The right way to buy a rental property

Rental PropertyIt is very possible to buy a relatively “safe” rental property that will all but guarantee you a steady income and help to make you wealthy in the long term. The keys to success are location, cost versus cash flow, and quality tenants.

Buying a rental property is the ultimate savings plan. You can buy the house and your tenants will pay it off for you over the life of the mortgage at effectively no cost to you. Fifteen to thirty years later, your house is paid off and has most likely appreciated significantly since you bought it. I like to say, “If I walked up to you today and told you “sign this paper and in 20 years I’ll give you a fully paid off house for free”, would you do it? Of course you would!

Now is the time to put on your walking shoes and get ready to start house shopping. People looking for investment properties should be extremely excited at the horrible shape the housing market is in right now. Housing prices are way down and falling in much of the country and interest rates are still at long term lows.

Financing 

While it’s true that lending standards are getting very tight, that is actually a good thing. The banks that were willing to lend almost any amount to anyone whether they truly could afford it or not are the reason that the market is in the tank now anyway.

If you can’t get financing that you can afford right now, you probably need to save more money for your down payment. It is in the bank’s and your own interest to make sure you can afford the property you are buying – even in the worst of times, so don’t be discouraged if the bank says that you need to keep saving before they feel comfortable lending you hundreds of thousands of dollars.

Location, Location, Location

Everyone tells you that location is important, but what does that really mean? When buying rental property, the right location doesn’t just mean buying the ocean front property.

Obviously, avoid buying in bad areas or areas that are on the way down. Some people will tell you properties in bad areas are gold mines because the price is way lower than in better areas. Just remember that the price is lower because those properties will be a management nightmare. You will have very high turnover, bad tenants, and good tenants get scared away by bad neighbors, and constant repairs from said bad tenants.

Investing gurus will sometimes tell you that you should diversify the locations of your properties and will give you great arguments for buying far from where you live, including out of state. I must vehemently disagree with this stance!

I own several properties out of state. I purchased them with the same logic as the gurus, they are isolated from local disasters, are cheaper than property where I live, and can give you the perfect excuse to take business trips to visit your properties which you can write off on taxes.

Then cold hard reality hit me – after the closing. When you own properties far from home, you are completely dependent on someone else – usually a property management company. The one thing you need to know right now is that no one will care for or about your properties the way that you would. With most property management companies, you are one of many customers that they have. If you have a vacancy, they’ll work on filling it with all of their other vacancies. That will come after any emergencies with their other client’s properties though, and it will probably take them a lot longer to fill it than it would take you.

What happens when that company also manages other client’s properties in the same neighborhood as yours? You now have competition from your own PM company!

Are there major repairs that need to be done? Prepare to pay your property management company an extra fee to manage the process and the repairmen.

Tenant leave? Prepare to pay the PM company a “make ready” fee for them to bring in people to paint, replace carpet, etc. Also, do not expect the repair companies prices to seem “normal”. The PM company has no interest in haggling with them on your behalf. In the worst case scenario, you will have a bad PM company that will inflate the repair costs or even lie about damage that needs repair in order to charge you for repair that weren’t necessary or were never done!

Not all PM’s are bad, but you do not know if you have a bad one until it’s too late. Now what? You are still hundreds or thousands of miles away and you now have to find a new PM company in that area and try to arrange a transition.

In case I’m not clear, I see no reason at all to buy property far from home. If anything, my experience has taught me the exact opposite.

In stark contrast to my out of state properties, my local properties are a dream. First off, I am not paying anyone else to manage them. Next, I meet and interview all of my tenanats myself, I can get to the property quickly and easily if there is a problem and, in most cases, can resolve the problem myself. In the event that I need a repairman, I can bring in several for estimates and am present to keep them honest.

The performance of my local rentals blows away the out of state rentals and I feel it’s directly tied to the fact that I care about my properties and am involved. The out of state rentals get basic attention at best from a property management company and suffer as a result.

