Are you interested in investing in real estate? If so, the first thing that probably comes to mind is owning rental properties. This is certainly the most common and obvious approach to real estate investing. And indeed, it can be a great way to build wealth. You can purchase the rental property with a loan from someone else, and that loan gets paid off by the person renting the property. You pocket some extra money each month, and then years later you have a free and clear property that was largely paid for by someone else. Not bad.
Yes, owning rental properties can be an excellent means of generating long term wealth. But being a landlord is not for the unprepared or faint of heart. There are a lot of potential gotchas with renting out properties, and it pays to be aware of them before you become a landlord. I will identify a few things that you should consider below.
Gotcha #1 – Cashflow
First, let’s talk about numbers. When you have a rental property, the goal is to make money, so you better know the numbers. When you’re calculating how much money you’re going to make each month, you just take the monthly rent and subtract off the mortgage payment and that gives you your monthly profit, or cashflow. Right? No, wait, we’re missing a couple of things. You also have property tax payments that have to be made. Maybe you don’t make these payments each month, but chances are the property tax payments will eat into your profit by no small amount. Oh, and you need insurance on the house, too. (And it needs to be landlord insurance, not your regular homeowner policy.) So that reduces the profit. Okay, so now we have rent minus the mortgage (principal and interest) minus tax minus insurance. So, that’s your profit per month. Profit = Rent – Mortgage – Taxes – Insurance. Right?
Well, not quite. It’s not really reasonable to assume that a property will be rented out in perpetuity, that is to say rented out for as long as you own it, with rent payments always coming in and with no vacancies. In fact, it’s not unreasonable to conservatively assume that you might have one month of vacancy each year due to tenants leaving the property. This would be one month with no rent coming in. Also, you may have a tenant that just stops paying. That obviously eats into your expected rent, too. And you may have to give incentives or concessions to get new renters. That reduces your expected rent income as well. Let’s just call all of these things Rent Loss. So, let’s treat this Rent Loss as a type of expense and subtract that off of our profit. Now our monthly profit formula becomes: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss. Okay, now we have our profit formula and can move on.
Wait a minute, not so fast. Let’s not forget that the house doesn’t just sit there in perfect condition year after year. It needs maintenance and repairs over time. We better estimate those costs and average them out over time so they don’t shock us when they come up. A new roof or AC unit can really take a bite out of your wallet. So, now we’ve got: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss – Repairs. That profit expectation is starting to shrink, isn’t it?
But we’re not done yet. There are other expenses, too, like legal fees, bookkeeping and accounting costs, eviction costs, lawn maintenance, etc. Well, that stuff shouldn’t be too bad, should it? Hmm. It certainly shouldn’t be overlooked. So now we have: Profit = Rent – Mortgage – Taxes – Insurance – Rent Loss – Repairs – Other.
Okay, so how much are these costs really? Well, a great quantity of research has shown that over a long-term holding time, the expenses on rental properties (not counting the mortgage) average out to be about 50% of the market rate monthly rent. This is referred to as the 50% rule. Sounds high, right? Yeah, it is. And it may be less in some cases, but may be more in others. You really need to calculate all of your expenses and make sure you have a buffer for big ticket repairs when they come up. The 50% rule is a quick way to estimate all the expenses. And as you have no doubt realized, these expenses greatly affect the monthly profit. Our Profit formula now becomes: Profit = Rent – Mortgage – 50%Rent. Ouch. This means if your rent is not at least twice the amount of your monthly mortgage, you’re very likely going to lose money over time. So, if you think it’s great that you’re renting a house out for $1000 and you’re mortgage payment is only $700, you are likely going to be in for a very painful lesson down the road.
The bottom line with evaluating your monthly profit (or cashflow) for a rental is you better make sure you know your numbers before becoming a landlord. You don’t want to have to rely on the price of your property going up in order to make any money.
Gotcha #2 – Maintenance and Repairs
I mentioned above that you should expect that you will be dealing with repairs to the property over time. The more time passes, the more repairs and updates you’ll have to do. When a tenant moves out, you may find that you have to paint and install new carpet. Or repair small holes in the wall. Or replace the cabinets that are now disgusting. Or replace the faucet that the tenant broke. Or the door that was knocked off its hinges.
Speaking of tenants causing damage, you better get a good security deposit up front. And additionally a pet deposit for that dog the tenant is moving in.
But even if the tenant takes good care of your place, stuff just gets old and breaks down over time. Toilets seem to always have issues. Water heaters only last about 10 years. Roofs take a beating from the sun and weather. Air conditioners are good for around 20 years if you’re lucky, and need maintenance over time. Fixtures and faucets get worn out. Door knobs break, appliances fail, garage door motors die. And stuff just gets old, ugly, and less desirable, making your property less attractive to renters. You can’t expect that your rental property will not need significant work over the time you own it.
Also, as a property owner, you have to be prepared to deal with emergency issues at a moment’s notice. Be ready for a call at 4 in the morning about a plumbing leak. And not all renters will be friendly in bringing up issues. Speaking of tenants…
Gotcha #3 – Tenants
While I’m sure you would love to hope that tenants in your properties will be trustworthy, upstanding, wonderful individuals with no problems that will affect you, that’s not living in reality. Some tenants will be great and some won’t. You should at least be mentally prepared for some of the headaches that tenants can cause you, especially if you live in a state where the laws are not friendly to landlords.
