Getting Real About Real Estate Investing
BEING A LANDLORD CAN BE HIGHLY PROFITABLE—OR A HUGE HEADACHE. TAKE SOME WISE ADVICE FROM PEOPLE WHO HAVE LEARNED HOW TO DO IT RIGHT
(MONEY Magazine) – Successful real estate investors sometimes make what they do sound almost too easy. "Rentals freed me from ever having to get a job again," says Orlando Rodriguez, a 38-year-old San Antonio landlord who makes about $100,000 a year off the 90 apartments he owns. "I'm a high school dropout—seventh-grade dropout, actually—so my story should tell people this isn't rocket science."
Yes, landlording isn't science (which is not to say it isn't often a lot of hard work), but if you're willing to put in the time and effort, buying and operating rental properties can pay off big. Try this math on for size: You purchase a $100,000 condominium with $30,000 down and a $70,000 mortgage. If the condo rents for $1,200 a month, your net profits—after costs such as mortgage, maintenance and property taxes—should be in the $2,000-a-year range. Conservatively invested, that sum should earn enough to pay off the entire mortgage within 14 years. You'd have turned $30,000 in equity into $100,000, even if rents didn't go up and property values didn't appreciate. Factor in 4% annual rent increases and price appreciation, and the property's net value to the owner would be closer to $200,000. A stock fund would need to return 15% a year for 14 years to beat that performance—and funds don't give you any of the tax breaks that can come with being a property owner.
The key thing to remember, though, is that buying rental properties is not for point-and-click investors. Even landlords who hire out the plumbing, painting and rent collection to contractors and management companies typically make a big time commitment.
Rick Lionhardt of Dallas, a 55-year-old retired telecom worker, owns 33 properties with wife Helen, 49, a secretary. Even when he was working full time, Lionhardt says, he spent 70 to 80 hours a week on real estate: "I'd make calls during lunch and drive around at night looking for more things to buy."
For the first-time landlord, there is plenty to learn—about taxes, financing, dealing with difficult tenants—and usually there are many mistakes to be made. The payoff can be terrific though, even for investors who own just one or two properties. Doing it right will get you extra income now and a valuable addition to your retirement nest egg down the road.
What does "doing it right" mean? Read on for some key tips and secrets—as well as pitfalls to avoid—from successful investors who had to learn the hard way.
KNOW HOW TO TAKE YOUR MARKET'S TEMPERATURE. When considering a rental property, your top concern should be whether you can make money renting it out now, not how much its price might appreciate in the future (although that's important too). All you're doing is speculating on real estate prices if you're shelling out more than you're taking in—and that can be dangerous, especially if you're doing it with borrowed money. "You never want to buy a property where every month you have to feed it," says Neil Binder, co-founder of New York City's Bellmarc Realty.
So before you buy, add up your projected property taxes, mortgage payments and maintenance costs, and make sure the total is less than your expected rental income. Experienced real estate investors say they generally look to pay anywhere from 45 to 85 times monthly rent for a property. That means annual rental revenue should be about 15% to 25% of the property's value.
Finding places with those kinds of yields can be difficult. Take California, probably the most bubblicious market in the country. A condominium renting for $1,200 a month in Southern California sells for $350,000 today, according to veteran California real estate investor Bruce Norris. A $1,200-a-month condo in the Dallas/Fort Worth area can be had for $95,000. To a landlord, that's the difference between an annual return on investment of 4% vs. 15%. "The only reason you'd be a California landlord at today's prices is because you're expecting price appreciation," says Norris, who thinks prices in the state are due for a fall. "Monthly cash flow would be almost impossible to achieve without an enormous down payment."
Another tool experienced investors use to measure the profitability of a market is price-to-rent—that is, the ratio of median home price to annual rent for three-bedroom homes. The bigger the number, the less likely you are to make money as a landlord. California has a price-to-rent ratio of 25 these days, the highest in the country. Hawaii (23) is second from the top, and Massachusetts (19) is third. Far more inviting to investors are states like Delaware, Missouri, Texas and Vermont, where the price-to-rent ratios are 11 or 12. For more information on median home prices and market rents in your area, visit realtor.org and huduser.org.
