After nearly 10-years of economic growth since the last recession, the U.S. economy seems to be firing on all cylinders. Economic growth is up, the stock market has reached new highs (even after the recent correction) and unemployment is at its lowest in nearly two decades.
As such, demand for housing has handsomely recovered from the real estate crash of 2008. In many parts of the country home prices and asking rents are at all-time highs. The solid housing market is prompting an increasing number of investors to become landlords in hopes of achieving positive cash flows to supplement income from their regular 9-5 jobs. However, it is imperative that prospective landlords be careful and realistics about their expectations. The most important part of becoming a landlord is to fully understand the various factors affecting your sources of income and your areas of expense. A superficial or incomplete view of being a landlord can result in financial difficulties or ruin.
Rents and Occupancy: Rents and solid occupancy rates are your bread and butter. The higher the rents collected, the better your chances of achieving positive cash flow. Therefore, you want to strike a balance between charging market rents while maintaining full occupancy.
Late Fees: Some landlords aggressively collect fees from tenants for late rent payments, which can add up over time.
Other Fees: Some landlords are able to install coin-operated laundry equipment for tenant use. Other landlords may place vending machines on the property. These are examples of maximizing revenue from residential income properties.
Rent Control: It is critical for owners to understand the impact of local restrictions on their ability to increase rents on tenants. The inability of landlords to bring rents to market rates should be considered when buying an investment property. Don’t be fooled with news about how average rents are so high in a given city. If you purchase a property with existing tenants in a rent-controlled city, you will almost certainly get lower than market rents.
Mortgage Payments: 30-year fixed mortgages are typically available only for properties with 1-4 units. Loans for properties with more than 4-units usually have higher rates and shorter maturity periods, usually with a balloon payment due at maturity. Additionally, loans for properties with more than 4-units require greater down payments.
Utility Meters: It is preferable that tenants pay for their own basic utilities, including water and electricity. However, unless units are separately metered, it is difficult to ask tenants to pay their own utilities because there’s no way to measure each unit’s consumption. Therefore, find out if the property you are buying is separately metered for water and electricity or not.
Property Management Fees: If you are an absentee owner you will most likely require the services of a property management company, or a resident property manager to help collect rents, pay bills, oversee repairs, find new tenants, evict troublesome tenants and resolve miscellaneous issues. Property managers employ various methods to collect their fees, including:
- Percentage of Rents Collected: Usually 7-10% of monthly gross rents collected;
- Commission for Finding New Tenants: Usually 6% of the annual rent collected from a new tenant (collected up front);
- Minimum Fee: Some property managers charge a fee even if a unit is vacant. For instance, they might charge a minimum of $50 per month for a unit, even if vacant.
- Fees for Overseeing Major Projects: Some property managers will add a certain percentage premium to major repair jobs. For example, if a new roof is installed, the property manager may add 10% to the cost of the new roof for their role in overseeing the project.
Of course, if you live within driving distance of your investment property and you can self-manage, then you will save on property management fees. However, be aware of the effort, frustration and possible legal liability involved with self-management.
Insurance: Fire and hazard insurance are a must for any property. However, depending on your comfort level, you may want to purchase additional insurance to cover repairs (i.e. a home warranty policy) or added insurance to protect against physical harm or injury to your tenants. Basically, you need a good, honest and knowledgeable insurance agent to guide your through the risk/reward ratio of insurance coverage.
Insurance Against Natural Disasters: Depending on your property’s location, you may be required to obtain additional insurance against natural disasters such as earthquakes, floods and hurricanes. Also, after several powerful hurricanes in the southeast such as hurricanes Katrina and Andrew, lenders and FEMA have expanded the areas where flood insurance is required. Therefore, make sure you fully understand the insurance you need and how much it will cost you when buying a new property.
Repairs and Maintenance: Repairs are a part of owning property. The more units and tenants you have, the more you will need to spend on repairs. When buying a property, make sure you properly understand the following:
- Existing Condition of the Property: Are you buying a property with lots of deferred maintenance? If so, be prepared to spend a considerable amount of money on repairs and maintenance. You especially need to look out for issues related to pest control (always get a termite report), plumbing, electrical wiring, roofing and structural matters. It is always wise to get an inspection report by a certified home inspector.
- Age of the Property: An older property will usually require more maintenance than a newer one.
- Number of Units and Tenants: The more units and tenants you have, the greater the likelihood of something breaking down and needing to get fixed.
Occasionally you will need to evict a tenant either for non-payment of rent or for other lease violations. Keep in mind that legal fees can run into several thousands of dollars, depending on your legal representation and how much of a fight your tenant puts up. Additionally, some cities such as San Francisco or Berkeley have very strong pro-tenant policies, which can enable some tenants to drag out the eviction process for a long time.
Municipal Fees and Other Local Nuances
Some municipalities require owners of residential income properties to obtain business licenses, which need to be renewed each year. Other localities may require annual inspections of your water heaters or fire extinguishers. These add to your expenses, so make sure you understand them.
Additionally, different areas present their own unique set of challenges. For instance, many areas of the nation experience heavy snow in the winter, which requires costly snow removal expenses for a part of the year.
Property and Other Taxes
Different states have different property tax rates. For instance, Californians pay a property tax rate of 1.25% of the purchase price, while Texans pay almost 3% in property taxes. Therefore, make sure you call the county tax assessor and make sure you understand the property tax rates as well as the due dates for payment.
In California, some local governments vote to assess a special funding mechanism called Mello Roos that can be used by cities, counties, and special districts (such as school districts). Texas also has similar funding mechanisms called Municipal Utility Districts (MUD), Water Control & Improvement Districts (WCID), or Special Utility Districts (SUD). They can help pay for infrastructure, water supply, sewer, flood control, etc.
Owning a residential income property can be either a very rewarding or very frustrating experience. The key to any successful experience is to know what you’re getting in. You don’t want to get blindsided by unexpected loan terms, local fees, rent control restrictions, insurance costs, etc. Basically, you need to ask lots of questions, engage your brokers, insurance agents, property managers and local government to ensure you make an informed decision.