4 Reasons Your Home Would Probably Not Make a Good Rental

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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.

owner-occupied-financing

Related: The Part-Time Investor’s Guide to Truly Passive Rental Income

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.

business-plan

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.

2-percent-rule

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!

About Author

Brad Lohnes

In 2013 Brad awoke from lifelong financial slumber and took responsibility for his family’s financial future. His primary vehicle for wealth-building is buy-and-hold real estate. He is passionate about financial education and helping others learn the tools they need to take control of their money. Brad believes there is nothing more empowering than self-reliance.

29 Comments

  1. Andrew halprin on

    “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.”

    Where are you renting that these things dont matter for rental cost?

    • Katie Rogers

      The income of median tenants is generally less than the income of median homebuyers. Tenants want to save their money for a down-payment. They do not want to waste it for high end stuff when good quality mid-range stuff will do. They also resent landlords who put in shoddy stuff.

      Same with cars. Why buy a beamer when a Toyota will get you from point A to point B.

      • Oh that can certainly be true… but many many of those people driving the bimmer instead of the toyota are leasing just the same way people out there want to rent the “BMW apartment” Demographics certainly play a part but anybody that isnt a hermit will want an above average style with appliances and counters to match in my experience.

        • Katie Rogers

          “…anybody that isnt a hermit will want an above average style with appliances and counters to match…” Not if the resultant asking rent prices out tenants by being more than one-third the typical tenant’s wage. Hard to know what you mean by above average when I consider what passes for average in my town. Personally, I would be happy if the landlords in my town offered something they would be willing to live in themselves.

      • Ivan Stoyanov

        How can you refinance at 100% of value? I was told that a bank will not provide a loan for more than 75% of appraised value. So the property has to either sharply appreciate in value or you have to pay the mortgage for an extended period of time, so that you have accumulated equity. I

    • Brad Lohnes

      Hi, Andrew. Thanks for your comment. In my experience, median rent for an area drives everything. So, if you are renting in a place with very high median rents and people expect high-end chattels, then fine. My point is more that adding these things themselves usually doesn’t increase rent. At least not by enough to make them a good investment. When people buy a home for themselves, it is very common for them to either a) pay more for the house because these things are included or b) make the house more comfortable for themselves by adding them. Either way, if they are out of line with what is common among rentals in the area, then you probably aren’t going to consistently get the rent you need to cover them. Is it possible to find someone who will pay more? Sure. But it’s going to be much more difficult to do consistently.

      • Bill Briscoe

        Brad, your example isn’t a great one. You bought your house for too much and then moved out. That’s where you lost money, not by renting it out.

        If you had sold the house in 2008 instead of renting it, you would have lost money. I hope that by making PITI payments for several more years you at least gained some additional equity that you were able to cash out on when you sold.

        The most accurate comparison should be whether you would have made a decent ROI from your decision date (in 2008) from selling at a loss vs renting and selling later. Your ROI should have been based on the opportunity cost of selling (equity cashed out after all expenses from 2008 sale) vs NPV of cash flows from renting for say 1 additional year then selling. Suppose your monthly cash Outflow from renting was -$100 per month, but then you sold for $1000 More plus you had gained $1600 in equity from your PITI payments if you had sold in 2009 vs 2008. You can ignore the selling costs/realtor fees, necessary repairs (unless they were necessitated during the rental period) and so on because you would have paid those whether you sold immediately or rented at a loss then sold later.

        But once you buy a house, transaction fees are a sunk cost. And so is the amount you overpaid by. Do you think if you had sold in 2008 vs renting that the next homebuyer would have “paid too much” for the high priced extras in your home, moreso than a renter? If so, then selling would be preferable. If not, then its likely a wash – you’ve lost your sunk costs either way.

        • Brad Lohnes

          Hi, Bill. I understand your points about the math of different options we could have taken given our specific situation. However, to your first comment – that is my point exactly! Most people pay too much for a property when they purchase it for their own home. When they then turn around and rent it out, the fact that they paid too much for it to begin with is what causes them to lose money while renting it out. That’s what happened to us. Sure, maybe it wasn’t fair to include the real estate fees. But usually when we sell a property for a gain, the real estate fees don’t COST us money. They are subtract from the gains, but usually money goes into our bank account. In this case, money came out of our bank account to cover it.

          I am saying exactly that: if you purchased your house for yourself and paid too much for it, it’s probably not a good rental.

          The funny thing is, many people on this web site probably didn’t make that mistake. But I’d say that’s probably the highest concentration of people who didn’t! 🙂

          Thanks again for your feedback. Cheers.

  2. David Krulac

    Brad,
    Agree but I would add that some properties by their attributes either make good rentals or lousy rentals and this would apply to accidental landlords as well as people initially buying to rent.

    Not all houses make good rentals. After buying and selling over 900 properties, I would not buy a property that was not positive cash flow unless there was some other great potential. And the best rental properties imho are properties at the median price level for the area or less. I know people make money with high priced housing but the numbers are harder to meet in my experience.

