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Things you need to Know Before you Become a Landlord

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Investing in Real Estate

The following is a contribution from my good friend Pauline, at Make Money Your Way. If you’re interested in contributing to Frugal Rules,  please consult our guidelines and contact us.

 

Being a landlord, for many, is a passive income dream. You collect a check every month, your tenants are clean and respectful, and when they go, you easily replace them with equally perfect tenants. While I am convinced real  estate is one of the best ways to make money and build wealth, in real life, there are still a few things to consider before you choose real estate as an  additional source of income.

There are Bad Tenants

 

I bought my first property at 22 without doing much homework. It was rented to an old man who apparently had always paid on time. He stopped doing that.  Then he died. Then his widow stayed for another 18 months without paying rent before I could evict her. They left the place with 20 years of clutter and a few months of garbage when the police evicted them.

What you can do: Thankfully, I had insurance and they took  care of everything. They paid me rent, sued the guy, followed up with the  eviction process and even cleaned the place afterward. I am really glad I didn’t  skimp on insurance. You should also do a background check, ask for references  and check them, make a credit check and if anything makes you feel suspicious,  do not take the tenant in. One month of vacancy is nothing compared to the  potential destruction a bad tenant can make.

Buy a House for Your Tenants, Not for You

 

When I bought that first property, it was in one of the worst areas around Paris. High crime rate, drug traffic, gangs… you name it. One of the advantages  was that tenants were not picky. I did the bare minimum in regards to maintenance for the 10 years I owned the property. Once you know what your  target tenant wants, give them that. Are you buying in a college town? Buy a place with three or four rooms but do not worry if the living room is a bit  small, students will mostly be in their rooms or outside. Buying a studio?  Imagine living there as a single person. What kind of features would be  essential?

What you can do: A fresh coat of paint doesn’t cost a lot if  you do it yourself, as well as small cosmetic upgrades and a deep cleaning of  the place. But for anything else, wait until you actually have a tenant making  an offer, and negotiate with them on further upgrades. A common agreement is to  offer them the first month for free in exchange for them painting the place for  example.

Do Your Research Before Becoming a Landlord

 

I was aware the neighborhood was not so great, but also knew that the state  was pouring a lot of money into renovations, green areas, and tax incentives for landlords to stop illegally renting small spaces to big families and start taking in singles and couples with no kids. It took 10 years but the area became a bit better and the prices doubled.

What you can do: You should visit the neighborhood by day, night, and during weekends to see what to expect. And also check out the HOA fees, ask neighbors what they are happy and unhappy about, check the HOA’s  accounts (mine was in debt and good payers had to pay for the bad debtors), etc.  The more you know, the more you can negotiate the price down or walk out before  you make a big mistake.

Having the Rent Cover the Mortgage Doesn’t Mean Positive Cash Flow

 

I also own a property in the UK whose rent covers my mortgage and all the bills (I rent with all bills included) and has a small positive cash flow. Does  that make it a smart investment? The correct answer would be that you do not have enough information to answer.

Say my property is worth $500,000 and my rent is $2,500 per month, minus $2,000 of bills and mortgage. My cash flow is $500 per month, right?

1. I may have put 80% down on the property. Having a  mortgage on the remaining 20% would mean I have $400,000 locked up in the  property and only borrowed $100,000. Would the property still have positive cash  flow if it were the other way around and my mortgage was four times bigger? How  about if I had no deposit at all?

2. Your deposit earns nothing. In real life, I put 25% down,  and that money is not earning me anything, it could be on the stock market  making 7 or 8%, is the rental yield over the deposit bigger than that?

$500 positive cash flow is $6,000 per year on a 25% deposit of $125,000, that  is a 4.8% return.

Calculating the yield over the total value of the property is a must as well $30,000 annual rent/$500,000 property = 6% return BUT as you can see once you  deduct your mortgage and monthly fees you are only earning $6,000/$500,000 = 1.2%. The beauty of it being the leverage that allowed you to make the return a  decent 4.8% over money invested. It does not mean that it is a good return  either.

