Intro

Being a landlord may sound appealing in theory—you find a decent tenant, collect a monthly rent check, and celebrate your good fortune. If only it were that simple. Before you start fantasizing about a multi-unit building on Park Place, let’s look at what it takes to own and manage rental property, and how to decide whether a particular property is actually going to make you money. Along the way, we’ll share some helpful advice from other first-time landlords.

Great Things About Being a Landlord

Owning rental property offers both financial and lifestyle benefits. As Laura, a landlord with properties in Washington, Nevada, and Florida, says, “I like people, and the feeling that I’m doing a good job. In fact, I have to be careful not to get too friendly—I have tenants in Florida with adorable kids, and I’m often tempted to volunteer to babysit, but have to remind myself to keep it all business. Of course, it’s also nice to earn money through my efforts, and to be able to take tax-deductible trips. I remember the first time I sold one of my rental properties, and made a nice profit on the sale, it made me very happy.”

Omitted from sample chapter: USA Today Snapshots: Housing: Owning vs. renting graph

Below is an overview of the various benefits that Laura and other landlords enjoy. Try to remember these later, when you’re cursing the latest plumbing problem or fretting over how to fill a vacancy.

Appreciation and wealth building

If you hold onto your property long enough, it will almost certainly go up (“appreciate”) in value—eventually. Since World War II, real estate prices in America have risen an average of 5% a year (with some nervewracking ups and downs in between). And even if the house’s value isn’t changing much, renting it may allow you to build equity until you own it outright. Owning investment property is a great way to increase your net worth.

Income

A well-managed investment property, with tenants who pay the rent on time and monthly expenses that are less than the rent, can bring you a steady stream of income. Fifty-one percent of landlords owning single-family homes (surveyed in 2007 by the National Association of Realtors®) bought with this purpose in mind.

Diversification of income

You never know what life is going to throw at you. If you’re laid off from your job, or your health takes a turn for the worse, your primary source of income—presumably your salary—could be jeopardized. Owning an investment property diversifies your income stream, and can give you somewhat of a cushion.

Low-risk investment

Unlike more volatile investments, the returns on real estate are fairly steady. While stock values can fall or even disintegrate entirely, land and property won’t disappear on you. And history shows us that they almost always hold their value—or at least bounce back after a tumble.

That may sound unduly optimistic given the recent drop seen in many of real estate markets across the country. But notably, 2007 was the first year in the previous 50 in which the average price of U.S. singlefamily homes did not go up. In late 2008, at the time this book went to print, median prices were still declining. Yet the number of sales was picking up, leading some experts to predict a turnaround.

Omitted from sample chapter: USA Today Snapshots: Highest and lowest homeownership rates by state graph

Investment diversification

Owning property also diversifies your investment portfolio, a cardinal rule of investing. And it’s pretty easy to understand, if you get the idea of not putting all your eggs in one basket. Should something unforeseeable happen to your riskier investments, such as stocks, you’ll have the backup of a tangible, relatively low-risk asset. As you approach retirement, it’s good to start shifting into lower-risk investments, to ensure the cash you need doesn’t disappear when you’re relying on it.

Leverage

Unlike other investments, a little bit of cash will buy a lot of real estate: A down payment of 10% or 20% of the value of the property is usually enough to get you started. You could, for example, buy a $400,000 property with a $40,000 down payment; while that amount will buy you only $40,000 worth of stock. And if the value of that stock were to increase by 10%, you’d have a $4,000 profit, whereas if the value of the property increased 10%, you’d have a $40,000 profit.

This is called being highly “leveraged”—in one sense, deeply in debt, but in another sense, poised to gain high returns based on a relatively small up-front investment. Leveraging your investment allows you to trade up to more profitable properties.

Example: Shari is selling a single-family house she bought three years ago for $400,000 with a 20% down payment ($80,000).The property’s value has increased to $440,000. If Shari sells for $440,000, she’ll recoup her $80,000 down payment plus walk away with a $40,000 profit (not factoring in costs like sales commissions and taxes). That gives her $120,000 to put down on one or more properties. Assuming she qualifies for a loan, with a 20% down payment, she can now buy property worth $600,000—perhaps a four-unit building that brings in even more income.

Omitted from sample chapter: USA Today Snapshots: Overpaid vs. underpaid graph

Short-term tax advantages

While the rental income from your property is taxable, you can deduct most of the expenses related to owning and maintaining the property. Among these are mortgage interest, insurance, repairs, and upkeep. They also include your business expenses, such as phone calls, office supplies, professional fees (for example, to the accountant who helps you figure out your business taxes), and more.

Another major tax advantage is the ability to “depreciate” your property—to take an annual deduction that reflects the decreased value of the property caused by wear and tear. (In the most literal sense, depreciation is a fiction, because the value of the property will probably go up—but it’s a wonderful fiction for tax purposes.) Chapter 6 of this book discusses tax issues in detail.

