Investing in Residential Real Estate
Investing in Residential Rental Property
Real Estate is one of the best ways an average person can build wealth and produce income. There are many different ways you can invest in real estate; residential rental property, fixing up and selling, commercial rental, real estate investment trusts, development and so on. Today, I am going to talk about residential real estate investing – becoming a landlord.
Buying property and renting it out sounds easy. You’ve seen the infomercials and ads that paint a glamorous picture of sitting back, taking it easy while your rental checks roll in each month. These ads talk about buying, which is fun, and they talk about collecting checks, which is fun, but they leave out the 80% in between which consists of all the hard work, problems and frustration you will encounter getting from Point A to Point B. While there are lucrative benefits to owning a rental property, there is much to be done to get yourself into a nice position of earning income. I have learned from personal experience that investing in rental property takes passion, patience, consistency, and hard work.
Having passion means that you are not just in it for the money. Yes, money is the main factor, but if money is the only reason you are an investor, your properties and tenants will suffer. The passion I am referring to is a passion of providing a nice place to good people. When you care about people and are concerned about their welfare, you will provide a good, clean, well-kept unit to them; a place they are proud to call home.
Not only is this the right thing to do, but it is also the smart thing to do. I have seen many landlords who are only in it for the quick buck. They buy property and begin collecting checks. The only time the tenants see the landlord is when it’s time to collect the rent. When repairs are needed, they avoid phone calls. When issues arise, they make excuses to avoid dealing with them. This leads to unhappy tenants and damage to the property. This type of landlord will not make it in the rental business. A good landlord must have the time and willingness to deal with tenants whenever needed.
This is the number one question to ask yourself, “Am I prepared to deal quickly with all the issues (tenant problems, calls at night, flooded basements, burst water heaters, etc, etc, etc) of owning rental property?” If the answer is yes, then you may have the passion and desire it takes to make it.
To maximize your return on your rental investment you must have the time and be willing to do some of the work yourself. You don’t have to be a skilled plumber or electrician, but you should be able to paint, clean and perform small jobs like changing doorknobs and trimming bushes. Being your own property manager is also a plus when it comes to maximizing your return.
Depending on the type of property and location of the property, property managers charge anywhere from 10-40% of the rental income received. This is a huge chunk of your income that is going to someone else. Again, you should ask yourself a question: “Do I have the time and am I willing to put in the effort of managing my rental property?” If not, is this venture going to be worthwhile if I must hire a third party to do everything for me?
A good landlord must have patience; as in waiting for the right deal and right person. When you begin playing with the notion of purchasing real estate, the excitement begins to mount. You begin scrolling through the listings on the internet and making notes on the properties you are interested in. It’s a rush!
It’s so exciting that you want to run out and buy the first good deal you see. I can tell you from experience, don’t do it! There is almost always some downside to any “deal” you see. Get the facts and don’t be pressured into buying quickly. The euphoria will soon be placed by “Oh, no” if you don’t take your time and perform your due diligence before you buy.
Once you buy and have prepared the unit for a showing, you are now ready to find the person or family who will live in your rental. You must find the right tenant as this will be the biggest factor in your enjoyment of the rental business. Finding the right people is the key to long-term success. Now it’s time to get the word out about the availability of your unit. Market the property through social media outlets and other advertising venues pertinent to your situation. The moment is now here!
You are getting calls and responses from your advertising and people want to come and look at your property! You must get the right information from possible tenants, which includes starting with an application. The application shouldn’t be a long, drawn-out process, but a one or two-page document that gives you enough information to assess the potential renter(s) and his/her capability of paying the rent.
You want to know things like name, social security number, address, current landlord, phone numbers, current employer, income, nearest relative and phone number. You will also need to verify as much information as you can before you commit to anything. Patience is a must because it is very tempting when a tenant offers you cash on the spot before you check into their history. Take my advice, never rent to anyone on the spot. Always be patient and perform your due diligence before renting to anyone. You can find an application online that will fit your situation and tailor it to fit your needs.
This is your business so you need to give it the attention it deserves. Consistency needs to show up in many areas of this venture you have decided to pursue. Areas where consistency is a must:
- Communicating with tenants regularly
- Responding to maintenance issues quickly
- Addressing late payment issues quickly
- Being fair and consistent when dealing with applicants
- Keeping accurate income and expense records for tax purposes
- Staying organized with a file system or spreadsheet
- Educating yourself as you continue this new venture
In summary, I congratulate you on your interest in residential rental property and wish you the best if you decide to take the plunge. It is a big step but one that is worth taking if you believe you are up for the task.
Investing in Residential Real Estate Part II
In Part I of this venture, I discussed some of the characteristics you must have to be a successful residential real estate landlord. If you haven’t read Part I, check it out before reading this one. If you have already read Part I and you know you are ready to try this new venture, then read on. If you have the characteristics already discussed then you have the foundation for a long career in real estate investing.
I enjoy all facets of residential real estate investing, but the next part is what I really get excited about. While I enjoy putting the finishing touches on a house or duplex making it ready for my next tenant, I love the financial side of the business. All of the numbers I will be giving you are just guidelines as rental property prices range widely throughout the country as do expenses and income. The supply and demand of rental property, which affects the price of housing, also dictates your overall income and expense numbers. Here, I will be giving you some general guidelines on the numbers you should be tuned into.
Down Payment or Equity?
The question of a down payment or using equity will be your first decision and may determine whether you can afford to get into a rental property at this time. Banks will require that you come up with cash or property equity to put into this venture, especially if this is your first purchase. A bank will usually require a 20% down payment on an investment property or the equivalent of 20% in the form of equity. I’ll talk about cash down first. The 20% down payment will be figured from the purchase price or appraisal price whichever is less.
