Hat tip to DOB for sending this along from the wsj.com – mistakes when buying rental properties:
Traditional investments are delivering low returns, and home prices are at bargain levels. Is it time to consider buying some rental housing?
Investing in real estate right now can be surprisingly profitable, if everything goes well. Rents are climbing in many areas, and more properties may be coming on the market. Last month, the Obama administration asked for proposals on how to convert at least some of Fannie Mae’s and Freddie Mac’s bulging inventories of foreclosed homes into affordable rentals.
Investors used to aim for rents that were 1% of the purchase price, or $1,000 a month for a $100,000 home—an annual gross return of 12%—says Michael McCreary. His firm, McCreary Realty, manages about 300 properties in the Atlanta area. Today, he says, some of his investors are getting as much as 2% of the purchase price.
In general, though, average returns after expenses are far less, more like 5% to 6% of the property value, says Ingo Winzer, president of Local Market Monitor, a real-estate forecasting firm. But that still is well above what many other investments yield.
Before you start scouring for deals, keep in mind that owning rental properties is time-consuming, expensive and fraught with challenges, and many investors lose money. You will want to avoid falling into one of these common traps.
• Mistake 1: Confusing a cheap deal for a good deal.
It is true that you can buy some homes for ridiculously low prices—but that doesn’t mean you can rent them out. Homes in deserted subdivisions aren’t any more appealing to renters than they are to buyers. The same is true for less-attractive properties or those in less-desirable school districts.
Investors from the San Francisco area often look at the Sacramento market assuming they can get Bay Area-like rents, and end up overpaying, says Robert A. Machado of HomePointe Property Management. He uses several resources, including the website FinestExpert.com, to estimate rents. Other experts suggest canvassing apartments nearby to see not just their rates, but whether they are offering special deals, like a couple of months of free rent.
• Mistake 2: Overlooking key costs.
Knowing the potential rent isn’t enough. Before you buy a property, you should also factor in closing costs of 3% to 6%, the costs to fix up the place and maintain it, and your holding costs. Then add the profit you expect to make (and more closing costs, if you intend to turn around and sell it). Only then can you figure out what you can afford to pay.
• Mistake 3: Forgetting that time is money.
In real estate, “time is your biggest enemy,” says David Hicks, co-president of HomeVestors of America, a franchiser whose motto is “We Buy Ugly Houses.” You lose money when your property is empty, whether you are painting it or between tenants. You also lose if you buy in the fall and can’t replace the roof until spring. You may be better off accepting a lower rent than waiting for a higher-paying tenant.
• Mistake 4: Assuming you will sit back and watch the rent roll in.
“When you become a landlord, you become a rent collector,” says Mark Kreditor of Get There First Realty, which manages 1,600 rentals in the Dallas-Fort Worth area.
Just like homeowners who can’t pay the mortgage, tenants lose their jobs and stop paying the rent. Evicting them can take several weeks, and some steal appliances or other property. Mr. Kreditor says that once or twice a month, a tenant removes a home’s copper tubing on the way out the door to sell the copper for its meltdown value.
You will need to screen prospective tenants carefully—or pay someone to do it for you.
• Mistake 5: Underestimating repair costs.
As with all homes, you will be making lots of repairs. You may find wood rot or mold when you remove that cracked bathtub. Carpet in rental homes typically must be replaced every five years, and you may have to repaint after every tenant. Tony A. Drost, president of the National Association of Residential Property Managers, or Narpm, suggests setting aside six months of expenses so that you will have funds if a major repair is needed.
• Mistake 6: Assuming that owning a rental is the same as owning a home.
You might put up with flaws in a home that a renter wouldn’t tolerate. In addition, many states and communities have strict (and complex) laws for landlords, even if you own only one property. A property manager can handle most of the headaches, but you should expect to pay one up to a month of rent for finding and screening tenants—and up to 10% of the monthly rent for management fees.
You can find property managers through the websites of trade groups Narpm and the Institute of Real Estate Management. In addition, many communities have local Real Estate Investor Associations, which can provide support.
Cap rates are too low to infest in rentals. Traditionally they have been north of 8% whereas now I see properties in San Diego trading at sub 4% cap rates. Better buy a 30 year bond and get the same yield hassle free.
Also, those low cap rates assume the units 98% rented, not turnover losses,and very low maintenances.
I know from experience, you get a bad tenant and your 4% cap rate soon become a negative -3%, a real money looser.
The ONLY time to buy rental property in California is when rents are going up and cap rates are going down. The ONLY time to leverage is when leverage is positive, i.e. the return on your money exceeds the loan rate.
I can’t think of a single market in coastal California where you can get any decent cash on cash return, even today. And although it’s nice to borrow at the current low rates, you still have to make money on the property somehow.
“The ONLY time to buy rental property in California is when rents are going up and cap rates are going down”
Well, rents seem to be going up and cap rates are very low.
Are you saying it is a good time to buy now or did I misread you and instead meant when cap rates are going up and not down?
California real estate values are still built on the foundation of appreciation. Values go up when cap rates go down and rents go up. If you are going to play this game, buy as the cycle turns to appreciation.
I’m getting 20% cash on cash
I think Jack is an example of why people with money (different than you typical ‘real estate investor’) are buying up houses around here – usually paying all-cash. When they compare the returns to what banks are paying, people get giddy!
