"I Wish I Were a Slum Lord"

Blake asks:
"People have often touted Real Estate as the most secure and steady of all investments. Conventional wisdom has been to buy a principal residence, and then buy revenue property if you can. What are your thoughts about revenue property given the current economic landscape?"



Thanks for your question Blake.
In my last post I explained some of the pitfalls of owning real estate, primarily owner occupied homes.
Today, I will address your question about owning rental property, and I will discuss current market conditions in my next post.
 
One of the most common ways that investors (particularly those wary of stock markets) have built their investments over the centuries is to buy revenue property and rent it out to tenants.



There are many advantages to this investment strategy:

First, you can usually buy a rental property for around 25% down (meaning you pay for a quarter of the property yourself, and borrow the rest). This means that the tenants could be paying your 75% loan off over time, leaving you with 100% of the property, having only paid for a quarter of it.

Second, if there is appreciation or inflation in the real estate markets (meaning property values rise), then your investment is worth even more. Even better, rents may go up, thus increasing your monthly income as well.

Third, unlike stocks, your investment is tangible (meaning you can see it and touch it), and you don't have to rely upon or pay someone else to manage your investment for you. There might also be ways you can improve your investment yourself (such as new cabinets or carpeting).



Oh yes, owning rental property is a dream come true.... a safe, simple way to grow your money.


Well, not so fast....

While it is true that there is money to be made in rental properties, there are some huge potential pitfalls as well. Many an aspiring landlord has purchased property only to learn the hard way that revenue property is not the walk in the park that the experts on TV make it out to be.



I will address the potential problems, which are the same as the advantages of owning revenue property, but in a less than “best case” scenario.



First, borrowing a bunch of money to buy an investment is risky. Many investors who bought as many revenue properties as they could during the boom, only to not be able to afford the payments later learned this. Also, because there were so many people wanting these rental properties, they bid the prices up, meaning that most investors paid too much for their investments. If you pay too much for a house, then the rent you collect from your tenants might not cover the combined monthly costs (mortgage, insurance, taxes and maintenance). If you have some months with vacancy of your properties, or worse, tenants damage the place or don't pay their rent, you could be forking over a lot of your own money for mortgage payments and repairs.
Since it can take up to 6 months to get a non-paying tenant evicted, and another month or two and lots of money to fix the damage they left behind, you should have several months of mortgage payments in savings.
Optimistic, (maybe naive) aspiring landlords might doubt that this could ever happen to them, but it happens more often than you think, and I have experienced things similar to this myself.
Also, should interest rates rise (and they will. Watch for a post on the subject in the next few days) you could find youself in a “negative cash flow” position. This means that you will be paying money out of pocket to cover the monthly payments of your properties.
If interest rates rise and you do end up with a bad tenant (it could happen), owning a revenue property could destroy your credit rating and bankrupt you.


Second, if property values drop below where they were when you bought your rental property, your investment will shrink. The bank will still expect the money they lent you, so the loss will come directly out of the money you paid in downpayment.
If property values drop, rent prices may drop too, leaving you in the dreaded negative cash-flow scenario.



Third, although it is nice to have a rental property that you can see and touch, and for which you do not have to pay a portfolio manager, this also leaves you making all of the decisions. It will be you who collects rent, visits your tenants to fix things, and should they leave any damage or stop paying, you will be left to deal with this too.
Some would-be landlords deal with this by hiring a property management company to manage their property. This is fine if you can afford it, but they often charge nearly 10% of gross rents, and if there is vacancy or damage, you are still left paying mortgage payments and repair costs.



Now, I am not trying to discourage anyone from owning rental property. I just want to make sure that potential landlords know what they are signing up for before they get themselves into a big heap of trouble.

So, is making a buck in the revenue property game possible?


First let me say that although it is a mistake to say that “real estate is always a good investment”, it is also a mistake to say that it is always a bad investment. It can be a great investment if the following conditions are met.

First, do you have the money to buy revenue property?
Now, I am not just asking if you have a downpayment to buy a small house. I am asking if you have enough cash to cover repairs and mortgage payments during vacancies.

Second, do you have the time needed to be a landlord?
You will not spend much time in a typical month as a landlord because, unless there is something wrong with your property, usually your tenants want to be left alone. BUT (and it's a big but), some months, there is a lot of work to do. In one month, you could have to chase a tenant for rent, then kick them out, then fix the damage they left behind, then rent the house out to new tenants.

Third, do you have enough knowledge to be a landlord?
Unless you have a pile of money with which to pay someone to deal with fixing leaky faucets, new paint, a new window now and then or new carpet, you will be dealing with this yourself. You should also know enough about the landlord/tenant regulations in your area so you do not run afoul of the law.

Fourth, do you know how to pick good tenants?
The second worst decision you can make as a landlord (the worst one is coming next) is to pick bad tenants. Now, as a landlord, you will occasionally get a bad tenant or two... one who won't pay their rent and damages the place, but if you are not a good judge of character and really good at attracting and choosing good tenants, having bad tenants will be a common occurrence. (I have had my share of them myself) A few bad tenants in a row could bankrupt you.

Fifth....drum roll please....The most important question is...Do you know how to buy good property?
In order for you to make it as a landlord, you will have to be able to find and buy properties that meet these two criteria:

• First, the property has to be nice enough and in a good enough area of town that you can attract the right kind of tenants. Good, clean, respectable houses attract good, clean, repsectable people, and the opposite is also true. The right property can attract good tenants which will rarely be a problem and rarely cost you money.
  
  
• Second, you have to get the property for the right price. If you overpay for a property, there is almost no way you will ever make money on it. If you overpay for a property, you are almost guaranteed to be stuck in a negative cash-flow situation, and that property will eventually bleed you dry. Worse (or maybe better), if interest rates rise, and you have a bad tenant or two, your rental property will kill you faster.

So, the bottom line:

1. Know what you are getting yourself into.
2. Learn all you can about owning and maintaining properties, being a landlord and picking good tenants.
3. Free up your schedule so you can deal with issues as they arise.
4. Save up a big bucket of money before you start.

So, Blake, owning revenue property can be a great way to make money, as long as you buy properties for the right price, pick good tenants, and keep costs low.

I will address investing in property in light of current market conditions in my next post.

Happy investing