Renting out a Single-Family Home
Renting out a Single-Family Home
2010 Robert Bruss Real Estate Book Award
Ilona Bray; Janet Portman; and Marcia Stewart
September 2014, 3rd Edition
Earn rental income
Do you own a house that makes more sense to rent out than to sell? It’s a common scenario in today’s market. And it may mean you’re about to be a first-time landlord. Follow the advice in this book to earn substantial profits while avoiding costly mistakes.
First-Time Landlord will show you how to:
- learn your legal obligations
- estimate costs and profits
- avoid problem tenants
- qualify for valuable tax deductions
- handle repairs and property management tasks
- and more!
The 3rd edition includes new material on renting out a room in your home via services like Airbnb; new IRS regulations relevant to landlords; plus a sample rental application. From timely tips to true stories from successful landlords, First-Time Landlord is an indispensible book for property owners who want to rent out a single-family home without the hassle -- quickly, efficiently and legally.
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Your First-Time Landlord’s Companion
1. Will Landlording Bring You Money and Happiness?
- Great Things About Being a Landlord
- Tough Parts of Being a Landlord
- Location, Price, and More: Features of the Ideal Rental Property
- Thinking About Buying an Investment Property?
- What Will Your Monthly Profit Be?
- What Will Your Long-Term Gain Be?
- Setting Your Goals
2. So Happy Together: Landlording With Family or Friends
- The Pros and Cons of Co-Owning Rental Property
- Having a Compatible Co-Owner
- How to Take Title
- Creating a Co-Ownership Agreement
3. Preparing and Marketing Your Rental Property
- Make Sure Everything Is Up to Code
- Should You Make Major Repairs or Improvements?
- Prepare the Rental for an Attractive Showing
- Set the Rent and Other Important Terms
- Get to Know the Neighbors
- Come on Down! Advertising Your House for Rent
- How to Show Your Property
- Pardon Those People: Renting Property That’s Still Occupied
4. Screening and Choosing Good Tenants
- Creating a Rental Application
- Check References and Run a Credit Report
- Avoiding Illegal Discrimination
- Is This the One? Characteristics of the Perfect Tenant
- Whom to Reject
5. Preparing a Lease and Getting the Tenant Moved In
- Which Is Better, a Lease or a Rental Agreement?
- State Laws to Know When Preparing a Lease or Rental Agreement
- Typical Provisions in Leases and Rental Agreements
- Signing a Lease or Rental Agreement
- Getting the Tenant Moved In
- Organizing Your Rental Records
6. Manage Your Rental Income to Maximize Tax Deductions
- Keeping Your Business Finances Separate
- Shielding Yourself From Liability for Business Debts
- Spent a Lot of Money? Take More Tax Deductions!
- Proving What You’ve Spent: Record Keeping
- Are You Rich Yet? Tracking Income and Expenses
- How Much Cash to Keep in Reserve
- What to Do When Expenses Exceed Income
- Finding Professionals to Help You
7. Keeping Things Shipshape: Repairs and Maintenance
- Dealing With the Legalities: Your Repair and Maintenance Obligations
- Adopting a Good Maintenance and Repair System
- No Thanks! Hiring Someone Else to do the Work
8. Landlord Liability for Injuries, Crimes, and More
- Ouch, That Smarts: Liability for Tenant Injuries
- Liability for Environmental Health Hazards
- Keeping Tenants Safe: Liability for Crime
- Insurance Coverage for Property and Liability
9. Living in Perfect Harmony? Dealing With Difficult Tenants
- Common Tenant Problems – And What to Do About Them
- Resolving Disputes
- When All Else Fails: Terminations and Evictions
10. Don’t Want to Do It Alone? Hiring a Property Manager
- What a Professional Property Manager Does
- Should You Hire a Property Manager?
- How to Find the Best Property Manager
- Put It in Writing: Drafting An Agreement With Your Property Manager
11. Ready to Quit? Exiting the Rental Property Business
- What’s the Driving Force? Identifying Your Exit Plan Objectives
- What Are Your Options? Exploring Opportunities
- What Rights Does the Tenant Have If You Sell?
- If You Decide to Sell: Getting Ready
12. A Slower Exit: Rent-to-Own Arrangements
- Advantages and Disadvantages of Rent to Own
- The Option Price
- Sale Price of the House
- When the Tenant Must Exercise the Option
- Seller Financing and the Tenant's Rent-Paying History
- How Will the Tenant Notify You?
- Tenant Improvements and Rent
- "Right of Refusal" and "Right of Offer"
- Get Legal Advice
13. Renting Out a Room in Your Home
- Is Renting a Room to a Lodger for You?
- Basic Steps to Renting Out a Room
Will Landlording Bring You Money and Happiness?