3. Vacancies will eat up your positive cash flow. If the  above property is empty for a month, you are down to a 4.4% return. Three months  and it drops to 3.6%.

4. Repairs and maintenance will take another share of that  cash flow. The common estimate is you should budget for 1% of the property value  annually. My example is not so good since it would make the repairs cost $5,000  and leave you with a pale $1,000 for all your efforts.

5. Taxes will want a bit too. The good thing is you can  deduce the repairs from the rental income to deduce the taxable income.  Depending on your tax bracket, you can see your profit reduced by a third or  more.

So make sure you do your homework on the property AND carefully screen your  tenants to avoid any troubles!

Are you a landlord or aspiring landlord? What did I miss? As a tenant, what  are you looking for in a property?

 

The preceding was a guest post by Pauline  Paquin, you may know her blog Reach  Financial Independence, Pauline has just launched Make Money Your Way to help  readers diversify their sources of income with real estate, investing,  entrepreneurship and online endeavors. Born and raised in Paris, Pauline writes  about how she has been traveling the world for the past 10 years, while trying  to build wealth and achieve financial independence, and how you can follow your  dreams and reach your goals too. 

 

Editor’s note: Thanks to Pauline for sharing her wisdom with us. I believe that investing in real estate is a great way to help aid your journey to build wealth. While it may sound easy, there are many things you need to take care of if you plan on becoming a landlord.

 

Photo courtesy of: James Thompson

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I'm the founder of Frugal Rules, a Dad, husband and veteran of the financial services industry. I'm passionate about helping people learn from my mistakes so that they can enjoy the freedom that comes from living frugally. I'm also a freelance writer, and regularly contribute to GoBankingRates, Investopedia, Lending Tree and more. If you're wanting to learn how to monetize your blog, check out my blog coaching services to see how I can help you take your site to the next level.

45 Comments

  • Alexa says:

    One of the hardest things for me would be buying a house for the tenants and not myself. Owning rental properties is one my must do list. So, when I get there I am going to put my feelings aside and view it purely as a business investment. I have also seen my family members get some bad tenants, but they pretty much just take first come first serve. I will do some heavy screening.

    • pauline says:

      You can buy a house for yourself, I bought a house as a single young professional, and took 2 roommates. Today I don’t live there anymore, but it is still occupied by 3 roommates. The kind of house you buy for you (as a single, a family, etc) will likely attract the same type of tenants once you put it for rent.

  • Great point about the cash flow. It’s definitely important to realize that just having the rental income cover the mortgage is NOT covering all the expenses and is certainly not positive cash flow. Great post as always, Pauline.

  • I like the advice about buying for you tenant. Too often I am seeing people say I wouldnt live there but they are not buying it to live there. If its a rental think about the people you want to rent it to. If you are looking for affluent couple then buy in that area but if its in a college town 3-4 rooms make more sense. I’ve long said that I don’t see the purpose in putting 20-25% down but hey what do I know I am not investing in real estate yet.

    • pauline says:

      I would love to be able to put nothing down, but the bank wouldn’t like that too much. Also in the US don’t you pay PMI on top? That would reduce the yields.

  • Buying for your tenants and not yourself is a good tip. I’m hoping to get into real estate next year after we get out primary residence purchased. I think the cash flows on the right property can be a big boon for someone looking for financial independence. And the leverage just adds to advantages. You can get the cash flow from $250,000 while only putting $62,500 down. Another thing is to make sure you research your market. A place with stable although smaller jobs growth can be better than a place with booms and busts every few years.

  • Mark Ross says:

    I really thought that I will be taking on positive cash flow every time. I didn’t knew before that there are other factors to consider. I also think that your advice of asking the tenant what they prefer or like is a great advice. Thanks a lot!

  • Matt Becker says:

    Great point on the cash flow. It’s very similar to buying a house for yourself. Looking only at the mortgage payment and forgetting the other expenses is an easy way to get yourself in trouble. You need a complete picture, including a comparison to other options, before deciding whether it’s a good deal.

