Buying a Rental? Run the Numbers
With stock and bond investments looking increasingly volatile, shifting your investment money into rental real estate may look like a safer bet.
But as with almost any investment, there are risks here too -- and now may not be the best time to jump in.
Real estate prices are high and the tenant pool has been depleted by low-cost loans that make owning a home more affordable, experts maintain.
“It’s a terrible time to think about buying a rental property if you are in for the short game,” said Lisa Vander, chief executive of Pacific Blue Investments, a real estate investment firm in Solana Beach.
Still, she believes that long-term investors can profit, if they’re smart and willing to run their investment properties like a business.
Vander and Robert Shemin, a Nashville landlord and author of “Successful Real Estate Investing: How to Avoid the 75 Most Costly Mistakes Every Investor Makes” (John Wiley & Sons, 2004), offer these tips to would-be landlords:
Calculate the carrying costs: Many investors make the mistake of thinking that if the rent on a property is more than the mortgage payment, the investment “pencils out” and produces a profit, Shemin noted. In reality, the total monthly costs of holding a rental property can be 30% to 50% higher than the mortgage payment, depending on the type of building.
In investment real estate circles the term for these other expenses is “tummi,” added Vander. It’s short for taxes, utilities, maintenance, management and insurance.
These costs can vary dramatically, so Shemin suggests asking the owner for several years of income-tax records on the property that would show what has been spent to maintain and insure this particular building -- as well as how much the owner has reaped in rental payments.
Inspect and interview: Investors shouldn’t be lulled into a false sense of security if the current owner’s records indicate that the property has had minimal maintenance costs, he added. Sometimes, that’s because of neglect. The best way to find out is to carefully inspect the building -- inside the units and out -- and to talk to the tenants.
“We looked at a building where the landlord’s repair numbers were really low, but when we talked to a sample of the tenants, they said that was because nothing had been fixed in a year,” Shemin added.
That building was a maintenance money pit waiting to happen. But even with a well-maintained building, maintenance costs are likely to equate to 10% of the rent. Those who are lucky enough not to have big maintenance costs in the first year should set up a reserve to handle those costs in future years, he cautioned.
Figure on vacancies: No building is 100% rented 100% of the time, Vander said. Prospective owners should figure that one or more units will be vacant at least part of the time. Local apartment owner associations and property managers can help prospective buyers figure out the normal vacancy rate in any given community. But buyers should also keep an eye out for changes in the business climate that can skew the numbers, such as when a large employer is gearing up or scaling back, she said.
Prepare for the worst: What drives some landlords out of the business -- often at the worst possible time -- is the disaster story. It comes in many forms. There’s the tenant who simply doesn’t pay rent and then fights eviction, stretching the process out for months. There’s the tenant who trashes a rental unit, causing thousands of dollars in damage and lost rent while the repairs are completed. And, there’s the natural disaster.
“I learned that the hard way,” Shemin said. “In Nashville, where I have a lot of rental properties, they had a tornado. It took me six months to get paid from the insurance company and I had 20 properties damaged. We got through it, but it wasn’t easy.”
Don’t invest in rental real estate without a financial cushion sufficient to pay the mortgage -- with or without a renter -- for at least six months, Shemin said.
Don’t buy cute: One of the biggest mistakes that buyers make is to impose their own taste on a rental property, Vander said.
“There are people who can’t make the leap that investment real estate is a business and has to be run like a business,” she added. “They won’t buy a place unless it’s cute and has nice curtains. A good investment property doesn’t have to be someplace that you’d want to live in. It’s all about whether the numbers work.”
Indeed, Shemin said, the best deals are the worst-looking properties. He tells prospective buyers to drive through targeted neighborhoods to look for eyesores. Those homes and apartments just might be owned by the most “motivated” sellers, he added.
Carefully qualify tenants: Once a building has been purchased, the most important decision a landlord can make is whom to accept as a tenant.
“You can either find a gold mine or step on a bomb,” Vander said. “The tenant selection process is critical.”
Shemin orders a credit report and criminal background check on each prospective tenant, and also requires applicants to provide the names of three previous landlords.
Neither he nor Vander puts too much stock in what the applicant’s current landlord says. “The one they are leaving now may want to get rid of them,” Vander said. “They’ll say anything for you to take them.”
The landlord from a move or two ago is less likely to have an incentive to lie.
Shemin also encourages landlords to think of ways to keep good tenants, since turnover is costly. He guarantees renters that maintenance problems will be fixed within three business days and rewards long-term tenants with televisions and other appliances.
“A television costs about $150, but it would cost me more than $1,000 to clean, advertise and rent a unit if they moved out,” he said. “It’s a great investment.”
Get it in writing: Every landlord should have a lease agreement that clearly spells out the terms and conditions of the deal, including what sort of economic penalties would be imposed if a tenant damages the unit.
Apartment owner associations often can provide standard leases and help new owners understand local rent laws so they can sidestep any legal land mines.
Inspect regularly: Once a month, every month, Shemin inspects his properties. He even puts a clause in each rental agreement that specifies when the renter should expect him to call.
Renters often like the regular inspections, he says, because it ensures that his property managers do their job by keeping everything in good working order. But, it also saves him from being surprised by tenants that do damage.
This, too, he says he learned through bad experience. He rented a house to a nice couple, who later began to abuse drugs. By the time he inspected the house, a year after they’d moved in, thousands of dollars in damage had been done.
Don’t grow weary: It’s easy for new owners to get discouraged if property values fall after they buy -- something that’s not unusual, Vander said. But anyone who buys a rental property should figure on holding on for a decade or more, she said. That’s when the real money is made because, by then, the mortgage has been paid down -- presumably with the help of renters -- and the property has had time to appreciate. Meanwhile, the landlord should have been hiking rents a bit each year, making the property increasingly profitable.
“Where people lose money is when they are in a down market and they don’t understand the benefits of owning long term,” she added. “They sell prematurely and they sell out of fear. Real estate is not a short-term project.”
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Kathy M. Kristof welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past columns, visit latimes.com/kristof.