Great Things About Being a Landlord
Owning rental property offers both financial and lifestyle benefits. As Laura, a landlord with properties in Washington, Nevada, and Florida, says, “I like people and the feeling that I’m doing a good job. In fact, I have to be careful not to get too friendly—I have tenants in Florida with adorable kids, and I’m often tempted to volunteer to babysit, but have to remind myself to keep it all business. Of course, it’s also nice to earn money through my efforts, and to be able to take tax-deductible trips. I remember the first time I sold one of my rental properties, and made a nice profit on the sale; it made me very happy.”
Below is an overview of the various benefits that Laura and other landlords enjoy. Try to remember these later, when you’re cursing the latest plumbing problem or fretting over how to fill a vacancy.
Appreciation and wealth building
If you hold onto your property long enough, it will almost certainly go up (“appreciate”) in value—eventually. Since World War II, real estate prices in America have risen an average of around 5% a year (with some nerve-wracking ups and downs in between). And even if the house’s value isn’t rising, renting it may allow you to build equity until you own it outright. Owning investment property is a great way to increase your net worth.
A well-managed investment property, with tenants who pay the rent on time and monthly expenses that are less than the rent, can bring you a steady stream of income. Most landlords owning single-family homes buy with this purpose in mind.
Diversification of income
You never know what life is going to throw at you. If you’re laid off from your job, or your health takes a turn for the worse, your primary source of income—presumably your salary—could be jeopardized. Owning an investment property diversifies your income stream and can give you somewhat of a cushion.
Unlike more volatile investments, the returns on real estate are fairly steady. While stock values can fall or even disintegrate entirely, land and property won’t disappear on you. And history shows us that they almost always hold their value—or at least bounce back after a tumble.
And even when property values are down, people need places to live —a fact that kept rents relatively high even during the recent recession.
Owning property also diversifies your investment portfolio, a cardinal rule of investing. And it’s pretty easy to understand, if you get the idea of not putting all your eggs in one basket. Should something unforeseeable happen to your riskier investments, such as stocks, you’ll have the backup of a tangible, relatively low-risk asset. As you approach retirement, it’s good to start shifting into lower-risk investments, to ensure the cash you need doesn’t disappear when you’re relying on it.
Unlike other investments, a little bit of cash will buy a lot of real estate: A down payment of 20%—or in some cases, as low as 10% of the value of the property—is usually enough to get you started. You could, for example, buy a $400,000 property with a $40,000 down payment, while that same amount will buy you only $40,000 worth of stock. And if the value of that stock were to increase by 10%, you’d have a $4,000 profit, whereas if the value of the property increased 10%, you’d have a $40,000 profit. (These are, of course, rough figures, in that they do not account for sales commissions, depreciation, capital gains taxes, and so forth.)
This is called being highly “leveraged”—in one sense, deeply in debt, but in another sense, poised to gain high returns based on a relatively small up-front investment. Leveraging your investment allows you to trade up to more profitable properties.
Short-term tax advantages
While the rental income from your property is taxable, you can deduct most of the expenses related to owning and maintaining the property. Among these are mortgage interest, insurance, repairs, and upkeep. They also include your business expenses, such as phone calls, office supplies, professional fees (for example, to the accountant who helps you figure out your business taxes), and more.
Does Owning Real Estate Create Millionaires?
Catherine McBreen and George Walper, authors of Get Rich, Stay Rich, Pass It On, are managing director and president, respectively, of Spectrem Group, a research and consulting company that has been studying the affluent since 1991.
Each year, the firm surveys more than 5,000 millionaire and megamillionaire (more than $5 million in assets, not including primary residence) households. While there are many ways to get rich, the authors identified two definitive ways to ensure lasting wealth: owning incoming-producing real estate and investing in an innovative company, product, or service.
In this model for getting rich, just below half of the typical megamillionaire portfolio is invested in marketable assets: stocks, bonds, mutual funds, and other securities. The rest of the assets are not
If you dream of being really rich, you will need to actively invest in real estate, they write. “Building up a nest egg with the equity in your home is a fine thing. But what distinguishes the model for getting rich, staying rich, and passing it on is its emphasis on investing in current and future income-producing real estate.” Look for opportunities initially in areas you know, they advise.
On average, 23% to 29% of your wealth should be allocated to real estate. Here’s how it breaks down: 11%–13% of your real estate investments should be equity in your principal home, 3%–6% should be income-producing property, 5%–7% a second home, 3%–5% other real estate holdings such as REITS, 2%–4% undeveloped land, and 2%–4% third or additional homes.
There are a slew of caveats, of course, on top of the myriad decisions that go into selecting the right properties. And yet, for those willing and eager to go the distance, consider the book’s parting thought: “Keep in mind that all this is doable.”
