income source, landlord, leverage, mortgage, rent payment, rental property, retirement income, tips for buying rental
A few years ago, my wife and I came soooo close to buying a rental property. We actually signed some of the papers, then backed out. It was an older single family “grandma” house built in the 1950’s. We saw the potential in this excellently maintained house. The exterior wood, paint, and siding were in perfect condition, as was the roof. The interior was very neat and tidy (though dated). The curb appeal and location were decent enough too. But there were the “non-code” basement bedrooms, the lack of parking on that side of the street, and no driveway. The only parking was in the rickety single detached garage off the back alley, or in a small gravel parking area off the back alley.
We could probably have made it work. But in the end we chickened out, telling ourselves that our personalities weren’t suited to being landlords. After all, we would really come unglued with someone trashing our place and be very unsympathetic with them being late with rent. And we definitely would not want calls and complaints all the time, or have to give up our precious spare time to go fix things at the property. Further, having debt again scared the heck out of us. So we continued on with the formula we’d started years before – keeping out of debt, and putting as much as we could into various retirement funds through work and on the side.
The no-debt formula had worked well for us. We really thought that we’d “arrived” when we first got out of debt (all except the mortgage) several years earlier. And we thought we were surely on easy street when we paid off the mortgage four years later. We were on top of the world! Can you imagine? No debt, no more student loans, no credit card debt, a paid off house, paid off cars! We could do anything we wanted. All we had to do from then on was to coast along and dump whatever we could into retirement funds, right? Retirement, no problem. It was many years off. At varying times, my wife and I both had even temporarily cut back from full-time at our jobs, thinking we could just coast and enjoy life. And we did.
Fast forward several more years and given a stock market that has been anything but impressive, we were growing tired of watching all our hard work to save and invest in various retirement funds not really materialize into the thrilling gains we thought we might see. Given the historical average stock market returns going back seventy years, your money could theoretically double every seven years, right? Right, depending what decade you’re living in! Instead, we’d seen quite the roller coaster ride, losing nearly half the value of our investments in the stock market at one point. The stock market has made some notable gains since that time, yes, but our retirement funds’ overall growth still hasn’t impressed us.
We’d gotten serious about this money thing pretty late in life. Time was not in our favor anymore, whether it be its effect on compounding interest or for improved stock market averages. So in recent years we were beginning to foresee the harsh reality of not having a big enough pile going into retirement. Company pensions are nearly a thing in the past. Our “pension” is only what we save ourselves and we weren’t nearly far enough along. “If I have to, I’ll keep working ‘till I die,” I’d jokingly tell my wife. Sure, I really would if I had to. But the thought of really having to was starting to bug me.
A friend of ours recently started working at a financial firm which pushes, among other things, annuities. While we really didn’t have enough extra cash lying around to even consider anything like that (and we’re not convinced we would do it even if we could afford it), we agreed to attend a free seminar and dinner. Both were excellent! And although the speaker was really talking about annuities, he made some memorable points that hit home with us. “You need income streams in retirement,” he said. “Peace of mind in retirement comes from having dependable steady monthly income, not a big pile that you are slowing whittling away.”
The light bulb came on. My wife and I again started talking about how rental property could achieve the “steady monthly income” thing. We had to get over our fear of debt, and of bad renters. So we did what anyone should do if they want to invest money in something. We sought council. We read books and magazine articles and blogs. We consulted experts. We asked friends and coworkers, and were quite surprised to find out how many of them were already doing this. There were many horror stories too, about bad renters. Seems like everyone we asked had had a bad experience.
Undeterred, we researched some more. We got materials from a local group that gives presentations on the laws regarding tenants and landlords, knowing that if we were really going to do this it wasn’t just about being an investor; there was the whole other side of being an active landlord and property manager. In general, the books and articles about buying rental property all said the same thing: Do the math, make sure that the rent you will receive will cover your mortgage and expenses, and have some cash reserves. Sounded like good advice. But there was something that kept eating at me.
