Getting into rental properties is profitable but a lot of work.
You have a decent job and are making some extra dollars. You’ve watched the late-night infomercials and read about how everyone is making it big getting into rental properties.
Bamboozling phrases used by self-proclaimed real estate gurus are thrown at you like “cash-on-cash return” and “cap rate,” leaving you with the tantalizing impression that rental houses are always profitable. Similar to our friends who stumbled their way into flipping houses, you’ve bought into the idea that you can become a landlord with little money down.
And the work involved? Pssh! That’s not even on the radar.
In my experience, the people who buy a rental property ready to roll-up their sleeves and get to work tend to be the most successful. And, even if you plan to do all the work yourself, it’s a good idea to begin by consulting a real estate agent knowledgeable about rental properties.
People like to buy into the idea that rental properties are a fast track way to making money without considering how much work it actually takes. Furthermore, they’re grinding away so hard at their 40 hour-a-week job that they simply do not have the time to manage a new rental property effectively.
“Flying through hyperspace ain’t like dusting crops boy!” And neither is getting into rental property.
Even still, the concept of someone sending you a check every month sounds very appealing. So you call up your real estate agent, John, and he says he has a whopper of a deal for you: A two unit duplex with two bedrooms, two baths per unit in a good neighborhood. So you check out the place, call up your bank to get a pre-approval, and make an offer on your first property.
Bam! You’re a real estate mogul!
As you bask in the afterglow of your purchase with thoughts of passive income dancing in your head, you sit back and crack open a beer, confident that your rental property will bring you Trump-like prosperity.
“Ah, wait a second though,” you think: “I need to get some tenants to actually make money from this place!” So you put your property up on Facebook Marketplace and grab another brew.
The next morning you head off to work. At lunchtime, you check Facebook. Beyond your wildest expectations, your property has gotten a ton of responses. People want to see your property.
“Awesome!” you think and feel elated. Then, two second later, you feel panicked: “Oh crap, when am I going to show all these people the property?” As the realities of how much work it takes to be a landlord set in, your boss comes up to ask you when the heck you’re going to get that report to him.
You’re so busy that you tell the first tenants who come to look at the place to move in. Things seem to be going well and you receive a few rent checks. Then, without explanation, the checks stop. You can’t visit your property easily to see what’s going on because it’s a few counties away and you’re taking a lot of flak at work that keeps you tied down. A month later, as you sit down to the evening news, you see your rental property live on Channel 4 News as it’s being raided by the Detroit Police Department for a meth lab your tenants have got going on in the basement. Holy shit!
Ok, so it’s usually not this bad. Yet, this scenario is not too far off from situations that I see many landlords get themselves into by not understanding what it takes.
Therefore, before you go down the path of acquiring rental property, there’s a two concepts that you need to understand. First, you need to buy the right property. And, second, you need to find good tenants. And, if it’s too much for you, consider a real estate agent or property manager to help you out along the way.
Hucksters that sell the idea how to get into rental properties like to focus on how much return you’ll get out of the property while not telling you about the work it will take. You’ll hear this return referred to as cap rate (or capitalization rate). Expressed as a percentage, the cap rate is the expected rate of return on a property. However, what you ultimately purchase should not be done solely based on how much investment return you plan to get on the property. You need to consider your expenses and whether or not the property is right for your particular situation.
While your expected rate of return on a property is an important factor when determining which rental property to buy, it is too often highlighted to without consideration to the expenses involved or situation at hand.
In terms of expenses, people overlook the labor and administrative costs of owning a rental property. If you plan on doing the management of the property yourself, then you should consider the cost of your labor and time doing things such as bringing in tenants, dealing with paperwork, and making repairs.
Many people don’t recognize these true costs of owning a property. Marketers of the idea of owning rental properties like to say that they produce “passive income,” like you can kick back and chill. Instead, it’s an opportunity to get to work. Unlike an index fund which tracks a basket of stocks like Vanguard’s Total Market Index Fund where you can put an amount of money in and start to collect dividends with little to no work, rental properties involve sweat and hustle.
You also need to consider whether or not the property is right for you. Consider your property like one would consider a farm. You put in the work seeding and planting and your hard work results in a bountiful harvest later in the year. While cap rate (investment return) is important, you’ll also want a property that you’re comfortable with and even enjoy tending to. For instance, many people who get involved in real estate first start by renting out a single-family home because it’s what with they’re most familiar.
Also, consider where the property is located. It’s easier to manage a property if it’s near where you live (you can access it). You’ll be able to more easily show the place to potential tenants, deal with repairs, and monitor your investment. No one will care more about your rental property than you!
Keep in mind, your property will be more successful if you buy a rental property that has an “economic moat.” An economic moat is a term made popular by the great investor Warren Buffett. He was referring to companies when he did so, yet the idea can also be applied when considering rental properties. An economic moat in real estate is having a property that has an enduring advantage, something it has over other properties. For example, perhaps your property is located only a short distance from a college campus. If so, college students will appreciate that their classes are only a stroll away. Equally, they will appreciate the short walk they’ll have tottering back home after a boozy tailgate.