“Path to wealth is through real estate holdings,” by Kerry
Another major tax advantage is the ability to “depreciate” your property—to take an annual deduction that reflects the decreased value of the property caused by wear and tear. (In the most literal sense, depreciation may turn out to be a fiction if the value of the property goes up a lot—but it can be a wonderful fiction for tax purposes.) Chapter 6 of this book discusses tax issues in detail.
Long-term tax advantages
Even if your property skyrockets in value on paper, the IRS won’t expect you to pay taxes on that increased value until you sell. (Your state and local property taxes may be another matter, however, rising steadily to catch up with the property’s value.) Unfortunately, when you do sell, you may lose the advantage of the capital gains tax exclusion ($250,000 per owner), if you haven’t lived in the place for two out of the previous five years. However, there are several strategies you can use to decrease your tax liability. We’ll discuss those in Chapter 11.
If you own just one property, and it’s not too far from where you live, you can probably handle its management in your spare time, while still working a full-time job. A little job flexibility will help, of course. Although weeks may go by when the property needs little or no attention, there will be times when it will need hours from you, for example, when you’re getting the place painted while dealing with the departure of the old tenant and interviewing prospective new tenants.
Your time commitment will be even less if you hire a property management company—though your profits will decrease as well. We discuss the pros and cons of hiring property managers in Chapter 10.
Being a landlord and owning property can give you a sense of accom-plishment (and some stories to tell at parties). It shows that you’ve broken out of the mold of the average working stiff, and are willing to take risks and accept major responsibilities. You’re learning new skills involving finances, dealing with people, and maybe even home repair, which may help you in other areas of life.
Being a competent and conscientious landlord will pay dividends in other respects, too—you’re going to feel pleased about the way you’re doing business. As Amy, who lives in Berkeley, California, and rents out her former home in Austin, Texas, puts it: “I’ve rented from a few crummy landlords myself, so it’s very satisfying to be able to give my tenants a positive experience, for example, quickly taking care of repairs if something goes wrong.”
Tough Parts of Being a Landlord
Landlording is not for everybody, and not every property is worth keeping or buying as an investment. The main reasons that people tend to give up on landlording are the time required to manage a property effectively, the risks involved (such as problem tenants, long vacancies, and legal risks), and the cost. Here’s a quick overview of these issues. Later chapters in this book provide detailed advice on minimizing and dealing with problems.
Even though landlording isn’t a full-time job, it will take more than an hour or two of your time every few weeks. For one thing, you’ll need to be reachable and available nearly around the clock, to respond to calls from tenants when the plumbing backs up or the neighbor’s dog is barking all night. Occasionally, you’ll need to put in large chunks of time, for tasks like listing and showing the property during a vacancy, screening and approving tenants, and handling rent checks and deposits, to name a few.
In this book, we’ll help you strategize ways to cut down on the time you spend landlording. For example, Chapters 3 and 4 will give you tips on how to market your property, attract and choose the right tenants (who will hopefully stick around for awhile), and list the property so as to fill vacancies quickly and efficiently.
One of the pitfalls of owning rental property is the possibility that you’re going to get that rare “tenant from hell”—someone who doesn’t pay the rent on time, trashes the property, or constantly bugs you about every little thing that goes wrong—all of which can be expensive to remedy. Catherine, who rents out a cottage behind her house in Berkeley, describes often feeling “vulnerable” because someone else has day-to-day control of property she owns and cares about.
It’s more likely that your tenants will be perfectly decent, responsible people. Good screening procedures (as described in Chapter 4) will help assure this. Nevertheless, people can change. Catherine’s low point as a landlord came, she says, when “one of my tenants, who six months before had a nice job and drove a BMW, developed a crack addiction. The neighbors formed a watch group around my house, and I’d see drug deals going on and find vials in the backyard.”
A properly structured lease or rental agreement (as covered in Chapter 5) will help deal with difficult situations like this and reduce many of the risks associated with problem tenants. And knowing how to deal with bad tenants (Chapter 9) will also help you do damage control when needed.
There may be times when the market is soft and it will be difficult to rent your place out. Vacancies are a reality of life for most landlords, but can be made worse by local economic conditions, the need for major repairs in your property, or just sheer bad luck. That’s why we’ll make sure you factor expected vacancies into your analysis of potential profits on the property.
If you really want to talk worst-case scenario, you could worry about the legal risks that come with owning rental property—that is, the possibility that a tenant, prospective tenant, or someone else on your property will sue you over a health, safety, environmental, discrimination or other legal matter. You could even face legal trouble from third parties, stemming from misbehavior of your tenant. For example, if a tenant’s drug dealing results in injury to a neighbor, you might be liable if the neighbor can prove that you knew what was going on but failed to take action.