But this article points out the additional costs that reduce the actual return. While Jack and others are elated with 20% returns now, all it will take is a bad tenant or leaky roof to lower them overall.
When appreciation was obvious, it was a no-brainer, and the reason prices went crazy on investment properties even thugh they didn’t pencil by the traditional methods. They still don’t, but it’s because the buyers have changed from appreciation-chasers to return-chasers.
Those who have experience with the pitfalls of landlordship can minimize the headaches. Reading an article like this will help, but typically the new chasers will learn the hard way.
The biggest lesson I have learned is to keep the rent reasonable to attract the most tenant-candidates, and, obviously, choose from the best quality. Missing a month or two of rent while replacing a bad tenant more than makes up for the extra couple of hundred dollars added in the beginning.
I also go montth-to-month so I can give them the boot if they don’t work out. A slow-paying tenant with a one-year lease will drive you crazy.
Do I need to mention the no-payers? I talked to a property manager friend in Tucson the other day who was telling me about the realtor tenant he has who went delinquent for a couple of months, then filed for bankruptcy right about the time that the eviction was to take place.
Jim. Those leaky roofs and disaster tenants are Write Offs and I need them bad. So it doesn’t matter
Ahhh, the voice of experience. As a wealthy (for South Africa – assets very slightly north of US$ 1 milion) property investor I charge 10 to 15% below market value rentals and PICK AND CHOOSE my tenants VERY carefully this is possible because I have lots of applicants due to the reasonable rents .
Having said that it is possible to become an overnight sucess as a property investor (it just takes 20 years and an awfull lot of painting, plumbing and wiring) I am essentially retired at 53 years of age, not from the proceeds of my job as a computer engineer but through PROPERTY, ask your parents what their first house cost and what they sold it for 20 years later bearing in mind the amount owing on the mortgage went down every year.
Inflation will decrease what you owe on your property while increasing what it is worth in terms of the US$ and Americans can claim depreciation against tax ( The South African version of the IRS says “Property depreciate? Dont be bloody stupid, You must be mad, give me my share of your capital gains”
I’m glad Jack, andrewa, and others have enjoyed the benefits of being a landlord!
But it’s everything it is cracked up to be – easy money when you have good tenants in quality properties (minimal repairs) in an appreciating market; but a nightmare on several counts when things go wrong – and they tend to go wrong at the same time!. Buyer beware!
Rental income is more about inflation protection, you can’t get that with a T-Note.
andrewa :
Ha ha. I too am a Computer Engineer
Jim. You got to have balls of steel to play this game. Money does not come easy and you need to take some calculated risk in life. Being a wuss will get you nowhere.
The number of properties in coastal San Deigo, Orange, and Los Angeles Counties that meet the 1% rule is very, very small. In the Inland Empire? Sure, there’s plenty. In Jim’s neck of the woods, maybe some in Vista, and that’s about it. But a million dollar house in most places will rent for maybe three to five grand a month, not the $10K that would be needed to meet the 1% rule.
Also, duplexes (including “two-on-a-lot” style properties (two houses on one property)) and fourplexes seem to pencil out a lot better than single family houses, in general.
“A slow-paying tenant with a one-year lease will drive you crazy”
Habitual late payment of rent is cause for eviction.
http://www.wassermanstern.com/articles/archives/articles_habitual.htm
10-4 on eviction eligibility, but the crazy part are their heart-felt pleas to give them a break, you know, with the economy and all and all they’ve been through and they are turning the corner it was just one bad month honest I’m caught up now and it’ll never happen again I promise…..
Need I say that all it takes to make your great 1% / month (maybe I should say my 1%/month) is to have your sweet tenant discover amphetamines (or a host of other life changing events). Then you, like me, can spend months getting them out while they trash the place. Maybe you, like I, will get a recycling reward for the several tons of accumulated junk that was left behind in your sweet little cottage. No free lunches! There’s risk in that higher return. Being a landlord isn’t like gambling, but make sure you can take a hit and continue smiling or you’re better off investing in something else.
I meant to say my 1% went out the window, but the sun will always come up tomorrow.
I was originally thinking of buying an apartment complex but the returns as others have stated here before are not that good in San Diego because rents have propped up pricing.
I would also consider buying 2-4 unit or even multiple SFHs although I was originally considered about higher maintenance cost per unit.
Are the returns any better on 2-4 unit properties or SFHs in San Diego county? If so, is there a reason that they would have better returns than 5+ unit apt complexes?
I haven’t heard one mention of mortgage paydown in this thread. With rates at 3.75% for 15 year mortgage, you don’t need to bank on apprciation to be a happy landlord. Put down 25% today and own it free and clear in 15 years–Especially great for those 30 somethings!
Being a landlord does not suit everyone, but one way to get started is when you decide to move up to a bigger place, hang on to your old place and rent it out if you can afford to.
Even if you can break even on a cash flow basis self managing, it is probably worth it. With fixed rates so low these days, it is a sound strategy to reduce your mortgage over time, take tax depreciation against your passive income, and learn if you like being a landlord with a place you know well already. Your beginner mistakes will be less costly, and you will be better informed if you want to launch into investing in additional properties. Rental income is a good inflation hedge, and cash flow will increase over time. If you have a long term outlook, the risk of unexpected problems can be minimized.
This is how I got started 20 years ago, and I think it is still a sound strategy for today.
I do too.
Everyone should move every 6-12 months – build the portfolio!