    • pauline says:

      Yes, comparing buying and renting if it is your own house, although there come other things that are not monetary like “feeling at home” or “rooting your kids”

  • Good advice! I’m a landlord but only because my hubby and I had to relocate due to his work. We rented our own house out so that we could move quickly. We’re not making much profit at all – but we’ll do better to rent it than to sell it at the moment! We did rigorous checks on our tenants beforehand and made sure they paid a month’s rent as deposit and another month’s rent upfront. We also have landlord insurance just in case things go pear shaped!

  • Michelle says:

    We are still debating whether or not we want to get into the rental business. Great post!

  • Keren says:

    This was a great post! We would like to get into rentals within the next year or two. We actually may have an opportunity to do a land contract on an already rented house on 3 acres. Would there be any pros or cons to doing a land contract rather than a mortgage?

    • pauline says:

      Sorry Keren I am not familiar with those contracts, what you are interested in is getting your money in, so make sure on both you have a way to protect yourself in case of non payment. What is the term to evict, etc? on both should tell you which is best.

  • kathryn says:

    My husband and I got into the rental property business in 2004. By 2010 we live soley on rent.Was it easy ? Not on your life. We took our life savings,(very meager) and all the equity we could draw out of our home, and used every bit of credit cards credit we could get our hands on. We now own 40 income producing units.
    My husband can fix and maintain a lot of things that initially broke. Now, we have grown large enough to emply tradesmen when the need arises.
    The most important thing was to know the rules of the residential tenancy act for your province/state (we are Canadian) Follow these rules.
    We purchased in 2 towns, so we could take care of them ourselves. I was spending every weekend cleaning/painting/repairing and working my full time job during the week. My husband did managing the properties full time, until I quit work in 2010..then we share the responsibilities.
    Most tenants will not look after your properties. They think the last month’s rent is optional. They will paint using the most disgusting colors, even if you forbid painting.
    We allow pets, as they do less damage than kids. We have never had a dog take a crayon and color every wall and cupboard.
    We make our properties safe. Beauty is in the eye of the beholder. Some applicants walk in to view and turn up their nose and walk away. Next applicants think the place is gorgeous.All depends on their life situations.
    Make sure you have a cash buffer or at least access to credit, in case you have a string of unexpected expenses…and there will be lots.
    On paper we are millionaires. In real life we live very frugally, but we have always been that way. We now employ 2 married couples (one set in each town) who draw a small wage and work for us as building/property supers. We travel 8 months of the year, and still manage the proerties via internet, with the help of these employees. When we return to Canada, we give them a vacation and evict tenants where necessary, follow up in court and collect money from the Sheriff.
    You will hear every sob story from tenants, promises made..and broken. We give every tenant at least one chance, as a benefit of the doubt. In many ways you will be their parents, and they are the teenagers who cannot manage their allowance. If this wasn’t true, they would own their own home.
    Good luck. Don’t get discouraged. Have adequate insurance. Don’t make the properties too pretty. Don’t get too emotionally attached, because they will break it.

  • I’ve only done it once, but when we were remodeling, people were looking at the house and could not see past the fact that it wasn’t complete and ready to move in. Once the updates were finished, it was rented pretty quickly. I think most renters, at least in our area, can’t see what a good deal it might be to say, “Yes I’ll move in if I can finish the paint and have a discount on rent” Everyone was looking for move in ready, which I guess garnered a higher rent in the end.

    • pauline says:

      I was ready to offer that deal at the end of my 10 year tenancy to someone ready to move in as is. Many friends have negotiated a free month even though the landlord hadn’t considered painting, they noticed a not so fresh paint and offered to do it.

  • Being a landlord is definitely not all smiles and sunshine. Even with ideal renters there are still headaches that pop up every now and then. We have awesome renters right now, but that didn’t stop our HVAC unit from going out and needing a $400 repair recently!