Knowing your own responsibilities and potential liabilities (which we’ll describe in Chapter 8) and acting to reduce the risk of problems occurring will limit the chances that you’ll face serious legal situations.
The costs of owning an investment property go well beyond the mortgage. They include property taxes, insurance, utilities, upkeep, repairs, property management costs (if you choose), wages for a handyperson, legal costs when needed, and much more. It all adds up to more than you probably spent on the home if and when you lived there.
As Dennis, a landlord since 1982, describes it, “We haven’t had much of a negative cash flow on our properties, but we have sometimes. From a financial point of view, if people are really tight, they shouldn’t get into the landlord business. There’s always the unexpected plumbing problem, or an appliance that wears out.”
Reducing costs is one of the keys to being a successful landlord. We’ll advise you on how to assess the cost side of your property in Chapter 6.
Location, Price, and More: Features of the Ideal Rental Property
Whether you’re planning to buy a rental property or deciding whether to keep a property you already own, one of your first considerations should be whether the place is actually suited for renting. Look especially hard at features of the property that can’t be changed, like its location and whether it has a yard. Let’s consider its suitability from both the tenant’s vantage point and yours.
What gives a property “tenant appeal”?
Here are the most important, primarily physical characteristics of a house that will appeal to a wide range of tenants:
Size. This depends on the local population. For example, a house with several bedrooms will be attractive to large families.
Location. Nearby transportation access—particularly public transport, with gas prices regularly setting new highs—is a big plus. So is proximity to shopping and commercial areas.
Security. No one likes to live in a high-crime area—and making sure the property is secure enough for your tenants can add to your to-do list as a landlord, too.
Good nearby public schools. A family that wants to make sure their children go to the best schools and finds a good home nearby to rent may settle there for years. But even short-term renters appreciate a good school and the corresponding community spirit.
Affordability. With rare exceptions, it’s difficult to find tenants for large, luxury houses. Any prospective tenant who has the money to afford the monthly rent can probably also afford to buy a house.
In good repair. Even if it’s otherwise in good shape, a house with ongoing maintenance issues—perhaps having a nearby creek that often floods, or being so old that everything is falling apart—may put off tenants who don’t want to be dealing with inconveniences or calling you with numerous repair requests.
Layout. Like everyone, rental tenants want a place that’s well designed. Don’t assume, for example, that a renter will be content with a tiny kitchen. And if the house is likely to be shared among roommates, each bedroom should be reasonably private and have bathroom access that doesn’t involve invading someone else’s room.
Charm and aesthetics. Like home buyers, renters will be drawn to a place that looks nice. But you can’t know every prospective tenant’s taste. That’s why a house with broad appeal rather than quirky features is your best bet.
Of course, tenants will also be concerned with certain nonphysical parts of the property, like how much rent you charge and whether you allow dogs. However, such policies are largely within your control, and don’t affect whether you’ll buy or keep the house in the first place, so we’ll discuss them in Chapter 3.
When Cheap Houses Make Good Rentals
Most real estate investors would jump at the chance to buy a condo with water views along Florida’s Gulf Coast, or a leafy estate in Greenwich, Connecticut.
Not Jonas Lee, managing partner of Redbrick Partners, a firm that runs the only U.S. investment fund dedicated to single-family housing. The 1993 Harvard Business School grad prefers to invest in humble row houses located in working-class neighborhoods in gritty Northeast cities, such as Philadelphia, Baltimore, and Trenton, New Jersey.
“It’s all about the numbers,” Lee said on a recent rainy day while inspecting the electric and heating systems in the wet basement of one of the 99 row houses he’s contracted to buy for $5.4 million in the Kensington section of Philadelphia. “You have to keep your emotions out of it. It’s not like I drive up to a home and say, ‘I love the bricks; they are so red.’”
Real estate investing isn’t as easy as it sounds on those late-night infomercials. Redbrick says residential landlords overestimate how much they will make off rental properties. The “Redbrick Rule” assumes 50% of rental income will get eaten up by expenses, such as vacancies, taxes, fixing leaky faucets, and replacing roofs and furnaces.
So why does Redbrick prefer buying homes in aging industrial towns rather than more desirable locations? The answer: Rental yields, which is how much you actually pocket from rent each year as a percentage of your purchase price. Redbrick uses a simple equation to calculate yield: It takes 50% of annual rental income and divides that by the property’s purchase price.
When Cheap Houses Make Good Rentals (cont’d)
For example, a $1 million home that rents for $6,000 a month, or $72,000 a year, nets a rental yield of 3.6%. In contrast, a $75,000 home that rents for $1,100 a month, or $13,200 annually, delivers a heftier yield of 8.8%.
