Many novice real estate investors soon quit the profession and invest in a well-diversified portfolio of bonds. That’s because, when you invest in real estate, you often see a side of humanity that stocks, bonds, mutual funds, and saving money shelter you from.
Proper diversification of your investments may include real property. However, purchasing and managing rental property isn’t for everyone. Most people are better off diversifying by purchasing REITs (real estate investment trusts) using a mutual fund or an ETF (exchange-traded fund).
Unfortunately, most real estate success stories are either not true or fail to factor in all costs.
Remember Florida like 15 years ago? Prices were climbing on a monthly, if not weekly basis. However, to achieve good returns, you had to buy well (not pay too much), sell well (not be left holding property after the frothy market collapsed), and cover your costs. Quick flips are taxed at ordinary rates, so having an after-tax profit means selling at a price that covers all you paid to purchase, hold until sale (mortgage interest, property taxes, maintenance), and the costs of sale (usually more than 5% of the gross), plus taxes on the profit – usually 25% or more.
But just investing in REITs is so boring ….
If you are serious about buying and managing rental properties, then you have made a decision to go to the business of being an owner/landlord.
Steps you need to take
Before you can hang out with Kar Po Law, John Sobrato and Hawken Xiu Li, take these steps:
1. This is a real business!
Almost everyone has heard a story about people becoming wealthy investing in real estate. However, the stories of true wealth accumulation involve people who dedicated substantial time to running a business investing in real estate. Just to be clear, claiming you need a massive profit on the sale of your home is neither investing in real estate nor a true profit. Your residence is part of your cost of living. So, before you claim that you profited on the property, you need to factor in all the costs of insuring, maintaining, repairing and improving that residence before sale, as well as the actual costs of sale. Rarely does the net return on a personal residence equal the stock market return over the same period.
2. Do some research!
For rental real estate, you will need to do your homework just like any other business to determine what is a good market. That is, find out where property values allow you to buy low enough that you can get a good return on your purchase. Part of your return will come from property appreciation. If the market changes and property values decline, you have lost capital. You want to know what segment of the population is likely to rent from you for a given property and the likelihood of vacancies or late payments. This is sometimes called a market study. You should anticipate some level of vacancy (times when you don’t get collect 100% of the possible rent). Furthermore, you will want to factor in, and anticipate, the cost for advertising, professional fees (legal and accounting), repairs, supplies, landscaping, snow removal, and so on. Finally, at some point, there will be capital improvements, including anything from a new roof to upgrading electrical systems or changing some part of the internal or external structure. If your anticipated rental income, less an allowance from vacancies, is sufficient to cover the debt service plus all projected expenses, then you should be in good shape.
3. Avoid too much leverage (mortgage financing)
When you have decided on the property, expect to use mortgage financing. This allows you to buy more property. You are counting on rental income to pay the mortgage principal, interest, property taxes and insurance. However, if you put very little down, your payments might be quite high, make it less likely that will cover all those expenses (you may need to put in more and use less mortgage financing). A downturn in property values when you must sell will mean that you must bring money to the closing – a bad thing! A change in the local economy, so that you lose tenants, could result in negative cash flow, which means you are effectively adding capital to the property – also bad.
4. Form the proper entity to own
Before you buy, you may want to form an entity – an LLC, corporation or trust. The entity protects your personal assets, because anyone who tries to sue you as the owner can only claim against the value of the property and other assets of the entity.
5. Set up all the systems you will need:
Bookkeeping – be sure you know how to treat security deposits, both so the money is not income to and so you meet requirements of local laws.
Legal – form of entity, rental agreements, local law, zoning … you are going to want help!
Tax prep – be sure you know what you can deduct vs. depreciate and so on;
Maintenance – expect to spend time and money on this, or else tenants won’t pay rent on time and may leave; and
The rest– Fire, police, zoning and other contacts. You may want some form of record keeping for all this, such as rent rolls.
As with our recommendations for starting your own business, setting up proper bookkeeping and getting legal advice at the outset is crucial. See 7 Things to do When Starting a Business.
6. Put your agreement with partners in writing
If you join with someone, you will want an agreement that makes clear who does what, in terms of funding and time spent. Otherwise, you could end up in an unpleasant disagreement or worse.
7. Don’t stay too long at the party
In the example of Florida mentioned above, many people jumped in too late, which helped push up prices for others until the market crashed. Many people were left stuck with properties valued at less than their mortgages in the mortgages bust of 2008 and took many years to finally sell.
The flip side of buying well is to recognize when the property so overvalued and sell. If you gauge this well, and if the market later declines in value, you get to redeploy your capital and start over!
So much keep in mind!
True, but you are now more prepared to be a landlord of the future. Good luck!