Let’s say the property you have decided to purchase appraises for the same amount as you purchased it for, which is $150,000. The 20% down payment required equals $30,000. As you are aware, many people don’t have that kind of cash laying around so what’s the answer? Equity. If you own a house or other real estate there is a chance you have equity that could be used to help you finance your new purchase. Equity is the difference in the amount you owe on a property versus the value of the property.
The difference may be enough to allow you to use this equity as additional collateral to complete the bank’s requirement. Of course, this comes with risk, as you are risking a property to buy another. This decision needs to be thoroughly thought out since your home or another valuable piece of property is at risk.
Purchase Price / Monthly Rent Amount – The 1% Rule
In general, I would like for you to think about the 1% Rule. This means that your monthly rent collected is equal to or more than 1% of the cost of the property. For example: Let’s say you are looking at a duplex and it costs $150,000 as mentioned above. Your rent from both units must be at least $1,500 per month to meet the 1% Rule. Assuming that you are 100% occupied, that comes to $18,000 per year in income. Of course, over time you may be 100% occupied at times, but not all the time. So the loss of rent would be your first adjustment.
Loss Of Rent / Vacancies
In hot markets, you can remain 100% occupied much of the time, but never figure 100% occupancy in your calculations. You want to figure no higher than a 95% occupancy rate for your personal calculations and if you need to pursue financing, be aware that bankers will use a 90% occupancy rate for their calculations. So, for this example, let’s use a 95% occupancy rate (also known as a 5% vacancy rate). Your annual projected income on this duplex is $18,000 x .95 which gives you $17,100 in income for the year. Next comes the actual expenses that are constant with rental property year after year.
Total Expense Figure / Return on Investment (Roi)
I want to start with the total expense figure because several of the expenses I will discuss will vary widely. Your 5% occupancy expense has already been deducted so you have a projected rental income figure to work with. As a general rule, you want your expenses to amount to no more than 35% of your total rent received. So let’s go back to our example:
Your projected rental income is $17,100. You take this figure and multiply by 35% ($17,100 x .35) which equals $5,985. This total expense figure will be subtracted from $17,100 giving you an annual Net Operating Income (NOI) of $11,115. This is the lowest total net income you want to receive on this property. For this example, your total Return on Investment (ROI) would be 7.41%. You get this number by dividing the NOI which is $11,115 by the purchase price of your unit which is $150,000.
Property Taxes & Insurance
The two biggest fixed costs related to any rental real estate are property taxes and insurance. Property taxes and insurance vary widely throughout the country so it is important to identify the amount of these before you buy. These two expenses will eat up much of your 35% allotment so the higher these expenses the more frugal you will need to be in other areas.
Property tax rates are set by each county and are figured on the value of the property. If the property is located inside the city limits, you will have county and city property taxes. If the property is outside the city limits then you will only have to pay county taxes.
You will also want to identify your insurance cost before buying a property. Insurance costs differ by company and costs vary within a company depending on the amount and quality of your policy. You may be able to deal with your local agent or you may be able to go with a company that specializes in rental real estate. Either way, make sure you request “Replacement Cost Coverage (RCC).” RCC is insurance that will replace covered damage on a dollar-to-dollar basis.
If you don’t get RCC, your insurance premium may be cheaper but if you have a claim, the affected areas will be depreciated and you will be paid on the depreciated amount instead of the replacement cost amount. Trust me on this one. I used to complain about the cost of my insurance until I had a fire. My insurance company was wonderful and paid my claim in full, including loss of rent. My insurance advice: Deal with an agent you know or a reputable company and always take the RCC option.
Other Operating Expenses
You have a little more control over operating expenses. While insurance and property taxes are considered fixed expenses, operating expenses fall into the variable category. These expenses include maintenance, small repairs, labor, advertising, cleaning, supplies, utilities, etc. The extent to which you choose to repair and maintain will depend on your financial situation and the condition of your unit.
Monitor your units and make repairs as needed. If you see a problem, don’t avoid it- get it fixed. If you don’t, the problem is going to get worse and your tenant will not be happy. If your tenant isn’t happy, you won’t be happy either. He/she will either complain constantly, stop paying or move out. You don’t want to lose a good tenant because of a repair or maintenance issue.
Capital improvements are larger, more costly repairs such as a new roof, new windows, new flooring, adding a room, new vinyl siding, etc. These larger items are not considered operating expenses but capital expenditures. Your rental property income may not be enough to cover these expenses, therefore you may have to borrow money or pay cash for these expenditures. You are injecting capital into your business, which means you are adding lasting value to your property.
I will use the example of the $150,000 purchase above. Let’s say you had to add a roof that cost $10,000 after you bought your duplex. Your investment is now $160,000. Your rental income is not likely to increase just because you had to replace the roof, therefore your ROI will be less. Taking the $11,115 NOI we discussed earlier and dividing by your investment of $160,000, you now have an ROI of 6.95%. I want to discuss capital improvements because I want you to know the difference between Operating Expenses and Capital Improvement expenditures
Lastly, it is a good idea to have a separate checking account and credit card for your rental business. Keep your business separate from all personal accounts. This will make it much easier when it comes time to do your taxes. Keep a ledger or spreadsheet of your income and expenses so that you will know where you stand at all times.
Your success as a landlord will be determined by how seriously you take your business and how much effort you put into it. I wish you all the best as you embark on this new venture. Real estate investing is an adventure worth exploring.