Most homes yield about 4% but can go as low as 2% and as high as 9%, depending on the market. Redbrick prefers yields at the high end of the range. The most expensive properties do not always translate into the best rental investments. If you strip out potential price appreciation, rents that fail to cover costs result in negative cash flow.
What makes a good rental from the landlord’s point of view?
After thinking about whether your property has sufficient tenant appeal, turn your attention to whether the house you’re considering is appropriate for you, given your available time, skills, and interest. In most cases, this is a house that:
Requires little fixing up and maintenance. For example, a house that’s relatively new isn’t likely to need new plumbing or wiring anytime soon. But this doesn’t mean a newly built house is necessarily the best. A place that’s well constructed but isn’t on the verge of becoming “historic” is your best bet.
Is close to your own home or work. Who wants to drive for an hour—or get onto an airplane—to interview new tenants or see to a maintenance problem? And even if you hire a property management company, it’s good to be able to check on the property yourself from time to time.
Dealing with maintenance gets a lot harder at a distance. As Kyung, who formerly rented out her triplex home in New Haven, Connecticut, explains, “For the ten years we lived in the unit above the rental, we had practically no maintenance problems. But wouldn’t you know it, as soon as we moved to Pennsylvania, things started to fail. The tenants were calling in the middle of the night, and I’d have to call some 24-hour service and pay a premium to get the repairs made.”
Isn’t in a heavily regulated city or area. If your property is in an area with rent control or other restrictions on landlords, take a careful look before you leap. Read the regulations and talk to other local landlords about their experiences. If you’ll be buying a property with existing, long-term tenants who show signs of planning to stay there forever, you’ll have to make do with below-market rent well into the future. In situations like this, your investment may be a losing proposition.
Will attract long-term renters. For example, a house near a vacation resort or a college might not be optimal if you’re hoping for year-round tenants. (Students tend to leave at the summer break and often switch housing every year, which means regular turnover and repairs.) If there’s high turnover, you’ll at least want correspondingly low vacancy rates and high rents.
Doesn’t require evicting long-term tenants. See “Evaluating Resident Tenants” in the discussion of buying foreclosed property, below.
Is convenient to commercial supply sources and repair people. In other words, avoid houses in remote locations where you’ll have to struggle to get to a hardware store or find high-quality help for maintaining or improving the property.
Is in a strong rental market. Ideally, you’re looking for a property that’s cheaper to buy than to rent, so you can bring in income. But you’re also looking for a market with lots of would-be renters: Otherwise, you’ll find profits eaten up by vacancy periods.
Special concerns when renting out a condo or co-op
Whether you already own a condominium or another home in a common-interest development (CID) or are thinking of buying one, you need to be aware of how the property’s unique features impact its suitability as a rental property.
Condos and townhomes are the most common types of homes in CIDs. Renting them offers special advantages, including:
Less maintenance responsibility. The homeowners’ association (HOA) will take care of common areas, freeing you from hands-on responsibilities like tending the garden or (in most cases) repairing the roof. (Of course, you pay to get these things done via your monthly HOA dues.)
Affordability. A condo or townhouse is usually cheaper than a single family home, because you own less—you own your particular unit, and own common areas jointly. And the maintenance can be less expensive too, because costs that might otherwise be individually paid—like landscaping and insurance—are instead shared.
Amenities to attract tenants. Without having to buy a whole apartment building, you may be able to offer your tenants access to a pool or other recreational or meeting spaces.
But let’s not forget the disadvantages:
Community rules and regulations. In a CID, residents typically must agree to live by a set of rules. These may govern everything from the size of residents’ dogs to whether they can hang clothes on the line, add a spare room, smoke in the unit, change the color of the curtains, or change the color of the outside paint. Getting your tenants to read and abide by these rules, when they don’t have a long-term stake in the community, can be challenging.
Restrictions on renting. Possibly the most significant rule in a CID is a restriction on renting. Some CIDs place numerical limits on how many units can be rented, or ban renting altogether. Although the association is unlikely to weigh in on your choice of tenants (which would expose it to liability for discrimination and the like), it may insist that you put certain clauses in your lease (for example, committing the tenant to abide by community rules), or exert other oversight.
Community fees and costs. Every CID charges a monthly fee for maintenance and shared costs, and the rules typically also allow special assessments for major expenses like a new roof on the property or dealing with a flood or other emergency. These can run into the hundreds, even thousands of dollars per month, which you’ll need to figure into your budget. (The landlord is normally responsible for making these payments, not the tenant.)
Slow property appreciation. Historically, condos and townhomes have appreciated in value at a slower rate than single-family homes.