    • Brad Lohnes

      Hi, David. Thanks for your comments. I completely agree. There are some additional factors that can make one property “intrinsically” better for renting. Location is the most obvious thing – both at the macro level but also the micro level. As an example, we have found that our rentals that are on a busy street are easier to rent (i.e. find tenants), get higher rents and stay rented longer. Nicer properties in the same neighbourhood but down a quiet side street, oddly, are harder to rent, get slightly less rent, and have higher turnover. Why? I have no idea. If I were buying one of my own rentals to live in, our poorest performing rental would be my first choice. And this is reflected in it’s market valuation. But it still doesn’t perform as well as the lesser properties on busy streets.

      I also completely agree with your point about median price. In fact, in my experience so far analyzing properties in my area it has become clear that a house purchased at median price and rented for median rent will actually lose money. You need to buck the trend to make money – buy well, add value, and hit the right notes to target tenants looking to rent in that area.

      Thanks again!

  3. Michelle C.

    There are some really good points here. However I think each situation is unique, and the local market will play into this. If you are in a desirable area, and people are willing to pay extra for a nicer rental, you might still have a good deal. In Chicago, there is literally a rental for every price point, from tiny cheap garden (basement) studio apartments, to high end luxury condos, duplexes etc… You can pay anything from $600 a month to $3000 a month and up.

    • Brad Lohnes

      Hi, Michelle. Thanks for your comment. I agree that there is something for everyone out there. And it is definitely market-specific. My experience in my wider market is that, while rents go up as you move into nicer neighbourhoods, they don’t go up as much as the property values do. This means that at some point, rents no longer cover the cost of owning the property. Most people who want to rent out their own home will often live in an average to above average neighbourhood. The key is to understand the numbers.

      I have friends who own and live in an apartment in Manhattan. Of course, you can rent out an apartment in Manhattan. But I also know what they paid for it and what it’s worth now. I think that, even in a market like Manhattan, they would struggle to get adequate rent to cover the cost of owning it.

      What I’m hoping to achieve with the article is to break through the romantic idea of a rental and help people realize that it’s about the numbers. Thanks again! 🙂

  4. Katie Rogers

    “If you originally purchased the house to live in yourself, then you probably paid too much for it. ” You can add to your bullet points the fact that buyer’s agents push their clients to pay too much. I recently dealt with a house where my buyer’s agent (not anymore) tried to use post-remodel comps to price a pre-remodel house. When I balked, he patronized me about how I should trust his expertise because as an agent, he obviously know the market better than I do.

    You know, most of the time, he would be right. Most homebuyers do not know the market. That is how buyer’s agents get clients. And a lot of buyer’s agents take advantage of that knowledge gap to fail to properly negotiate the price of the house for their client.

    • Brad Lohnes

      Hi, Katie. Thanks for your comments.

      Agents 🙂 I have found working with agents to be an interesting experience. They are necessary, I understand that. But most of the difficulty that I’ve encountered so far in the real estate market comes from dealing with agents. Particularly before I knew anything – I felt that they were definitely taking advantage of the unwary rather than helping (I have some specific experiences here). Now that I am comfortable with the law and my rights, my main goal is to get them to present my offers to the vendor (which they have to do by law here). Usually, they try to do the negotiating before they ever present the offer, or just decline the offer outright.

      I’ve not worked with a buyer agent specifically, but I know that the way it works here, they split the commission with the vendor agent, so they are both hostile to the vendor agent and incentivised to behave in a manner similar to the vendor agent.

      I just need to find a better way to work with agents. 🙂

      Thanks again.

  5. Christopher Smith

    My first rental was the “accidental landlord” scenario. In fact I still own that property and operate it as rental. Its probably not the very best performing of my rental properties (for some of the reasons in the article), but its actually turned out fairly well. Its always cash flowed very nicely and appreciated modestly over the 15 years I have leased it.

    I think part of the reason it turned out reasonably well is because it was built in a new very desirable suburb which has experienced growing demand over the years. It was also the smallest model (a 3/2) for its area with some reasonably nice upgrades, but nothing really extravagant. Fortunately expenses to operate it have been exceedingly low and that has helped.

    In the end, I’m really glad I held on to it since I now live on the West Coast where I have had a number of rental properties for about 5 years, but where prices have become ludicrously high in the last two years. By holding on to my original “accidental landlord” property (which is in Ohio), I had all the rental infrastructure (mgr, agents, etc.) already in place there which allowed me to shift all my recent acquisitions (totally sight unseen) to that specific area of Ohio without having to worry about things.

    So this was a case of turning lemons into lemonade.

    • Brad Lohnes

      Hi, Christopher. That’s fantastic. You’ve definitely had a good experience – but specifically it was good based on the numbers. That can – and as you attest, definitely does – happen. Many of the people that I speak to view having a rental as a kind of romantic thing. A way of not having to sell their beloved house even though they’re moving on. When we rented out our first “accidental” as you put it, we thought it was kind of cool. I just want to make sure the wool is pulled back and people can see clearly whether their property is a good candidate for a rental or not. Thanks again!

