You’ve decided you want to invest in rental properties.
There are so many benefits to rentals, including cash in your pocket each month, tax benefits, equity building, and most importantly it’s passive income!
So you know you want to invest in them, but where do you start? You probably know to “find a house undervalued” and “rent it out” and “boom you make money”. Well, okay, that isn’t necessarily wrong but there is a lot more that goes into the success of a rental property than just buying a house at a good price.
When I first started buying rental properties, I had no idea what factors are truly important in ensuring financial success. Had I known, I could have saved thousands of dollars in losses over the few years I’ve had my properties!
The caveat I throw out here is that if you buy a rental property that goes against any of my suggested risk factors, it is not to say at all that the property won’t be a success. You have to look at risk vs. reward as a spectrum, of sorts.
On one end of the spectrum you have super high risk but high return. On the other end of the spectrum is minimal risk and lower returns. On neither end of the spectrum, or anywhere in between, is any particular result guaranteed.
You can most definitely have financial success with a property caked in risk factors, however the chances of success are much lower (and with a lot more headaches). You increase your chances for success as you move up the spectrum towards the lower risk side, but even at that end it’s not to say you will always have success either. You just have much better chances of it.
So what are the actual factors that can hurt your rental property investment?
How to Invest in Real Estate While Working a Full-Time Job
Many investors think that they need to quit their job to get started in real estate. Not true! Many investors successfully build large portfolios over the years while enjoying the stability of their full-time job. If that’s something you are interested in, then this investor’s story of how he built a real estate business while keeping his 9-5 might be helpful.
5 Ways to Lose Money with a Rental Property
1. Price-to-rent ratio.
This term refers to how much it costs to purchase a property versus how much rent it can bring in. If the price-to-rent ratio on your property doesn’t work, you will consistently lose money every month. For example: an Atlanta property purchased for $95,000 that rents for $1100/month vs. a Los Angeles property purchased for $460,000 that rents for $2250/month. If you run those numbers, the Atlanta rent will easily cover the mortgage and expenses and then even leave some extra in your pocket each month. The Los Angeles property rent, however, will doubtfully even cover the mortgage each month much less any of the expenses.
See the difference between the two? The difference is the price-to-rent ratios. If you buy that Los Angeles property, or any other high-priced property whose rents don’t cover the expenses, you will lose money all day long.
2. Bad tenants.
Assuming your price-to-rent ratio is intact, the next fastest way to lose money on a rental property is with bad tenants. Worse than ending up with bad tenants one time is ending up with bad tenants consistently. Most people think they understand this, but it seems like everyone attributes the loss from bad tenants to having to do excessive repairs on the property after they leave (which is certainly what I thought too). The repairs can end up costing a lot for sure but often worse than repairs is vacancy.
The scenario – bad tenants decide to up and stop paying rent. They inevitably give some bunk excuse, but regardless, you have no income coming in.You, or your property manager, file for the eviction immediately but even in the states where the eviction process happens “quickly”, this will still take some time. The tenant stops paying. The eviction is filed and a court date is scheduled for likely a month or so later. After the court date the tenants still have another week or so to pay their debt. If they don’t pay, a writ has to be filed – in some counties you have to wait for the sheriff to escort the tenants out! And even then it may take 1-3 months to find new tenants, all after paying money to clean up and repair the house to make it rent-ready again.
All of that can easily be 4-5 months of no rent coming in (and that is only for a landlord-friendly state who does fast evictions! Never mind the states that are tenant-friendly and take months to get the tenants to court and out of the house). Or maybe your tenants spared you all that trouble by just leaving the property with no warning (but of course they steal your appliances on their way out). Even then, you are still looking at 1-3 months of vacancy while you look for new tenants.
If you have a mortgage on the property, you have to continue to make those mortgage payments every month regardless of whether you are getting income or not. That can be rough! Nevermind the thousands in lost rents, but you are also spending potentially thousands on the mortgage and other expenses. Repairs are the least of the worries with bad tenants in comparison to the detrimental expenses of evictions and/or vacancies. No doubt, bad tenants are the fastest way to lose money on a rental property.
While I just let repairs semi off the hook as being a culprit for costing you money on your rental property, I’m bringing them back on the hook. Yes, tenant damage can definitely cost you money (always check with your insurance policy and see if it covers tenant damage), but general maintenance of a property can cost way more. I’m talking roofs, HVAC systems, wiring, siding, appliances, flooring, anything. Anyone who has ever owned a house, whether for themselves or as an investment property, knows how much these things can cost. Thousands! Not to say a newer property won’t have any of these problems, but the older the property you buy, the more you better expect to dump into maintenance quicker. It can be brutal.
4. Declining market.
What happens if the market you invested in starts declining? Maybe a major industry goes out of business or a natural disaster hits, who knows. Or maybe it’s just consistent population decline. Either way, the value of your house will drop. The good news is the value of a house doesn’t matter if you aren’t trying to sell it, but if you suddenly need to sell or maybe you have a financing issue where you really need to refinance (like if you have an adjustable-rate mortgage that jumps, knocking out your cash flow each month), you might be hosed. Let’s take the example of needing to sell. If you have to sell for much less than you bought the property for, you could lose tens of thousands (or more).