The rental property investment method most touted seemed to always involve multiple long term mortgages and leveraging. It was a house of cards. My wife and I had done some math years before when we almost bought that grandma house rental property. It seemed that in order to make things profitable, we would have to compromise our wish list and somehow juggle buying an older fixer-upper or other property in distress with questionable location, and go with as long a term on the mortgage as possible in order to keep our payments down.
We knew some people who were doing the landlord thing in our town back then, so we checked out several of their properties. Our conclusion was that the only way they could be making any money was if they were being slum lords – buying lower end properties, not putting a lot of money into improvements, going with thirty year mortgages, and leveraging as many properties and loans as they could since they surely could only be making a few hundred dollars a month profit on each rental. This was not the game we wanted to play, then or now.
We wanted a game with lower risk. So we did some more math, this time some different math. And the results surprised us. It turns out that the lowest risk and highest return approach for us (and perhaps you, the “average Joe” landlord wannabe) is this:
- Buy a modestly sized three bedroom, two bathroom house, which is more desirable for the average family whether you are renting or selling. The trend is going towards smaller homes because they are more efficient (lower purchase price, lower taxes, lower utility bills, lower maintenance costs). Don’t buy a mansion.
- Buy a house in a neighborhood where you would want to live (location, location, location). A bargain in a seedy part of town will cost you in how much you can get for rent. So it’s not really a bargain.
- Buy a house that is newer or a recent total remodel so that constant surprises and repairs won’t be a concern. The last thing you want to have to deal with is lead paint, asbestos, or knob and tube wiring. If you are in the business of remodeling homes, then ignore this piece of advice.
- Plan to keep your properties long term. The longer the better. This is why you can afford to buy the nicer rental house you really want in the decent neighborhood and pay full price for it if need be, instead of a fixer in a bad neighborhood. In the long haul, you come out ahead.
- Do not overpay. Yet at the same time you really shouldn’t be apprehensive about paying fair market value if the above criteria are met (size, location, condition) since you will be keeping this property a long time. Foreclosures may be an option if they weren’t neglected or trashed, assuming they meet the above criteria as well.
- Buy only one rental property at a time.
- Have only one mortgage at a time (which means paying off your own home mortgage before you even do this rental property thing).
- Get a ten year mortgage (maximum) with aggressive plans to pay it off much sooner.
- Take a deep breath for this one: Have sufficient income and/or cash reserves to cover the delta between the rent you will receive and your monthly mortgage payment/expenses (which will likely be higher than the rent since you are getting a ten year mortgage). You will be subsidizing this first venture until your mortgage is paid off. Having this temporary negative cash flow flies in the face of what nearly every “rental property for dummies” book will tell you. Ignore any criticisms. You’ll likely only have to subsidize your first rental property anyway. And, there is minimal risk if you have only one mortgage yet two properties (your personal home, and the rental).
- Be diligent in developing tenant selection criteria and a legally protective rental/lease agreement. There are many available resources, often free, to help you.
- As soon as you pay off the mortgage, buy another property.
This is a “slow brew” approach, conservative in risk. By not stretching out the mortgage, you are saving a boatload in interest. This is money you will put into your own pocket! By not having a leveraged house of cards (that is, you will have just one mortgage at a time) you are minimizing your risks should something hit the fan.
If, on the other hand, you don’t want to rent out your first rental property for less than the mortgage payment (as well as paying off the mortgage in ten years or less), and you instead want to use the “rental property for dummies” house of cards method of long drawn out mortgages, then you should question why you would help the banks get richer faster than yourself. Don’t do it. Here’s why.
With a paid off mortgage, you will reap the most profit on your rental property with the lowest risk. Then when you buy your second rental property, you’ll have two renters helping to pay off just one mortgage. See the pattern? When you buy the third rental property you will have three renters kicking the one mortgage to the curb in no time. And your property snowball will grow larger and larger depending on how many years you have to work at this.
Contrary to popular belief: Start slow, and you will greatly increase your chances of winning.