    • Colin Reid

      We’ve grown our modest portfolio based on owner-occupied turned rental. My first was pure luck. I bought a home. Just a home. When I got orders to move, a coworker who was an investor persuaded me to rent it out. It cashflowed modestly for a few years until I refinanced last year, and now it’s doing pretty well.
      I didn’t learn my lesson.
      I bought another home at my next duty station. I still live in it, but looking at comps and rents in my area, it will probably cashflow when I move.
      Then the Air Force announced big personnel cuts and I assumed wrongly that I’d be fired. I started learning about REI. My next purchase was a pure rental, bought by the numbers, and it’s cashflowing very nicely.
      My then fiance was looking for a house where she lived at the time. We knew she’d be there for a year before she could move near me. So we bought it like a rental. We used investing strategies, and got owner-occupied financing. That one sets the rent for the neighborhood now.
      Then it was time to move closer to me, but I’m stationed in a location where she’d take a huge salary cut. So she lives two hours away in a much better market. Boom! More owner-occupied financing! We found a good deal, renovated it, and in a few years it’ll be a rental when I leave the service and we move to where we want to settle down.
      You make money when you buy, not when you sell or accidentally rent.

      • Katie Rogers

        “…we bought it like a rental.” Homebuyers need to evaluated their purchase of a home as if it were a rental in order to push back against the buyer’s agent continually pushing you to pay more than you should. Buyer’s agents use comparables to cycle the prices higher and higher in a kind of crazy version of confirmation bias. Naive first-time buyers get taken in because they are relying on their agent’s expertise. I can tell you that when I was looking for a home, and I told my buyer’s agent that the house had to make sense as if it were a rental, maybe you can believe the protest I received.

    • Keith Knobloch

      Kafui, I’m not sure if there is a scientific way to find the actual median rents for a locality (someone must collect that data, right?), but market rents shift almost as readily as the real estate markets and there’s a decent chance the data will be a little outdated anyway. I’ve listed rentals in the paper (not for a few years now), on Craigslist, Zillow, Trulia, and HotPads, and I would guess that around 95% of my tenant leads come from Craigslist in my market. Now, when I’m thinking of adjusting rents, I just punch in the criteria of my unit and see what on Craigslist comes up for matches. Of course, you can’t always see the whole picture from a Craigslist post, but it should get you in the ballpark anyway…

      • Katie Rogers

        You can find HUD’s annual determination of fair market rents on their website. Their most readily available data is for MSAs, but if you drill deeply enough, you can find the annual determinations by zip code. I found it quote by accident once.

        Another website is City-data which includes a lot of useful demographic data on the likely jobs and wages of prospective tenants, median rents and median houses prices.

        A third website is Rentometer.

  6. Jerome Kaidor

    I have been investing in rentals since 1996. In that time, I have *never* “moved and rented out the old house”, because the numbers never worked. As it happens, I missed out on some serious appreciation on those old houses ( on the San Francisco Peninsula ), but who can tell the future?

    Investing in multifamily, it took 7 years from starting that activity to leaving the W2 rat race in 2003.

    The 2008 housing crash was hard on us. All the sharpies who were flipping houses got stuck with them, and decided to rent them out. Our phone stopped ringing like somebody flipped a switch. Many of our section 8’ers moved out because they could now rent houses on their vouchers. Luckily, the interest rates fell down enough to cover the vacancies!

    Times are good now. We are almost 100% occupied, interest rates are still low, and we are busy like little squirrels salting away nuts for the winter.

    • Brad Lohnes

      Hi, Jerome. Congratulations! Financial freedom must be satisfying! 🙂

      Your point about capital gain is a good one. Many houses that people purchase to live in themselves probably do see good gains over a long period of time (though not always, as we’ve experienced). If you have good cash flow from a number of properties it’s probably fine to have some small number of these types of properties that don’t do so well on cash flow but are likely to see great gains in a strong market.

      I think that overall, though, the average person doesn’t understand that cash flow is what makes a rental a viable business, rather than just a money pit.

      Cheers!

  7. Jerry W.

    Brad,
    Thanks for writing the article. So far I have only rented out the house after I moved once, and it was a trailer house and land. I was a HORRIBLE landlord, knew nothing, got horrible tenants, had a friend helping out who not much more than me. Eventually evicted them and sold the place. The rent did just cover the payments and taxes and insurance. When I sold it a few years later, I took the leftover cash and paid off the house I lived in. That is actually what hooked me on real estate.

    • Brad Lohnes

      Hi, Jerry. Thanks for sharing your experience. The numbers definitely can work, depending on how well you bought.

      As for being a landlord – I really don’t want to deal with that. 🙂 I prefer to have my properties managed and consider it money well spent. 🙂

      Cheers.

      • Katie Rogers

        That’s fine, as long the property manager is properly representing you. Many property mangers are well-aware that landlords just do not want to be bothered, and implement policies you might not like. When the tenant balks, these property managers use the landlord for cover, “It’s the owner’s policy,not ours,” when the fact is the owner might be aghast at what is happening in his name.

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