Long-term tax advantages

Even if your property skyrockets in value on paper, the IRS won’t expect you to pay taxes on that increased value until you sell. (Your state and local property taxes may be another matter, however, rising steadily to catch up with the property’s value.) And when you do sell, there are several strategies you can use to decrease your tax liability. We’ll discuss those in Chapter 11.

Part-time commitment

If you own just one property, and it’s not too far from where you live, you can probably handle its management in your spare time, while still working a full-time job. A little job flexibility will help, of course. Although weeks may go by when the property needs little or no attention, there will be times when it will need hours from you, for example, when you’re getting the place painted while dealing with the departure of the old tenant and interviewing prospective new tenants.

Your time commitment will be even less if you hire a property management company—though your profits will decrease as well. We discuss the pros and cons of hiring property managers in Chapter 10.

Professional development

Being a landlord and owning property can give you a sense of accomplishment (and some stories to tell at parties). It shows that you’ve broken out of the mold of the average working stiff, and are willing to take risks and accept major responsibilities—you’re learning new skills involving finances, dealing with people, and maybe even home repair, which may help you in other areas of life.

Personal satisfaction

Being a competent and conscientious landlord will pay dividends in other respects, too—you’re going to feel pleased about the way you’re doing business. As Amy, who lives in Berkeley, California, and rents out her former home in Austin, Texas, puts it: “I’ve rented from a few crummy landlords myself, so it’s very satisfying to be able to give my tenants a positive experience, for example quickly taking care of repairs if something goes wrong.”

Tough Parts of Being a Landlord

Landlording is not for everybody, and not every property is worth keeping or buying as an investment. The main reasons that people tend to give up on landlording are the time required to manage a property effectively, the risks involved (such as problem tenants, long vacancies, and legal risks), and the cost. Here’s a quick overview of these issues. Later chapters in this book provide detailed advice on preventing and dealing with them.

Time

Even though landlording isn’t a full-time job, it will take more than an hour or two of your time every few weeks. For one thing, you’ll need to be reachable and available nearly around the clock, to respond to calls from tenants when the plumbing backs up or the neighbor’s dog is barking all night. Occasionally, you’ll need to put in large chunks of time, for tasks like listing and showing the property during a vacancy, screening and approving tenants, and handling rent checks and deposits, to name a few.

In this book, we’ll help you strategize ways to cut down on the time you spend landlording. For example, Chapters 3 and 4 will give you tips on how to market your property, attract and choose the right tenants (who will hopefully stick around for awhile), and list the property so as to fill vacancies quickly and efficiently.

Problem tenants

One of the pitfalls of owning rental property is the possibility that you’re going to get that rare “tenant from Hell”—someone who doesn’t pay the rent on time, trashes the property, or constantly bugs you about every little thing that goes wrong—all of which can be expensive to remedy. Catherine, who rents out a cottage behind her house in Berkeley, describes often feeling “vulnerable,” because someone else has day-to-day control of property she owns and cares about.

It’s more likely that your tenants will be perfectly decent, responsible people. Good screening procedures (as described in Chapter 4) will help assure this. Nevertheless, people can change. Catherine’s low point as a landlord came, she says, when “one of my tenants, who six months before had a nice job and drove a BMW, developed a crack addiction. The neighbors formed a watch group around my house, and I’d see drug deals going on and find vials in the backyard.”

A properly structured lease or rental agreement (as covered in Chapter 5) will help deal with difficult situations like this, and reduce many of the risks associated with problem tenants. And knowing how to deal with bad tenants (Chapter 9) will also help you do damage control when needed.

Difficulty renting

There may be times when the market is soft and it will be difficult to rent your place out. Vacancies are a reality of life for most landlords, but can be made worse by local economic conditions, the need for major repairs in your property, or just sheer bad luck. That’s why we’ll make sure you factor expected vacancies into your analysis of potential profits on the property, below.

Legal risks

If you really want to talk worst-case scenario, you could worry about the legal risks that come with owning rental property—that is, the possibility that a tenant, prospective tenant, or someone else on your property will sue you over a health, safety, environmental, discrimination or other legal matter. You could even face legal trouble from third parties, stemming from misbehavior of your tenant. For example, if a tenant’s drug dealing results in injury to a neighbor, you might be liable if the neighbor can prove that you knew what was going on but failed to take action.

Knowing your own responsibilities and potential liabilities (which we’ll describe in Chapter 8) and acting to reduce the risk of problems occuring will limit the chances that you’ll face serious legal situations.

Costs

The costs of owning an investment property go well beyond the mortgage. They include property taxes, insurance, utilities, upkeep, repairs, property management costs (if you choose), wages for a handyperson, legal costs when needed, and much more.

