Is buying income property a good investment? 9 things to consider before diving in
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Should you buy income property?
Colin McConnell/Getty Images
So you’ve been watching HGTV’s “Income Property” and are wondering: Is it time for me to buy a rental and become a landlord?
You’re not alone. Between our “Friends”-like economy (“… It’s like you’re always stuck in second gear …”), historically low interest rates, flat-line wages and the mood of millennials to rent instead of own, income property has been on an uptick since the Great Recession.
In fact, for the first time in five years, more Americans are putting their money into investment properties than vacation homes, according to the National Association of Realtors.
Should you? Experts offer a qualified “yes,” provided you do your homework first.
Here are nine things to consider before diving into income property.
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It’s not as easy as it looks
Forget the TV sitcom stereotypes of clueless landlords. Making the most of income property requires an accountant’s eye for detail, a lawyer’s grasp of landlord-tenant laws, a fortune teller’s foresight and, should you choose to manage your rental yourself, a landlord’s firm-but-friendly disposition.
“Where people who want to become landlords fall short is, they don’t realize how much work goes into it,” says Diana George, founder of Vault Realty Group and president of 946 Bay Capital, a real estate investment firm based in Oakland, California.
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Success requires a long-term outlook
Jeremy Kisner, a senior wealth adviser at Surevest Wealth Management in Phoenix owns two Las Vegas rentals. The unit he’s had for 13 years has had two tenants and low maintenance; the other has had three tenants in four years; the last one of which required a costly eviction.
He’s taking the same advice he gives his clients.
“The way that people get in trouble with almost all investments is, they just don’t hold onto things long enough,” he says. “With rentals, if you break even on a cash-flow basis, that’s actually not too bad because you’re paying down the principle and building equity that way. Then you hopefully also see some appreciation.”
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It’s easy (and costly) to break the law
State landlord-tenant laws can act like an open manhole cover for rental owners who ignore them, according to Kathy Hertzog, president of the Erie, Pennsylvania-based, LandlordAssociation.org.
Case in point: tenant security deposits.
“There is definitely bookkeeping involved. You need to have that account for each tenant and keep that money in that account and save it,” Hertzog explains. “Security-deposit laws govern how much time you have to return a security deposit when tenancy ends, less any expenses for cleaning and repair, all of which have to be itemized. In some states, if you don’t turn that in, the tenant can go after the landlord for double their security deposit for failing to return it within the specified time period.”
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Should you hire a property manager?
If you purchase a rental, should you be your own landlord, or fork over 6 percent to 10 percent of your rental income to a management service? While there’s no right answer for everyone, George and Kisner prefer to subcontract the work.
“They do the background check on your tenant, make sure they sign the lease and pay their rent on time,” George says. “That frees you up to manage your money, not your property and tenants.”
Hertzog adds that there’s a potentially steep downside to being your own landlord.
“If you get too close to your tenants and the tenants have financial problems, you can find yourself stuck because you don’t want to evict them,” she says. “You have to be very professional about it, because if somebody doesn’t pay their rent, they’re stealing from you.”
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Should you buy your rental outright or finance?
While some financial pundits, Dave Ramsey among them, insist you should never buy a rental unless you can pay cash for it, Kisner thinks otherwise.
“Leverage (i.e., a mortgage) typically magnifies returns, on both the upside and downside,” he says.
Kisner gives this example: A property purchased for $380,000 will be worth $486,432 (assuming 2.5 percent annual appreciation) after 10 years, leaving a loan balance of $244,781. However, the annualized rate of return for the 10-year holding period increases between 8.09 percent and 8.84 percent in the scenario with a mortgage. The cash buyer has a lower rate of return because there is no leverage to magnify gains.
George concurs: “I definitely agree with going conventional (mortgage). It’s a really good way to maximize your dollars,” she says.
RATE SEARCH: Are you planning to leverage your investment? Compare mortgage rates at Bankrate.com today.
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Be sure to budget for the unexpected
Failure to plan for the myriad expenses of owning a rental can become a fast track to disaster.
“As a landlord, you want to save about 20 percent to 30 percent of your rental income for upkeep, maintenance and emergencies,” Hertzog advises. “You want to make sure you’re not just living off that, because then when something big happens, you won’t have any money to fix it.”
Kisner agrees: “It’s been my experience that you always underestimate all the different expenses that have a way of coming up, and always overestimate just how positive the cash flow is going to be,” he says.
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Remember to renew your leases
If mom-and-pop landlords have one glaring blind spot, it’s failure to renew tenant leases in a timely manner, according to George.
“You’d be surprised how many landlords don’t renew their leases every year, so they’re letting their tenants go on month-to-month leases,” she says.
“What’s wrong with that? What’s wrong is their whole thinking is that now, if I want to get my tenant out, I can’t because now they’re not strapped to a lease. Also, they can’t raise rent. The only way you can change rent is if you have tenants sign a form changing the lease every year. That’s how you keep your tenants in check.”
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Searching for long-term tenants? Consider Section 8
Sudden tenant vacancy is the bane of every rental owner.
“Each month that a rental stands vacant, you’re having to pay mortgage, utilities and maintenance out of your pocket, so turnaround is one of the things you need to address really quickly,” says Hertzog.
One popular solution? Give Section 8 renters a try.
Section 8 is the Department of Housing and Urban Development’s housing choice voucher program. It pays 33 percent to 75 percent of the rent for low-income Americans who qualify.
While some landlords are skeptical of the paperwork and potential upkeep problems presented by some Section 8 renters, Hertzog views these tenants favorably.
“Older populations and persons with disabilities are usually excellent tenants; they take excellent care of the property because this is their home; this is where they want to be. Plus, if they don’t pay their rent or (if they) ruin your home, they risk losing their Section 8 voucher,” she says.
RATE SEARCH: Did you find the right property to buy? Compare mortgage rates at Bankrate.com now.
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Don’t forget your rental at tax time
There’s a singular ray of sunshine that beams down upon income property owners each spring as they hunker down with their accountant to prepare their federal income-tax return.
“When you have your own home, you can write off the interest and that’s about it,” says George. “But when you own an investment property, your Schedule E tax form enables you to write off nearly everything under the sun, from painting the home to changing the lightbulbs.”
True, you’ll have to report rental income, but between the write-offs, including mortgage interest and the depreciation deduction, the income is offset and you’re building equity at the same time, she says.