We’ve given a broad description of CIDs, which can vary immensely in physical features and character. Your job, before deciding to buy or rent out one of these properties, will be to fully research its costs, rules (often in a document called Covenants, Conditions, and Restrictions, or CC&Rs), and current community concerns. Read the CC&Rs and recent meeting minutes thoroughly, talk to neighbors, and investigate the reputation and financial strength of the property’s builder or owner.
Is Airbnb or VRBO for you?
Many people who own rental property in popular tourist destinations, such as San Francisco, or in college towns, such as Ithaca, New York, choose to rent their homes through Airbnb or another short-term hosting or rental service.
This book focuses on more traditional rental situations, where you sign a fixed-term lease or month-to-month rental agreement with one or more tenants. You will have screened these longer-term tenants by running a credit report and checking references.
Renting through Airbnb or a similar service involves a separate set of legal and practical issues concerning taxes, insurance coverage, liability for guest injuries, and so forth. Having different people come in and out of your rental house can cause major headaches for neighbors and may even violate municipal restrictions (some of which were under discussion as this book went to print).
While you may end up bringing in more money each month by renting your house through VRBO or a similar service, carefully consider all the relevant issues, including how much time you’ll need to spend screening guests or arranging for cleaning in between visitors. To get further informed, see the Short-Term Rentals of Your Home area in the Real Estate section of Nolo.com. You’ll find articles on insurance, taxes, screening renters, legal restrictions, and neighbor concerns. Also, to prevent your tenants from renting a room or space within their rental via Airbnb, make sure your lease or rental agreement prohibits sublets, as recommended in Chapter 5.
Is sharing your home with a lodger for you?
Some homeowners decide (either for financial or social reasons) to stay in their homes and rent out a room in their house to a lodger. Because this is different than the typical landlord-tenant relationship, we’ve devoted a special chapter to the subject. See Chapter 12 for details.
Thinking About Buying an Investment Property?
Not all landlords are accidental landlords. You may be thinking about buying a property so that you can rent it out. (If not, and you already own a property, skip down to the next section, “What Will Your Monthly Profit Be?”) In fact, a survey by the National Association of Realtors® showed that 1.1 million second homes, or 20% of all new home sales in 2013, were for investment purposes.
Before you make that decision, you’ll want to do a careful analysis of the costs and potential returns of your investment. Keep in mind that real estate is not a get-rich-quick business. You’ll have to invest some significant cash up front. And while your rental income may be a source of ongoing profit (we’ll help you calculate how much below), a large portion of the financial gain will come about as time passes and the value of the property increases. And you won’t actually realize that benefit until you sell (though you could use your increased equity as collateral for a loan).
While some people have gotten rich in real estate, you’ve probably seen the headlines about the many who’ve been disappointed—the would-be house “flippers” who, during the recent real estate downturn, found they couldn’t buy and sell property for quick profits as they’d planned, and ended up in foreclosure or bankruptcy. For many of them, turning their house into a rental property wasn’t an option—their carrying costs were too high compared to the rents they could charge, and they faced a long road of losses ahead.
We’re going to assume you don’t have aspirations toward house flipping, but are looking to invest in rental property over the long term, and ride out the inevitable ups and downs of the market. Or perhaps your ultimate goal isn’t to sell, but to live in the home yourself, after you’ve retired. Let’s evaluate your budget and how buying a rental property will fit in, both as a short- and long-term investment.
This book doesn’t attempt to present a complete guide to choosing a house to buy or financing investment property. Some good resources for that include:
• Real Estate Investing for Dummies, by Eric Tyson and Robert S. Griswold (Wiley Publishing, Inc.)
• Nolo’s Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart, and
• the Real Estate section of Nolo.com, which includes hundreds of useful articles on buying, owning, and selling real estate, including investment property.
How much cash you can put down
To determine whether buying an investment property is even a financial possibility for you, let’s start with a simple calculation: How much cash can you free up for a down payment, and how much house will that buy? Most lenders require 20% down, especially on an investment property. (The days of zero down payments are gone, victims of the bursting real estate bubble and subsequent foreclosure crisis.) A quick visit to the real estate section of your local paper, or to an online site like www.realtor.org, will show you typical prices in the location where you’re interested in buying.
You’ll also need to budget around 2%–3% of the house’s price for closing costs, depending on what state you live in, what kind of mortgage you get, and what you can expect to pay in escrow fees, title fees, real estate agent commissions, and taxes and insurance at closing. So if you can put down $80,000 plus pay $12,000 in closing costs, you’re well on your way to buying a $400,000 property. If your cash on hand will likely buy a worthwhile rental in your area, keep reading.