As Dennis, a landlord since 1982 describes it, “We haven’t had much of a negative cash flow on our properties, but we have sometimes. From a financial point of view, if people are really tight they shouldn’t get into the landlord business. There’s always the unexpected plumbing problem, or an appliance that wears out.”

Reducing costs is one of the keys to being a successful landlord. We’ll advise you on how to assess the cost side of your property in Chapter 6.

Cute, Cheap, and More: Features of the Ideal Rental Property

Whether you’re planning to buy a rental property or deciding whether to keep a property you already own, one of your first considerations should be whether the place is actually suited for renting. Look especially hard at features of the property that can’t be changed, like its location and whether it has a yard. Let’s consider its suitability from both the tenant’s vantage point and yours.

What gives a property “tenant appeal”?

Here are the most important, primarily physical characteristics of a house that will appeal to a wide range of tenants:

• Size. This depends on the local population. For example, a house with several bedrooms will be attractive to large families.
• Location. Nearby transportation access—particularly public transport, with gas prices setting all-time highs—is a big plus. So is proximity to shopping and commercial areas.
• Security. No one likes to live in a high-crime area—and making sure the property is secure enough for your tenants can add to your to-do list as a landlord, too.
• Good nearby public schools. A family that wants to make sure their children go to the best schools and finds a good home nearby to rent may settle there for years. But even short-term renters appreciate a good school, and the corresponding community spirit.
• Affordability. With rare exceptions, it’s difficult to find tenants for large, luxury houses. Any prospective tenant who has the money to afford the monthly rent can probably also afford to buy a house.
• In good repair. Even if it’s otherwise in good shape, a house with ongoing maintenance issues—perhaps a nearby creek that often floods, or being so old that everything is falling apart—may put off tenants who don’t want to be dealing with inconveniences or calling you with numerous repair requests.
• Layout. Like everyone, rental tenants want a place that’s welldesigned. Don’t assume, for example, that a renter will be content with a tiny kitchen. And if the house is likely to be shared among roommates, each bedroom should be reasonably private and have bathroom access that doesn’t involve invading someone else’s room.
• Charm and aesthetics. Like homebuyers, renters will be drawn to a place that looks nice. But you can’t know every prospective tenant’s taste. That’s why a house with broad appeal rather than quirky features is your best bet.

Of course, tenants will also be concerned with certain nonphysical parts of the property, like how much rent you charge and whether you allow dogs. However, such policies are largely within your control, and don’t affect whether you’ll buy or keep the house in the first place, so we’ll discuss them in Chapter 3.

What makes a good rental from the landlord’s point of view?

After thinking about whether your property has sufficient tenant appeal, turn your attention to whether the house you’re considering is appropriate for you, given your available time, skills, and interest. In most cases, this is a house that:

• Requires little fixup and maintenance. For example, a house that’s relatively new isn’t likely to need new plumbing or wiring anytime soon. But this doesn’t mean a newly built house is necessarily the best. A place that’s well constructed but isn’t on the verge of becoming “historic” is your best bet.
• Is close to your own home or work. Who wants to drive for an hour—or get onto an airplane—every time to interview new tenants or see to a maintenance problem? And even if you hire a property management company, it’s good to be able to check on the property yourself from time to time.

CAUTION: Dealing with maintenance gets a lot harder at a distance. As Kyung, who formerly rented out her triplex home in New Haven, Connecticut, explains, “For the ten years we lived in the unit above the rental, we had practically no maintenance problems. But wouldn’t you know it, as soon as we moved to Pennsylvania, things started to fail. The tenants were calling in the middle of the night, and I’d have to call some 24-hour service and pay a premium to get the repairs made.”

• Isn’t in a heavily regulated city or area. If your property is in an area with rent control or other restrictions on landlords, take a careful look before you leap. Read the regulations and talk to other local landlords about their experiences. If you’ll be buying a property with existing, long-term tenants who show signs of planning to stay there forever, you’ll have to make do with belowmarket rent well into the future. In situations like this, your investment may be a losing proposition.
• Will attract long-term renters. For example, a house near a vacation resort or a college might not be optimal if you’re hoping for year-round tenants. (Students tend to leave at the summer break and often switch housing every year, which means regular turnover and repairs.) If there’s high turnover, you’ll at least want correspondingly low vacancy rates and high rents.
• Is convenient to commercial supply sources and repair people. In other words, avoid houses in remote locations where you’ll have to struggle to get to a hardware store or find high-quality help for maintaining or improving the property.
• Is in a strong rental market. Ideally, you’re looking for a property that’s cheaper to buy than to rent, so you can bring in income. But you’re also looking for a market with lots of would-be renters: Otherwise, you’ll find profits eaten up by vacancy periods.