Or, let’s not even think of the value of your property. Let’s think about a declining population causing a decrease in market rents, forcing you to adjust accordingly and causing you to suddenly lose money every month because the income isn’t high enough to cover your expenses anymore. Or maybe people just stop wanting to live in that area, or never wanted to in the first place, so you can’t find a renter. But you are stuck still paying the mortgage if you have one and property taxes and insurance. Money will flow out of your pocket faster than you can count the bills.
5. Not using a tax professional.
One of the biggest financial advantages to owning rental properties is the tax benefits. If you do your taxes correctly, you are likely to set yourself up so that the income you earn on the properties ends up being (essentially) tax-free and then you may even get more money in tax benefits on top of that. If you own one rental property, maybe I would be okay with you doing your own taxes. But even then, and most certainly if you own multiple properties, you are going to do yourself damage by not using a tax professional whose primary clients are real estate investors. A lot of CPAs will be worthless in maxing out the tax benefits on your rental properties, but if you find one who specializes in the field, you are certain to maximize the money you get to put in your pocket. The reason you need a CPA who specializes in real estate is because the laws change so often, impacting your write-offs and ways to properly report the numbers, those CPAs will be up on all of the latest much more than one who only has one or two real estate investor clients. Even if you are extremely good and diligent with filing taxes, or even if you are a retired CPA yourself, I still think you need to check-in with a current CPA professional or you are bound to miss out on easy income you would otherwise pocket.
Preventing the Losses
Have I completely scared you away from buying rental properties? I wouldn’t blame you. All of the above certainly sounds horrifying. And the worst part is, those problems are so common in rental properties! That’s the bad news. The good news is that there are actually ways to mitigate all of those risk factors. Although even if you mitigate every single factor, you still aren’t guaranteed perfect success but you will have so dramatically lowered your risk that you are in a much better position for avoiding those issues.
What are the mitigations? These guidelines go for investment properties in general:
- Buy in areas with good price-to-rent ratios. Make sure the market rents suggest that you will profit every month after all expenses, compared to how much you have to pay for the property. This is critical. You won’t find good price-to-rent ratios typically in places like Los Angeles, San Francisco, New York, and most Florida cities. Those are just examples and far from all-inclusive of every market with bad price-to-rent ratios.
- Do not buy in lower-quality areas. This includes the ghettos, the slums, or generally any area where typically the people living in that area are not of great quality. Not to say every person living in a lower-quality area is bad, but the chances are much higher that they will be which will increase your chances of the bad tenant scenario. The nicer the area, the higher-quality the tenant your property will attract. If you really want to shoot for the areas that are likely to attract the highest-quality tenant, look for areas that are more primarily owner-occupant residents than renters. This goes for general markets too. Some cities boast that they have a huge percentage of renters, which suggests you will always be able to find a renter, but that kind of statistic actually says that the general quality of the population may not be as high. Not to say you have to own your own home to make you “high-quality”, but you get my drift. If you do choose to invest in a low-quality area, I highly recommend sticking with Section 8 tenants which will dramatically increase the chances of you receiving your monthly rents.
- Try to buy newer properties that check out in an inspection. No matter how good of an old house you get, it is an old house and will cost you a good bit in maintenance much sooner than if you were to buy a newer property. Always get a full inspection before buying any property so you know all the potential issues, but regardless of the initial condition you will have to start putting money into maintenance eventually. The nicer a property you buy upfront, the longer you can go without forking over that money and maybe less total over time.
- Buy in growth areas. This goes for both macro and micro markets. Large cities in general may be on the decline due to industry failure or lack of desirability, or small areas within a larger growth market may be going down the tubes for any random reason. Don’t buy in those areas. Buy in cities with good industry diversification (so if one industry tanks it will have little to no effect on your property), a solid trend of population growth, and generally cities where people actually want to move.
- Use a tax professional who specializes in real estate investors. If you really think you are that good at taxes, spend the money at least once to let a professional do your taxes one year and compare them to what you come up with. If there is no difference, maybe you are that good. But try it out to see.
There are so many mitigations to lower the risks of rental properties. People just don’t realize what factors realistically cost an investor more than they ever bargained for. I know I didn’t know when I started! And when I hear other people talk about wanting to buy rental properties, I realize they don’t realize the reality either. The other trick that gets people is that to buy a newer property in an owner-occupied neighborhood in a nice area will inevitably cost you more money than buying an old property in a not-as-nice area.
When people see the higher returns on the lower-quality properties, they take those numbers as gold and buy like crazy. Don’t be tricked by supposed numbers! No returns estimate can take into account the level of disaster the above factors can cause. You may pay more, but buying higher-quality properties in nicer areas will almost always put more money in your pocket over the long-run.
Be smart, use common sense, and be willing to be taught on how to make a rental property work!
Does anyone have a property that totally rocked it and a property that totally tanked? What was the difference between them?
Photo Credit: susivinh