Looking at a fixer-upper? In that case, you’ll need even more cash on hand. Major home improvements always seem to take more time and money than originally expected, so think twice about this strategy if you’re not experienced with home repairs or construction.
How large a loan you’ll qualify for
You’ll probably be taking out a loan with which to buy your property (unless you’re among the approximately 35% of real estate investors who pay all cash). That means you’ll need to show a lender that you can afford the monthly payments. One of the tests that lenders use is your credit history and score, or your record of paying debts on time. We’re not going to discuss credit scores in detail here—for more information, see the free articles in the Debt Management section of www.nolo.com.
The other test that lenders use is the comparison between your income and your debt load, called your “debt-to-income” ratio. The more debt obligations you already have hanging over you, the less likely the lender is to let you take on more. In fact, the lender may be stricter than when you bought your first home, because lending practices have tightened and mortgages on investment properties are considered riskier.
Evaluate your monthly expenses even more strictly than your lender does. What we’re discussing here is how much mortgage you’ll qualify for. But if you tend to spend everything you earn each month—and perhaps aren’t even sure where the money is going—you need to get your first house in order before taking on a second one.
The concept of “debt-to-income ratio” isn’t as complicated as it sounds. The lender looks first at your household’s gross monthly income (the amount you earn before taxes and other monthly withdrawals, plus income from all other sources, like rents, royalties, alimony, or investments). Then it makes sure that your combined minimum debt payments on the property—going toward your PITI (principal, interest, taxes, and insurance), plus any community association fees, credit card payments, car debt, student loans, and more—don’t eat up more than a certain percentage of that gross income. See the “Sample Debt-to-Income Ratio Worksheet,” below.
How high can your debt-to-income ratio go? Traditionally, lenders said that your PITI payment shouldn’t exceed 28% of your gross monthly income (sometimes called the “front-end ratio”), and your overall debt shouldn’t exceed 36% (the “back-end ratio”). Although that formula was largely tossed out during the real estate boom of the early 2000s, it’s not only back in full force, it’s more stringent than ever. As of 2014, federal guidelines say that a home borrower’s total debt-to-income ratio for a “qualified mortgage” should not exceed 43%.
With that ratio in hand, the lenders set your maximum monthly mortgage payment. Using the calculators listed below, you can arrive at roughly the same figure—and then decide whether that amount is enough to buy a rental property in your chosen area.
Sample Debt-to-Income Ratio Worksheet
Gross monthly income:
Gross monthly income x .28
= Maximum monthly PITI payment
Gross monthly income x .36
= Maximum monthly debt overall
Ready to run some real numbers? Find online affordability, as well as household budget, calculators at www.nolo.com/legalcalculators, www.hsh.com, and www.interest.com. Make sure any calculator you use factors in the amount of your down payment, income and debts, and estimated taxes and insurance.
Apartment Rents Projected to Rise in 2014
Higher rents are ahead in 2014 for the nation’s apartment dwellers, but some cities will see smaller bumps than in recent years, market researchers say.
Rents will increase 3.1% nationally in 2014, about the same as in 2013, apartment market researcher Axiometrics says. Meanwhile, researcher Reis sees rents rising an average of 3.3% in 2014.
Tight supply and rising demand are still the key drivers.
“The construction pipeline really closed during the recession. We’re still clawing our way back,” says Ryan Severino, Reis chief economist.
Cities that have seen some of the sharpest increases will see rents rise a little more slowly in 2014, says Jay Denton, Axiometrics vice president of research.
Since the end of 2009, rents have soared 43% in San Francisco, including an 8% jump in 2013, Denton’s data show.
In 2014, they’ll rise 5.1% given still strong demand and limited new supply.
Seattle, which posted a 6.5% increase in 2013, will rise 4.4% in 2014. Austin, which rose 5.2% in 2013, will see an increase of 3.7%
Construction has been uneven across the country. Some major metros that have led the way in new construction are now at risk of having an oversupply of apartments.
Washington, DC “has probably already gone over that cliff,” Denton says. Rents there will fall 2.5% in 2014, Axiometrics predicts.
Austin also has seen a lot of construction. “It’ll be difficult to raise rents there,” Severino says.
Nationwide, almost 230,000 new apartments will be added to the supply, Axiometrics says. That’s up from 170,000 in 2013 and only 87,000 the previous year.
Half of all U.S. renters paid more than 30% of their income for rent—
Apartment Rents Projected to Rise in 2014 (cont’d)
points from a decade earlier, according to a study from Harvard’s Joint Center for Housing Studies.
Apartment rents have risen every year since 2010, market data shows.
Meanwhile, the share of Americans who rent grew from 31% in 2004 to 35% in 2012, the study says, driven in part by the foreclosure crisis.
