Things you need to Know Before you Become a Landlord
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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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