Some tenant problems are probably obvious, like causing damage to your property. This is one of the reasons for getting a security deposit from the tenant upon move-in and for having a landlord insurance policy on the property. And tenants sometimes pay late, so you need to determine your method for handling that. For example, you have to enforce late fees, but how much latitude do you give, and when do you ask the tenant to leave or file an eviction. But there are also innumerable other things you may have to deal with because of tenants.
Ever hear of a professional tenant? This is someone who is well-versed in tenant laws in your state. In other words, they know almost every way to screw the landlord and live in the property rent-free for as long as possible, causing you not only a loss in rent income, but also a pile of legal fees and headaches, in addition to possible damage to your property.
Here is one story of a professional tenant: http://blog.nj.com/njv_barry_carter/2011/05/carter_newark_man_acts_as_his.html
Here is an example of a nightmare tenant that was inherited with the purchase of a property: http://www.biggerpockets.com/forums/67/topics/64944-the-occupants-from-hell-
Anyway, the examples go on and on. The point is to be careful who you let rent your properties. This leads to another thing you have to deal with when landlording, …
Gotcha #4 – Screening Tenants
You wouldn’t just let anyone rent a property from you, right? So, what are your guidelines? How do you screen people? Who do you rent to, and who do you say no to? Well, it’s up to you. But you better know the laws and you better come up with a good consistent screening process that you stick to.
Regarding the laws, there are some protected classes, which means you can’t rule out applicants just because they are a member of that class. For example, you can’t turn away someone because of the person’s race. So, you need to make sure you’re in compliance with the law.
But what other criteria will you use to screen applicants? Will you do a criminal background check? Will you do a credit check? Do you consider previous financial issues, like foreclosures or bankruptcies? What about previous evictions? Do you check references? If so, how many? Do you look at where they live now? Do you consider things like tattoos? The smell of the person?
Again, it’s up to you to determine what your screening criteria will be, but it’s part of your job as the landlord, and it’s a process you have to go through for each applicant. Or maybe you could hire a Property Manager to both deal with tenant issues and tenant screening. Which brings us to the next thing to be prepared for…
Gotcha #5 – Property Managers
A Property Manager seems like a great solution to dealing with a lot of things that cause you headaches as a landlord. The Property Manager will deal with advertising that your property is available to lease, managing the tenant screening process, collecting rents, managing tenant issues, handling repairs that come up, and helping evict tenants. Great, so all you have to do is get a Property Manager, right? Maybe, but you have to really interview your Property Manager and also check up on them.
Some Property Managers add additional costs beyond the expected fee. They’ll charge extra for placing tenants, for example. Maybe that incentivizes them to turn over the property more, which is not a good thing. Or maybe they add hidden fees when dealing with repairs. Maybe that repair only cost $50 but you got charged $100. Or maybe they got a friend of theirs to do the work in exchange for some kind of kickback. Or maybe there wasn’t a repair done at all and you just got billed for one.
You also have a layer now between you and the tenant. Often this is a good thing, but sometimes it can lead to issues. Do you really know what the tenant is telling the landlord, or what the landlord is telling the tenant? For that matter, do you even know what rent the Property Manager is collecting. Maybe they are charging more for rent than they are giving to you. Maybe there are severe issues brewing with a tenant that the Manager is not telling you about. Maybe they are neglecting maintenance on the property, creating health or safety hazards and thus exposing you to a potential lawsuit.
Maybe they completely lied to you when you interviewed them. Perhaps that comprehensive tenant screening process they sold you on never actually gets used, and you end up with one bad tenant after another. Their claim that they regularly do physical inspections both inside and outside the property – are you confident that they’re really doing those?
Not all Property Managers are unscrupulous, but I’m sure you’ve been around long enough to realize that some will be, and that you need to be on your guard. And even for the honest ones, it’s not likely that anybody is going to care about your property as much as you, the owner, so you have to expect that you will never be perfectly happy with a Property Manager, and that you will still have to follow up on things. That takes me to Gotcha number 6…
Gotcha #6 – Umm.
I’m too tired from typing to come up with a sixth, but hopefully you get the point. Landlording can be a profitable venture and a good means for acquiring wealth, but it’s not without its share of potential issues. You need to make sure you do the math before you buy a property to rent out (or decide to turn your residence into a rental). You need to understand that you’re going to have frequent maintenance and repair issues. You’re always going to have to deal with tenant issues, from the screening process through their eventual departure. And even hiring a Property Manager does not free you from paying attention to what’s going on with your property.
In our business, we rehab homes, also known as fix-and-flip. We hear from a lot of landlords who are tired of dealing with their rentals. Often we get contacted through our website http://WeLikeHomes.com from people who want to sell rentals they have. Many times the properties need massive repairs, or they just haven’t been maintained, or the owner is sick of managing tenants or messing with other issues with the house. So just consider these potential gotchas to landlording before diving in. It can be simple to get into landlording, but it’s not always as easy to get out.