    • pauline says:

      ouch! mine had the heater break for $500 but they took care of everything, calling support, being home to let support in, etc. I just had to pay the bill so that was not so bad.

  • Great post. There is a steep learning curve to being a landlord. It’s good to read and learn from others, but learning from experience is probably the best way to go. If I knew all the problems involve, I wouldn’t have started.

  • krantcents says:

    All good points! The front end work checking out the prospective tenant is really important. Most landlords do not do enough and have problems later. I even include visiting the tenant at their current residence to see how they are taking care of their place. There is a rush to fill a vacancy too quickly.

  • Justin @ The Family Finances says:

    So many people rave about being a landlord, but it just isn’t something I’m interested in. The potential pitfalls are such that I’d rather put my money elsewhere. I know the rental income plus the increase in property value can make it worthwhile, but you have to figure the hassle factor as well. But to each their own. I know some people that are landlord and love it, and I know others that dabbled in it and hated it.

    • pauline says:

      the big risk (leverage) can bring big rewards or make your life a living hell. Stock picking can be tough too but without leverage the end results are not as bad as a potential foreclosure.

      • Derek - MoneyAhoy.com says:

        That’s a good point. In the stock market (as long as you don’t use leverage) the most you can lose is your investment.

        In housing you are normally levered 5 to 1 or more, so if anything goes terribly wrong, it can really reek havoc on your finances!

  • Monica says:

    Hm..this make me think about whether being a landlord is worth the money. Certainly not “passive” income

  • We don’t have rental property and I don’t think that we will go down that route anyway but my rule in buying houses is – could I sell it easily. In the late ’80s I bought a very large and expensive house at a time of rampant house price inflation. In 4 years divorce required me to sell it but by then other stupid policies meant that we were facing 15% mortgage rate. Still I sold the house in 2 weeks because it was eminently saleable. In the UK there is so much legislation about tenant protection – some absolutely necessary IMHO – but the rigmarole and high entry price makes it uneconomic.

    Rental property is for the long term and you hope some capital appreciation occurs. Because the rent should be based on the house value, not the mortgage you have on it. So it is really not in our time frame.

    Interesting topic though!

    • pauline says:

      tenant protection I fully agree on as far as deposit protection is concerned, but in France it takes about 18 months to evict a tenant who doesn’t pay and that is too much. As a result it is incredibly hard to get a lease, you have to earn 4 times the rent and prove a lot of other things to get a place to stay, it is hell for tenants, instead of free market.

  • I think real estate is a good way to diversify your investments, but I am not sold on being a landlord anytime soon. I might think about hiring a management company, but that would eat into any potential profits.

    • pauline says:

      It would, although a 0 cash flow property is still a property that will be paid for by your tenants in 25 years. Of course cash flow positive is much, much better.

  • Great post, Pauline. Very thorough. Thanks for covering how to avoid some of the renter pitfalls too. That is the one thing that scares us about owning rental properties.

  • Jake @ Common Cents Wealth says:

    These are awesome things to think about, Pauline. I think figuring out your rate of return is great. So many people think that if they have positive cash flow that the rental is worth it. As you showed, that may not be the case if you’ve put down a lot of money.

    • pauline says:

      I used to think the same, free property paid for by tenants, how much better can that be? But if you put 100% down or a big amount you may be able to get better returns elsewhere.

  • Good points, I’ve been looking for a rental property recently & hadn’t considered a few of these!

  • We have tenants in a unit that we own and I did a really in-depth background and credit check on our tenants. I think it was well worth the money to make sure we got a good couple in our condo.

  • Derek - MoneyAhoy.com says:

    This post is filled with so many gems on owning rental property! You could easily turn this whole thing into a small ebook and charge for it.

    I really like you’re approach to calculating the rate of return. It makes the whole thing very comparable to investing in stocks to see where you’ll come out.

  • We are landlords and it has been a journey. We are finally making money on it but its def. not for the faint of heart. I would say you need to have a good EF just in case your tenant doesn’t pay and for repairs. People only like to think about the money they get every month but its so much more than that.

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