FIND SMART WAYS TO CUT YOUR FINANCING COSTS. Borrowing to buy real estate as an investment is more expensive than borrowing to buy a home. Lenders generally think they are taking more of a risk on buildings that the owner doesn't live in. Consequently, the interest rates they charge tend to be 0.5 percentage points or more above those for traditional home mortgages. Not only that, but borrowers need excellent credit scores to qualify for the lowest rates. In addition, the minimum down payment is usually 20% or 25%, instead of the 10% for standard home mortgages.
There are a couple of ways around the higher rates and steeper down payments. To qualify for a traditional mortgage, you are required by most lenders to live in the property for a minimum of one year. But there's nothing stopping you from buying a home or a condo with a traditional mortgage, living in it for a year and then renting it out afterward.
If the down payment rather than the rate is the stumbling block, ask the seller whether he's willing to self-finance the mortgage. With owner financing, the buyer signs a promissory note in which he agrees to make his mortgage payments directly to the seller. In exchange for forgoing a down payment, the seller typically gets a premium rate—8% to 10%, perhaps. Why would a seller take the additional risk implicit in skipping the down payment? "It's a lot faster to sell a house owner-financed than conventionally," says San Antonio landlord Rodriguez. (There are also brokers who buy owner-financed notes from sellers who want their money up front.)
LEARN TO TAKE ADVANTAGE OF THE MANY TAX BREAKS. For tax purposes, what you make in rent is generally taxable as regular income. Real estate taxes and mortgage interest on an investment property are fully tax deductible though. Operating expenses such as utilities, insurance, repairs and condominium common charges are also deductible. So are rental fees paid to brokers, although they must be spread out over the life of the lease.
Even better, the federal tax code entitles rental-property owners to a depreciation deduction even though housing prices usually go up, not down, over time. (There are, however, numerous conditions and catches, which is why it is essential to consult a tax adviser before you invest a cent.)
ANTICIPATE PROBLEMS (THEY WILL BE NUMEROUS). Reliable, prompt-paying tenants do up and leave suddenly. Minor leaks have a way of becoming expensive repair jobs. That's why it's smart to line up inspectors and contractors before you buy. And why it's important to establish rainy-day funds. Two or three months' rent is usually—but not always—sufficient. Just ask Marla Renee, a 55-year-old semiretired hairdresser who owns six rental properties in the Detroit area. Five years ago Renee bought a run-down duplex for $28,000. She figured the house needed $10,000 worth of work, but three months later the tally was nearly three times that. "The last tenant had turned on the water on purpose and flooded the whole place," she says. "The floor, ceiling and walls were all messed up."
Finally, don't skimp on fees should you decide to hire a management company to tend to your rental property. The typical fee is 5% to 10% of rental income. Experienced landlords say it's not worth it to be cheap: Property managers often work harder to fill vacancies and to maximize rent when they are better compensated.
PUT POTENTIAL TENANTS UNDER THE MICROSCOPE. Picking tenants may ultimately be the most important real estate decision you make. This is where listening to the voices of experience really pays off—although you should be discreet about how you apply their lessons. Elderly people are better tenants than college kids, as everyone knows, but in many states, landlords acting on that type of commonsense judgment would be running afoul of fair-housing laws.
Michelle Bizik, 35, of Lake Ariel, Pa. owns two small apartment buildings with her husband Goran, 30. For the most part, they've had lots of success finding good tenants. They require potential renters to provide Social Security numbers, ostensibly for criminal and credit background checks (which are a good idea), but Bizik says it's more about renters proving to her that they have nothing to hide. She also checks references with employers and prior landlords. If prospects pass those tests, she and her husband always meet them in person. "I need to get a vibe off of them," she explains.
These are all good ideas for screening tenants. Here are a couple more. When checking references, don't stop with the most recent landlord. Contact the second or third most recent as well. "The current landlord may just want him out of the property," says Ellis San Jose, a 39-year-old real estate investor from Los Angeles. Also, consider making an unannounced visit to the prospect's current residence. Marcia Glantz, a Coldwell Banker broker for 27 years in Yorktown, N.Y., says, "Explain that your house is important to you, and that you want to get a sense for how they live."
