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Opportunity Knocks

Steve Abramowitz

YOU’VE SOCKED AWAY some cash, waiting for the chance to snap up a small rental property. Property prices are down. Meanwhile, interest rates are up and many folks can’t qualify for a loan, but you’ve already been preapproved. It’s time to strike.

Now comes the hard part. Much literature is available on how to buy and sell residential income units. But there’s much less written on how to manage them. What follows is a primer for first-time landlords. Keep in mind that the best approach will vary based on factors such as region, taxes and local regulations.

What’s the minimum annual return you’ll accept? Because of the high price of real estate in California, we often have to settle for a lackluster 4% to 5%. This percentage is the estimated annual net income, or rents minus expenses, divided by the property’s purchase price. You can set the bar higher in the Midwest and South.

If even a moderate single-digit return doesn’t seem worth all the time and trouble of owning real estate directly, there’s an alternative. Many funds owning real estate investment trusts trade on the stock market. For instance, you might look at the popular Vanguard Real Estate ETF (symbol: VNQ). Like private ownership of real estate, it offers not just income, but also the opportunity for capital appreciation. You’ll have no hassle and no liability, but you will have the gyrations of the stock market.

I know it seems like the easiest way to wade in, but I’d stay away from free-standing single-family homes. In our part of California, you almost surely won’t get a positive cash flow and your estimate of potential capital gains is probably a pipe dream. Instead, I’d start with a duplex. Why? A duplex produces more rent than a comparable rental home and benefits from economies of scale. For instance, its fire insurance doesn’t cost twice as much.

Now, let’s consider capital appreciation. Yes, there’ll be years you’ll be up 20%. But residential real estate can be risky, as evidenced by the current environment. We’re down 15% across our 11 investment properties since the Federal Reserve began ratcheting up interest rates. Ignore the real estate industry’s propaganda. The average annual total return on a residential income investment is about 10%, very similar to the stock market, though with a slightly less bumpy ride.

Some choice words on expenses: Be real and be exhaustive. Don’t forget to factor in those one-time big hits. Like rents, costs of insurance, utilities, taxes and most incidental items trend up slowly over time. Payments on a fixed-rate mortgage, of course, don’t change.

The wild card for your cash flow is maintenance and repairs, which fluctuate widely from month to month and year to year. To insure yourself against a ruinous expense like a new roof, HVAC failure or water heater dysfunction, set aside a few hundred dollars each month. You must do that, painful as it is and despite the temptation to cheat. You’re a step ahead if you’re a hands-on type. Handyman costs can add up and those for major jobs are subject to the integrity of the repair people.

Ready to rent? Check for comps in the neighborhood, preferably on the same street. You’ll want a reference from the previous landlord and a signed lease. Size up the applicant’s character. If a prospect asks where she should send the check, you’ve learned she’s conscientious. If she demurs because the rent is high, I might negotiate. You want to avoid picky tenants and nuisance phone calls. If a person you’re showing around the unit grouses about a couple of hairline scratches on the refrigerator, you can stop the music right there.

The credit score is the landlord’s reliable speedometer. It’s a snapshot of payment history, untarnished by outside opinions and first impressions. An applicant’s score should preferably be above 670, the sign of a good payment record. Ignore the credit score at your peril. It has often saved me from my tendency as a psychologist to overinterpret.

What will your rental strategy be? Many owners want to see their rents take flight, and they’re willing to tolerate unpleasant confrontations and frequent renter changes to make that happen. I’m a longevity guy because I believe the macho approach has major drawbacks. It wreaks havoc on a landlord’s lifestyle and is financially shortsighted. While my brother spends hours pressing his aggressive agenda, my rental properties are far less of a time drain.

Painting one side of a duplex after the departure of a long-term renter recently cost me $4,800, the cheapest of three bids. Even refreshing only the most offending rooms would have cost more than $1,000. Add to that outlays for a new carpet, landscape enhancement and electrical rewiring, and you’ve racked up a turnover cost of more than $10,000.

On top of that, if you chase out a responsible tenant with a stinging rent increase, you’re doomed to an unknown commodity. And don’t forget a very substantial and often overlooked debit: two months of lost rent due to all the primping and searching for a newbie. There goes another few thousand.

To offset those costs, the revolving-door owner must raise rents close to the limit imposed by local authorities. Okay, let’s start new recruit Tanya at 10% above the previous occupant’s rent, say $150, or $1,800 a year. How many years will it take to recapture the cost of prepping the unit for Tanya? Two years? Three? Maybe four. My brother calls me Mr. Softee. Frankly, I think it should be Mr. Shrewdie.

Want a readable introduction to managing residential income properties? You might pick up a copy of The Book on Managing Rental Properties by Heather and Brandon Turner.

Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.

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