Another example of an economic moat is the purchase of a commercial property in an emerging downtown that is on the up. Your building, at the center of economic activity, is where every business wants to open a storefront. When your property is the closest to “the game,” whether that’s an actual football game, a vibrant downtown, a hospital, a park, etc.—you’ve got an economic moat!
Again, rental property income is not “passive,” like an index fund. You actually have to put real people in them to get any money flowing to you. And, while putting tenants in the place is a priority, you’ll want to make sure you find quality tenants who will reliably pay their rent each month.
Real estate is just as much about people as it is about the house and land. You’ll want to know the local market the rental property is located in: What companies and local businesses are in the area; what are the best schools; are there any hospitals or local government buildings? Are there any parks nearby?
You’ll want to get to know about the folks in the neighborhood where your rental property is located: Who is the person your property is going to appeal to? If you’re renting one bedroom apartments, they’ll be more likely to appeal to a single person or maybe a couple. If you’re renting out a single-family home you can expect to get (you guessed it) families.
You’ll also want to get a sense of your typical renters’ income. Knowing your typical renter gives you a realistic idea of who you’re looking for. This way, you’re not wasting your time looking for a highly paid doctor to rent out your one bedroom apartment to in a town that doesn’t even have a hospital. You might as well be looking for a unicorn.
Knowing your local market and the folks who live there is just the starting point. You’ll need to advertise your property. There’s a variety of online websites to do this such as Craigslist, Trulia, and Zillow. High-quality images taken with a professional camera market your place better than crappy, low-quality photos. A virtual tour using drone and camera technology can provide your potential renter the ability to view your rental property from their own couch. Or, you can always try newspapers and flyers. Lastly, don’t forget to ask family and friends if they might know someone who might be interested in renting your place.
For these advertisements, you’ll need to write up a description of your rental property. The more transparent you are with your description, the more likelihood potential tenants are to give you a call. So, point out both the positives and negatives of your rental property. If there’s no washer or dryer, if there’s no parking, or if you have a no pets requirement—say it now.
Marketing is necessary to attract potential tenants to your property.
Once you attract the bees to the honey, you’ll need to select the right bee. Uh, I mean the right person!
Selecting the right tenant involves a series of checks. To conduct these checks, you’ll need each tenant to fill out an application if they’re interested. You’ll need to collect their name, birthdate, employer, and a variety of other information. Be cautious however, collect it without the proper paperwork and you expose yourself to liability.
First, you’ll need the tenant to consent to a credit check as you’ll be dealing with their personal information and could be legally liable if you misuse anything you glean. Typically, running a credit check involves a fee, so you’ll need to ask your potential renter to pay you that in advance.
A credit check is done to reveal if your potential tenant is possibly up to their ears in debt. If this person has a lot of debt, it raises the risk that they may not be able to pay their rent. You’ll also be able to see if they have any past bankruptcies or evictions from rental properties in the past.
Yet, don’t rule them out if they have debt by itself. The credit check will also reveal their history of paying their bills, so take this history into consideration. If they have a long history of paying their bills on time, that’s an indication that they’re a reliable tenant. Also, with their permission, you can call their current or past landlord and ask things such as: if they gave enough notice before their move, if treated the property with respect, and if paid their bills on time.
The second check you’ll want to do is verifying their income by asking for a few copies of their paystubs. You’ll also want to ask for their employer information and verify that they actually work there. Checking their income will verify that they actually have money coming in that can pay the rent.
Given the amount of debt you discovered in the credit check, does it seem reasonable that they’ll be able to pay the rent now that you’ve verified how much income they have coming in? Generally, you want someone who is paying no more than a third of their take-home pay in rent.
The last check is the criminal background. As you can imagine, this check ensures that the tenant doesn’t have any “red flags” on their record in terms of disqualifying criminal activity. You’ll be able to see if they appear in any federal, state, or local court records. This way, you don’t accept them only to discover that meth lab two months later.
A real estate agent familiar with investment properties can be very valuable in your search for a rental house. They will be able to direct you to properties that not only have a good return on investment but are situated in good locations with economic moats to best position your investment.
Now that you understand the administrative burden of marketing your property, showing it to tenants, running credit checks, and selecting a good tenant, you will want to consider this workload with your current work schedule to determine if you need help.
If you’re working 40 hours a week, you may want to delegate some of this work to a real estate agent. Someone familiar with the rental process will be able to perform this work much more effectively. A real estate agent will have an array of different online websites, including the Multiple Listing Service (MLS) with which they will be able to market your property in a way you couldn’t do otherwise. They’ll be able to write a concise, accurate description of your property and know exactly what prospective tenants will be looking for.
A real estate agent will also be familiar with the tenant approval process. They will be able to process all the necessary checks discussed above (credit, employment, and criminal) and provide a best recommendation on a prospective tenant. Additionally, they’ll know the local rental market and be able to give an idea of what tenants are likely to be interested in your property and the factors that attract them.