We all make mistakes.
Some are more costly than others. Each contains a lesson.
In mid-2006, my wife and I purchased our first home. The property market in our area was booming. In early 2008, we needed to move to another city for career reasons. Unfortunately, during the time span that separated these two events, the global financial crisis happened. We couldn’t sell our house; we didn’t even get an offer.
With an eye toward making lemons into lemonade, we decided to rent the house out. What we made was more like sour medicine. For nearly a decade, we poured dollar after dollar into a money pit. Ultimately, we sold our former home for a loss nine years after we bought it. We lost money on our capital, we lost money every week we owned it, and of course, we paid real estate fees to get rid of it. The house cost us a small fortune to operate as a rental.
We’ve learned a lot since then.
“Maybe we can rent it out.”
I love to talk about real estate. That’s what happens when you have a passion for something — it tends to work its way into conversation. But time and again, friends, colleagues, and acquaintances tell me that they aren’t interested in “fixing toilets.” The closest a few will come is to say that maybe they’d like to turn their existing home into a rental. In fact, this is a line that I hear often: “I’m thinking of buying a bigger house for our family. Maybe we’ll keep our current house and rent it out.”
Most of the time, it’s bad idea.
I think it’s great that these people are considering rental property, but most don’t know how to make the numbers work. I didn’t know either.
For me, getting through the learning curve involved taking on board a number of lessons that I think are critical for people who want to use rental property as an investment vehicle for their future.
Lesson 1: A rental is a business.
Unlike stocks, which represent shares in a business, a rental property essentially is a business. The purpose of a business is to make a profit. Think critically about this. The rental income from your property must cover all costs with something left over: profit. Costs include property taxes, insurance, ongoing maintenance, capital repairs, property management, and more. They also include the mortgage payments. In my experience, the size of the mortgage is usually what pushes the property from being a good, cash flow positive rental into a cash flow negative money pit.
Put simply, if the market rent that you can easily get for the property does not cover all of your expenses, then the property is not a good rental.
The main issue is this: If you originally purchased the house to live in yourself, then you probably paid too much for it. You purchased it based on emotion — the desire to find a place for you and your family to live comfortably. This was not a business decision. A large percentage of the time, when you look into market rents for your home, you’ll find that the rent you can expect to get cannot cover all of the expenses.
There are a number of reasons for this:
- You overpaid to begin with because you really wanted it and because you were looking at what you could afford.
- The property has many features that don’t increase rent. Marble countertops, plush carpet, top-of-the-range appliances, elaborate decking, swimming pools — the list goes on.
- You paid for a large yard. Land costs money, but yards need to be maintained and renters don’t usually want the hassle.
It’s not that renters deserve less. It’s that, in many cases, they won’t pay for more. But you did.
Lesson 2: A rental is an investment.
Are you looking for an investment or a hobby? A lot of “mom and pop” investors put a lot of their own time and money into the rental. They do this either a) by putting in a very high deposit (or using existing equity) in order to have the rent cover the difference in the mortgage plus other expenses, or b) by constantly paying out-of-pocket for the difference. Either way, they are “topping up” the mortgage with their own money. Let me ask you this — if you purchase stocks or bonds, would you expect to keep dumping money into the investment every month just to hold onto it? I don’t think so.
But with a rental property, if you are “topping up” the mortgage payment every month, then you are not investing. You are subsidizing the lifestyle of your tenants. You’re paying for your tenants to live in a house that they can’t actually afford (or are at least not willing to pay for).
The problem with using a lot of personal cash or equity to make a deal work is that it doesn’t scale. The reality is, depending on the market that you live in, it can take a long time to save up the money for a down payment on a property. If you leave that money there — known as “parking your money” — then you will have to continue to save money in order to purchase another property. Let’s say that it takes you five years to save enough to purchase another rental. This severely limits the number of rentals that you can purchase in a lifetime.
This brings us to our next lesson.
Lesson 3: A rental is part of a bigger strategy.
Why do you even want a rental? If the purpose is to have some income from your rental property in your retirement, I encourage you to take a close look at how much income you can actually get from a single rental. Look at the total rent that you collect in a year. Then subtract all of the costs other than the mortgage payments. This is how much gross income your rental could produce in a year once the mortgage is paid off. Then don’t forget that if you take this money as income, you will have to pay taxes on it.
Looking at just one of our single family residences as an example, after all expenses other than mortgage payments, it brings in about $12,000 per year. If I were to take that as income, then I’ll have to pay tax on it as well. I don’t know about you, but that’s not going to change my lifestyle in a significant way on its own.
You need to think bigger. If you want $100,000 in gross annual income, for example, then you’ll probably need around eight or nine similar rentals. Ten is a nice, round target. Some investors like to get into multifamily housing, as this tends to produce higher yields.
You can’t live on one single rental property that you nurture and coddle because it was once your home. Of course, it’s still an “investment,” but it’s not enough to live on alone.
Lesson 4: You need the skills of an investor in order to scale.
Let’s go back to that first rental that you bought. If you are parking your money in that one rental, then it’s going to be very difficult to continue buying more rentals in order to fund your “financial freedom.” An investor looks at it differently.
Related: 6 Tips to Craft a Highly Coveted Rental — Without Over-Improving It
An investor will look at the median rent for the property being considered. Next, the investor will tally up all of the actual expenses (e.g. property taxes, insurance, etc.) and likely expenses (e.g. maintenance allowance, vacancy allowance, etc.). The investor will then look at current and expected future interest rates and plug in a likely purchase price. If the rent will not cover the expenses and mortgage payment, then the purchase price is too high. The purchase price needs to be lowered until the rent does cover all costs. Once a price is found that will work with the numbers, that represents the highest price the investor is willing to pay. Negotiation should, of course, start lower.
Even though you will need to put down a deposit and will initially have a mortgage less than the amount of the full purchase price, you cannot scale if you don’t eventually refinance the property and get your original deposit back. If you can’t do this, then you paid too much for the property and it will take years — sometimes decades — to make up for it. This is why an investor will use the full purchase price for calculating mortgage payments when running the numbers.
The truth is in the numbers.
I have experienced both sides of this.
We lost approximately $5,000 per year for about 7 years while renting out our first home. We also lost $20,000 on the purchase price, plus we had to pay the real estate agent about $18,000. So, all up, the property cost us about $73,000. We learned a lot from this experience, but the lessons were very expensive.
Did you purchase your home on the basis that it might be rented out in the future? If not, the numbers probably won’t work. As an exercise, run the numbers and see what you come up with. Find out what median market rent is in your area for a property of your size. Consider all of the costs of owning the property and renting it out. This exercise will most likely tell you how much money you will lose each year.
In the end, it’s not about fixing toilets; you can pay somebody to do that. The risk in owning rentals, as with most investing, lies in not knowing what you’re doing. The math is actually very simple. It’s the mindset that needs to be shifted.
A rental isn’t a house that you’re not living in. A rental is a property that is purchased at the right price.
Would your house make a good rental?
Let me know what you think with a comment!