five to 10 years, or whenever you switch renters.
How do you plan for these irregular, but foreseeable, expenses? The best bet is to read the manufacturer's specifications on appliances to find out their useful life, then shop around to figure out the cost of replacements. Divide the replacement cost of each item by the number of months left in its useful life. Add the figures together and set aside the result in a repair/replacement reserve each month.
In other words, if the $500 stove will need replaced in two years; and the $2,000 air conditioner will need to be replaced in five, you add $21 (500 divided by 24 months = $20.83) and $34 ($2,000 divided by 48 months = 33.33) and set aside $55 each month to ensure you have the money available for replacements when something breaks.
Step Six: Hire a tax professional. When you move from passive investing to actively managing real estate, you open the door to a wide array of tax opportunities and traps.
Even if you're an avid do-it-yourselfer, this is one time it can pay to hire a professional to help. Make sure your tax preparer is experienced with small business and investment real estate issues. The right professional can save you a fortune.
Step Seven: Determine whether you have the right disposition. Sure, you know how to do the math and research prices and rental rates like a pro. But, do you have the disposition to be a landlord?
If you're not certain whether you could handle evicting a likeable tenant who can't pay the rent; if you're not detail oriented enough to remember to always do a thorough background check on your tenants; or if you're the type of person who can't imagine putting up with an investment that might literally call you in the middle of the night to discuss annoying problems, like a leaky faucet -- this is an investment that can make you personally and economically miserable.
Not sure if you have the right disposition? Check out our related post -- Six Signs You Should Never be a Landlord. If more than a few of these Six tell-tale signs speak to you, restrict yourself to buying rental real estate through Real Estate mutual funds and Real Estate Investment Trusts. You'll get similar profit potential with a fraction of the misery.
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