Cost vs. Cash Flow

The first criteria that I apply to any property I’m considering buying as a rental is Total Cost of Ownership (TCO) vs. Cash Flow. This simply means that you take ALL of the properties expenses (and I mean all) and compare that to the real amount of rent that the property will bring (note, I did not say CAN bring). If the rent will at least pay all of the bill and break even, then it is worth buying, if there is any money left after, then it’s fabulous!

When calculating TCO, I make sure to include the following:
     – Mortgage payment
     – Taxes
     – Insurance
     – Utilities (if not all paid by tenant)
     – 5% for unexpected repairs
     – 5% for vacancies between tenants

There are always other expenses, which if you can think of them, you should include them in your formula.

I will tell you right now that most properties will not work with this formula! That’s expected and is ok. This formula separates the ‘ok’ properties from the Great properties that will make you money and not cost you money every month.

When I’m shopping for a new rental, I will go to the local realtors and will tell them up front exactly what my formula is and that if they can find a property that meets this formula and is in decent shape, I will make an offer on it the same day. Let them know that you are very serious and that you are telling them your criteria so that they don’t waste time – theirs or yours, calling you about properties that just won’t work.

After visiting the realtors, you may not hear from them for a while. Check in with them once every week or two, just to let them know you are still looking. When a good property comes up, you will probably get calls from several of the realtors about the same property. First come, first served, I always tell them.

Do not limit your search to just realtors, there are many websites like realtor.com and local versions of it that will often have different properties on each. You can often glean some good crumbs of extra information about the property by viewing it on several different sites.

I prefer to buy two family or duplex properties. A two family home will usually generate more rent than a single family home of the same size. It also spreads out your risk. If you rent a single family home and lose your tenant, you are out 100% of your rent. If you lose a tenant from a two family home, you are only out 50% of your rent.

 Quality tenants

I cannot stress enough how important getting and keeping quality tenants is. This will make or break whether you are successful as a rental owner or not.

We have all heard nightmare stories from landlords that swear that there is no such thing as a good rental property and that it’s nothing but a 24 x 7 headache. I guarantee you that the majority of those people did not follow the advice below!

1) You must check credit reports and references for all tenants. I don’t care if the prospective tenant is a 90 year old nun! The famous last words that you can almost always hear from unhappy landlords is “they seemed like such good people”.

You cannot tell whether someone is going to pay the rent on time by their handshake or their personality. There are many “normal” seeming people out there that do not pay their bills when they commit to.

2) Make sure that you have a lease that protects you and covers exactly what responsibilities are yours and which are your tenants. Cover as many scenarios as possible in your lease. Do not assume that anything is “common sense”. Just remember that the only rules you can enforce are the ones that are in the lease that the tenant signed. You cannot add or remove parts of the lease once it’s signed and in effect. My lease is currently four legal pages long and I have no problem adding to it if necessary.

Keep in mind when making your lease that you are not trying to get over on your tenants, you are just trying to protect your legitimate interests and clarify anything that you are adamant about. I also recommend that after you complete your lease that you submit it to a lawyer to approve. There are many things that are either illegal or not enforceable by law that you shouldn’t put in the lease. Don’t assume that just because the tenant signed the lease with the offending entries in it that they can be held to it. Not only can a judge strike that part of your lease, but they can even penalize you if it was illegal in the first place.

3) Avoid groups of unrelated people that want to move in together. I can’t tell you how many “room mate” horror stories I’ve heard. It almost never works out. Either the roomies end up not liking each other and all move without paying and trash the place on the way out, or one of them gets engaged and moves out leaving the remaining ones to pay the rent (which they can’t afford alone).

No matter how you slice it, groups of roomies almost always goes bad. My limit on roomates is two. They are both listed on the lease, both are equally responsible for the entire rent, and both will be sued or penalized if they violate the lease. Wherever possible, go for couples or families before room mates.

I would rather have a vacancy for an extra month or two than have to deal with bad tenants. It will cost you much more to evict someone and stress about the problems bad tenants bring then it will for you to have an empty apartment for another month.

Never let someone that’s not ideal rent your property just because you want to “hurry up” and get it filled. Following my own advice has worked every time, meanwhile watching others around me take their own advise and getting burned routinely.

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