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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I have often thought about buying some real estate, probably condos. My son manages maintenance for 2 reat estate investors, so I would have one leg up. He has one client in CA who oversees her real estate from there, including buying properties. He often does additional things for her like inspecting properties for problems before buying, checking out prospective clients in person if necessary, and occasionally, showing a property.
He has learned a lot about this business, and this might work for us as I have the capital and financial expertise.
There was an article on HD recently, which I can’t currently find, claiming that the ROI on owning your own home was extremely small. I wasn’t sure I agreed with the article, as it didn’t seem to take into account the savings from not paying rent, especially after the mortgage was paid off. Have you calculated the ROI on your rental property for, say, the last 10 or 20 years? Is it really 4 or 5%? How would it compare to investing the capital in VTSAX?
Without tax return research time, I did a quick check of the mortgage-free rental I’ve owned for 12 years and my ROI looks like 5.5%…could be a bit more or even less if something was overlooked. Looking forward to any comments from Mr. Abramowitz.
According to Vanguard the 10 year pre-tax return on VTSAX is 11.82%, and since inception in late 2000 it’s 7.30%. It’s not clear to me whether that includes reinvesting dividends. Also, does your 5.5% include the value of your time?
It hasn’t taken much of my time at all due to the 3 excellent tenants in 12 years. I know tradesmen that I can call upon for cosmetics, and have always had a reasonably-priced homeowners warranty for plumbing, electrical, etc. I have replaced the majors – roof, HVAC, screened porch, flooring, tree removals, all the big hits (I hope). And it is a very salable property in a premium location so it can be a great price or a less great price depending on whether I am desperate or not.
If I had found it an aggravation to own, it would have been gone long ago.
An article with lots of hard truths. Maintanance and big ticket expenses can wipe out a good year. I agree with your long term approach with tenants. If I have a good long term tenant I will work with them as even a single month can make up for any rent increase you may get from the new tenant. Not to mention the unknown that person or family brings as well.
My perspective exactly. A good tenant means reliable income and few nuisance requests.
My rental property is owned outright which gives me a lot more flexibility with tenants. Thus, I can afford to and I’m willing to make a sacrifice on “market rent” to have a good quality tenant that takes an interest in my property.
I know some landlords that are forever going to the eviction desk to file, a headache that isn’t for me. Yep, I’m lazy…but living in peace.
Same situation—no mortgages. Also, more conservative because don’t get whipsawed by leverage. That’s frustrating in real estate bull markets, but it does give more peace of mind. Maybe more leverage (loan) for younger guys, free-and-clear for retirees.
Buying individual properties and renting them is like running a business. If you do not want the hassle and still want to invest in real estate you can buy an index fund like VGSLX (Vanguard real estate index fund) with an expense ratio of 0.12%.
Steve, a very interesting article on something I know next to nothing about. Thank you for the well thought out article!
Thanks Nate. Good to hear from you again.
Thanks, but no thanks. Bad enough maintaining the house I lived in. Why go to all that trouble when, as you say, you can invest in REITs if you want exposure to real estate?
So interesting. I did not intend to turn off people to private real estate ownership but I can see how easy it would be to come away with that. The tone of the piece may reflect my weariness from 40 years of direct investing.
Doubling down on rentals after the GFC was the best financial decision I ever made. I know I wasn’t born with the landlord gene because my sister was. But I’m not weary yet perhaps because I’ve only been a LL for 20 years?
Hi Twenty Years
Ha ha! Yes, timing in investing is so important. Psychologically it’s a little easier to buy in a real estate bear because we’re bombarded with propaganda that owning property is such a sure thing. Stocks on the other hand are viewed as riskier, so it sometimes takes more guts to dive in after a big hit. I have also been very fortunate about timing, though in my case I realize it was largely luck. I think of myself as having diversified over time, but that’s probably sour grapes.
Don’t feel bad. I have never had any desire to be a landlord, you merely provided reinforcement. I remember reading a book on getting rich through real estate many years ago, and thinking there must be a better way. Instead I have been happily invested in Vanguard mutual funds, which require minimal oversight and charge minimal fees.
….and can be bought and sold without commission and are liquid in the event of a family financial emergency.
Steve, thank you for a detailed primer on why I never wanted to be a landlord!
The same take on it as Travel had! I now really do think you guys got some fallout from my jaundiced (though I think pretty accurate) look back at my experience with private ownership. I don’t think it would have remained such a major part of my investment life were it not for being raised by parents willing to sacrifice peace of mind to assure an abundant life for their kids. Direct ownership done the right way can be very lucrative but, yes, it takes a toll. Thanks guys for putting me in better touch with my gradual disenchantment.