Personal Finance > Your Home
Does rental property pay?
You can reap gold, but deadbeat tenants aren't the only pitfall.
October 10, 2002: 1:42 PM EDT
By Leslie Haggin Geary, CNN/Money Staff Writer

New York (CNN/Money) So, you want to be a landlord. The way you figure it, somebody's rent will cover your expenses while you build equity in a valuable piece of property.

Not so fast.

Being a landlord can be profitable, especially if your property is perched in a college town or a desirable location like the beach. But there's no guarantee you'll strike it rich. In fact, one survey by the U.S. Census Bureau a few years ago found that 44 percent of landlords renting out small, single-family homes lost money.

Deadbeat tenants who don't pay the bills are just one problem. If rental demand slows, you're stuck with a vacant dwelling -- and a second mortgage payment to pay.

There are intangibles, too: the "price" of worrying whether tenants are trashing your property or 2 a.m. calls to say the plumbing's leaking. A management company to do the dirty work for you, of course, but you'll pay 10 to 12 percent of the monthly rent for the privilege.

"You have to be patient. It took us a few years before all our expenses were covered because we were still learning," says Cathy Thomas, one of 600,000 "small" landlords nationwide who currently own from one to 100 residential units.

The lay of the land

The first step to success involves taking the pulse of rental demand. Landlords often find it tough to make money during housing booms like the one we're experiencing now, notes Jay Butler, director of the Arizona Real Estate Center at Arizona State University in Tempe. Low interest rates, coupled with individuals' desire to invest in something other than Wall Street, have driven home sales up across the country.

"If they can afford the rent, they can afford to buy," Butler explains.

In the area around Sacramento, California, for example, "renters are moving out and buying homes," says Jim Lofgren, executive director of the Rental Housing Association of Sacramento Valley.

Lofgren tells would-be landlords to know their market before getting into the business. Look in the local paper to see how many landlords are advertising properties and check them out. How much are they charging? How competitive is the market? Many areas have local rental associations, that can help answer your questions. If the market's inundated, you may want to hold off on renting or look at a different market.

"You can't just buy something and expect to watch your investment grow," says Lofgren. "You've got to do some work."

Think like a renter

When you begin scouting properties to buy, you'll want to proceed with caution.

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Even if you're smack in the middle of a potentially rich rental market, it doesn't mean tenants will find your unit attractive. In other words, it's time to think like a renter. If your investment property is in a dangerous part of town that you'd never live in, why would others? Are the rooms cramped? Do you have amenities like a dishwasher?

Experts say it's best to rent new places that won't cost you a lot of time and money to keep up.

That's what Cathy Thomas did. She and her family built a simple post-and-beam cottage in Nantucket five years ago, which now rents for $2,800 a week during peak summer months. Though designed to look like one of the island's charming older dwellings, the cottage is equipped with modern appliances, including an oversized washer and dryer.

"People really appreciate the new appliances," says Thomas. "If they're spending that kind of money they don't want to rough it."

The price is right

There's a big difference between a couple who decide to rent out their vacation home for a few months of the year to cover some of their costs and a couple who rents properties for big bucks. In the first scenario, you may have some wiggle room to set prices. In the second, you'll have to pay close attention to what you charge and what you can reasonably expect.

Butler said it's imperative that you know what your rental property costs you in maintenance and mortgage before you start set rent prices. That's because ideally, rental income will pay those expenses plus leave you with extra funds to build reserves for capital improvements and profits. Experts are leery about setting a hard and fast formula, but some have say charging 15 percent over your costs should be sufficient.

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Next, compare the rent you need to going rates for the market you're in. If it's astronomically higher than other local landlords, you could be in for disaster.

Choose tenants carefully

There's no way around it. Once you turn your keys over to tenants you've given up a certain degree of control over your property. To protect it, run due diligence checks. Lofgren's association, for example, runs credit checks, criminal background checks and eviction histories on behalf of its members. Other groups, like National Apartment Association, can help, too.

Specifically, NAA's Independent Rental Owners Committee has a slew of tips on running credit checks, rental agreements and other issues that small landlords have to contend with.

Still, most tenants are reputable, insists Jack Terrillion, chairman of the NAA's committee. Terrillion rents 20 condos and duplexes in Dallas, but he started with just three. By his own account he's "made every mistake in the book."

"I'll never forget the first time I let someone into one of my apartments without doing a credit check," he recalls. "Two gals pulled up in a Mercedes Benz. They told me 'We had a lease [but] we have to be out tomorrow. Can we give you a deposit?' "

Terrillion gave them the keys, their checks bounced and he ended up having them evicted. Now he runs credit checks on all applicants, verifies their employment and talks to former landlords.

Make friends with Uncle Sam

Tax breaks for rental properties can be substantial. Landlords can potentially deduct their mortgage interest, taxes and depreciate the dwelling over 27.5 years. They also may write off maintenance costs.

What's more, if you lose money on your rental, you can deduct up to $25,000 in rental losses a year if your adjusted gross income does not exceed $125,000. (Loss write-offs are phased out for individuals who earn more than that.)

That said, the tax break you can claim will depend largely on how long you rent the property, said Evan Snapper, senior manager, personal financial counseling, at Ernst & Young

If you want to grab the full rental deduction, you can't personally use the property more than 14 days out of the year or 10 percent of the time that it's rented.

If you don't meet the criteria the property is considered own residence and you won't have to report any of the rental income on your taxes. But you no longer get to deduct maintenance and other operating costs.

When it comes time to sell rental property, you lose some tax perks. Currently, you can claim a $250,00 capital gains exclusion ($500,000 for married couples) for primary residences, but not rentals.

However, if you sell a rental and swap it for another, you can delay paying capital gain taxes under the so-called like-kind exchange.

In other words, treat your rental like any other investment. If you want to boost your chance of success, go slowly and do your homework.  Top of page

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