Saying no can be tough when a vacancy is burning a hole in your wallet. Stay strong. The one time Michelle Bizik caved proved to be a big mistake. "We were both against him," she recalls, "but the apartment was empty and he was a friend of another tenant." Soon after the guy moved in, his pregnant girlfriend, five cats and two friends did too. And he was late with the rent. "All the tenants were complaining," Bizik says. "The hall smelled like cat urine. The music was so loud, tenants were calling me at 11 o'clock at night." The Biziks offered to pay him to leave. He declined, so they had to go through the aggravation and expense of having him evicted.
THINK ABOUT INVESTING IN REITS INSTEAD. If you want to buy in to real estate but don't want to deal with all the headaches that can come with managing it, you may want to consider a real estate investment trust (REIT). These are publicly traded building-management companies that pass the bulk of their earnings on to shareholders in the form of hefty dividends. That makes them a great choice for retirees and other income-hungry investors. One catch is that REIT dividends are taxed at higher rates than regular corporate dividends.
REITs offer several advantages over buying properties on your own. First, there are economies of scale: On a per-square-foot basis, REIT maintenance costs are much lower than those of most individual landlords. The management expenses of a typical REIT are only 0.5% of total assets under management, says Russell Platt, manager of the Dividend Capital Realty Income fund. Another plus is diversification, since REITs typically invest in many markets and sometimes different types of property—residential, commercial and retail. And finally, there's liquidity: You can sell a REIT whenever you want, and your brokerage commission will be a drop in the bucket compared with the 6% charged by most real estate brokers.
A conservative REIT bet would be Equity Residential Properties (EQR), run by Chicago mogul Sam Zell. Equity Residential is the nation's largest landlord, which makes it something like an index fund for apartment buildings. Earnings have taken a hit lately owing to, among other things, the Florida hurricanes. But occupancy rates have been ticking up, and Equity Residential still offers a juicy 5.1% dividend yield.
A more aggressive play is Archstone-Smith Trust (ASN), an apartment building owner with a big presence in suburban Washington, D.C. and other East Coast markets. Archstone-Smith also has a dividend yield of 5.1%. The company has profits from condo conversions, and high occupancy rates, which put it in a good position to raise rents. And that's a very nice position for any landlord to be in.
Interest-only mortgages have become very popular with real estate investors. Do they make sense for you?
Imagine your bank cutting your mortgage payments by 20% now in exchange for higher payments 10 years later—by which time you'll probably have moved anyway. Sweet, right? That's the appeal of interest-only mortgages, which in just over two years have gone from a novelty to 10% of the total mortgage market.
They work like this. Say you're considering a $200,000 adjustable-rate mortgage (ARM) with a fixed 4.32% rate for five years. An interest-only ARM would carry a slightly higher rate but also delay repayment of principal for up to 10 years. Your monthly nut becomes $746 instead of $1,011. The catch—and it's a doozy—is that if you don't sell or refinance within 10 years, the principal comes due and your payments can balloon by 50% or more.
Interest-only mortgages can be useful for investors or people who expect to be earning much more in the future (a doctor near the end of his residency, say). Some advisers even recommend them as tools for retirement savings, suggesting you use what you save on your monthly mortgage payments to fund your 401(k). But there are risks. "There are people using this to buy more house than they can afford," says Michael Moskowitz, president of New York mortgage lender Equity Now.
Perhaps the biggest danger is tied to the chance of a downturn in home prices. Say prices fall 25%, as they did in Houston in the mid-1980s. A borrower who purchased his home for $250,000 would be unable to move without taking a big hit. With the house now worth only $187,500, he'd lose his entire $50,000 (20%) down payment. Once you tack on a real estate broker's 6% commission, the actual revenue from the sale would be only $176,000. That's $24,000 less than the mortgage. The homeowner would face a brutal choice—sell and somehow come up with the $24,000 to pay off his mortgage or hold on and swallow a huge increase in his monthly payment.
Financial planner J. David Lewis sees pitfalls even if real estate continues to appreciate. An interest-only mortgage may give a young couple the ability to buy into a fancy neighborhood, but it won't give them the dollars to afford to live there."Buying a house that's beyond your means brings a whole raft of other expenses with it," says Lewis of Resource Advisory Services in Knoxville, Tenn. "You've got to have a different car to live in that neighborhood. Maybe you have to join a certain country club. It goes on and on.... What you're doing is setting a pattern in your lifestyle that will make it harder and harder for you to save money and, ultimately, build wealth."
SOURCE: MONEY Research.