Trevor Coccimiglio, 24, is looking to rent a room in a shared house in San Francisco for less than $1,200 a month. That’s about what his father pays to rent an entire house in suburban Salt Lake City.
“That’s just the cost,” says Coccimiglio, who has taken a new investment banking job.
He recently looked at a $900-a-month room in a 3-bedroom, 864-square-foot apartment. The parking space costs $75 extra a month.
Keep in mind that interest rates are higher on investment properties, so your calculations shouldn’t assume that you’ll qualify for the rock-bottom rate offered to buyers with stellar credit who are buying primary residences. You won’t be offered these rates, because lenders know they’re in a riskier position when their borrower is paying two mortgages: If you hit hard financial times, you’ll pay the mortgage on your primary residence first.
Some investors with lots of equity in their primary residences get around these higher rates by doing a cash-out refinance (drawing out cash from their main home to pay for a second) or taking out a home equity loan. This strategy is beyond the scope of this book; in general, while you can use it to get a lower interest rate, the lender will subject you to the same financial evaluation discussed above.
Fortunately, lenders will allow you to include your expected income from the rental property in your calculations. This will help you qualify for a bigger loan. However, lenders will probably be conservative in estimating your likely income, for example, by figuring a higher-than-expected vacancy rate.
You’ll need to know how much loan you qualify for so you can estimate what kind of property you can buy, how much it will cost you each month, and how much you can expect it to bring in. Later in this chapter, we’ll cover whether it’s profitable to buy based on these factors.
Buying a Foreclosed Property
Although the flood of home foreclosures has turned to a trickle, many savvy buyers have braved the uncertainties and frustrations associated with such sales to buy homes for use as investments.
Foreclosure properties tend to be in rough shape (there’s a reason they’re known as “distressed”), and some come with resident tenants and even recalcitrant former owners. You’ll need to be prepared for the special challenges that come with obtaining a distressed property that you intend to rent out. But first, here’s a brief description of how to find and secure a distressed property.
The main advantage to buying a foreclosure is price—you’re likely to get a good bargain, whether you buy from the owner (preforeclosure), at a foreclosure sale, or directly from the bank (known as “real estate owned,” or REO). The main disadvantages to buying foreclosure properties are:
Going without the usual buyer protections. As we’ll explain further, below, at most stages in the foreclosure process you’ll forgo at least some of the normal protections available in a typical transaction. For example, you may not get to see the property before you buy, have to accept it “as is,” and have to go without title insurance.
Waiting to make sure the owner’s rights are protected. All states have laws to make sure banks can’t rip properties out from under late-paying owners on a moment’s notice. For buyers, that means deadlines, delays, court rules, and uncertainty—particularly in the many states that allow the former owner to “redeem” or buy back the property within a certain period of time after it was sold in foreclosure (usually from ten days to one year). Of course, if the owners redeem the property, you’ll get your money refunded. But as attorney Fred Steingold notes: “Do you really want to be held in limbo, unsure of whether you’ll ever be able to occupy the house?”
To find out your state’s redemption period and get other summaries of your state’s law regarding foreclosures, see www.nolo.com (choose Foreclosure and then Foreclosure Laws).
Competition from experienced real estate investors. If there are good deals to be had, you can bet real estate investors will be lined up in front of you, with cash at the ready.
Risks of undisclosed repair needs, tax liens, or other issues with the property. Remember, these homeowners were probably financially stressed for a while. They may have held back on maintenance, gotten behind on their taxes, or used the house as collateral for other debts.
Still interested in pursuing foreclosed properties? Find an agent who specializes in them—most don’t handle them at all, while some go so far as to arrange bus tours of local foreclosures. A good source is www.reonetwork.com. If you still have a regular real estate agent, explain to both agents what you’re doing, so that you can agree on each agent’s limited role. You’d also be wise to hire a real estate attorney to help navigate this somewhat touchy area.
Buying a house in preforeclosure
When a house is in preforeclosure, this means that the homeowner has fallen behind in payments and the lender has filed a notice of default or started a lawsuit to officially begin the foreclosure process. The foreclosure sale has not yet taken place; this is simply an early stage of the foreclosure process. During the preforeclosure period, the homeowner typically has a certain amount of time in which to either catch up on past-due mortgage payments plus fees, sell the home to pay off the loan, or work out an alternative to foreclosure, like a mortgage modification, short sale, or deed in lieu of foreclosure.
Preforeclosure listings are publicly available even if the homeowner hasn’t listed the property for sale. Online services like foreclosures.com or realtytrac.com compile this information from public records, and members pay a modest monthly fee ($30–$50) to get the information.
We hope you enjoyed this material. The rest of this chapter is available when you purchase the book.