Special concerns when renting out a condo or co-op

hether you already own a condominium or other home in a common-interest development (CID) or are thinking of buying one, you need to be aware of how the property’s unique features impact its suitability as a rental property.

Condos and townhomes are the most common types of homes in CIDs. Renting them offers special advantages, including:

• Less maintenance responsibility. The homeowners’ association will take care of common areas, freeing you from hands-on responsibilities like tending the garden or (in most cases) repairing the roof. (Of course, you pay to get these things done via your association dues.)
• Affordability. A condo or townhouse is usually cheaper than a single family home, because you own less—you own your particular unit, and own common areas jointly. And the maintenance can be less expensive too, since costs that might otherwise be individually paid—like landscaping and insurance— are instead shared.
• Amenities to attract tenants. Without having to buy a whole apartment building, you may be able to offer your tenants access to a pool or other recreational or meeting spaces.

But let’s not forget the disadvantages:

• Community rules and regulations. In a CID, residents typically must agree to live by a set of rules. These may govern everything from the size of residents’ dogs to whether they can hang clothes on the line, add a spare room, smoke in the unit, change the color of the curtains, or change the color of the outside paint. Getting your tenants to read and abide by these rules, when they don’t have a long-term stake in the community, can be challenging.
• Restrictions on renting. Possibly the most significant rule in a CID is a restriction on renting. Some CIDs place numerical limits on how many units can be rented, or ban renting altogether. Although the association is unlikely to weigh in on your choice of tenants (which would expose it to liability for discrimination and the like), it may insist that you put certain clauses in your lease (for example, committing the tenant to abide by community rules), or exert other oversight.
• Community fees and costs. Every CID charges a monthly fee for maintenance and shared costs, and the rules typically also allow special assessments for major expenses like a new roof on the property or dealing with a flood or other emergency. These can run into the hundreds, even thousands of dollars per month, which you’ll need to figure into your budget. (The landlord is normally responsible for making these payments, not the tenant.)
• Slow property appreciation. Historically, condos and townhomes have appreciated in value at a slower rate than single-family homes.

We’ve given a broad description of CIDs, which can vary immensely in physical features and character. Your job, before deciding to buy or rent out one of these properties, will be to fully research its costs, rules (often in a document called Covenants, Conditions, and Restrictions, or “CC&Rs”), and current community concerns. Read the CC&Rs and recent meeting minutes thoroughly, talk to neighbors, and investigate the reputation and financial strength of the property’s builder or owner.

Thinking About Buying an Investment Property?

Not all landlords are accidental landlords. You may be thinking about buying a property so that you can rent it out. (If not, and you already own a property, skip down to the next section, “What Will Your Monthly Profit Be?”) In fact, a survey by the National Association of Realtors® showed that 1.35 million second homes, or 22% of all new home sales in 2007, were for investment purposes.

Before you make that decision, you’ll want to do a careful analysis of the costs and potential returns of your investment. Keep in mind that real estate is not a get-rich-quick business. You’ll have to invest some significant cash upfront. And while your rental income may be a source of ongoing profit (we’ll help you calculate how much below), a large portion of the financial gain will come about as time passes and the value of the property increases. And you won’t actually realize that benefit until you sell (though you could use your increased equity as collateral for a loan).

While some people have gotten rich in real estate, you’ve probably seen the headlines about the many who’ve been disappointed— the would-be house “flippers” who, during the recent real estate downturn, found they couldn’t buy and sell property for quick profits as they’d planned, and ended up in foreclosure or bankruptcy. For many of them, turning their house into a rental property wasn’t an option—their carrying costs were too high compared to the rents they could charge, and they faced a long road of losses ahead.

We’re going to assume you don’t have aspirations toward house flipping, but are looking to invest in rental property over the long term, and ride out the inevitable ups and downs of the market. Or perhaps your ultimate goal isn’t to sell, but to live in the home yourself, after you’ve retired. Let’s evaluate your budget and how buying a rental property will fit in, both as a short- and long-term investment.

RESOURCE: This book doesn’t attempt to present a complete guide to choosing a house to buy or financing investment property. Some good resources for that include:

• Real Estate Investing for Dummies, by Eric Tyson and Robert S. Griswold (Wiley Publishing, Inc.)
• Buying a Second Home: Income, Getaway or Retirement, by Craig Venezia (Nolo)
• Nolo’s Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart.

How much cash you can put down

To determine whether buying an investment property is even a financial possibility for you, let’s start with a simple calculation: How much cash can you free up for a down payment, and how much house will that buy? Most lenders require at least 10% to 20% down, especially on an investment property. (The days of zero down payments are gone, victims of the bursting real estate bubble and subsequent foreclosure crisis.) A quick visit to the real estate section of your local paper, or to an online site like www.realtor.org, will show you typical prices in the location where you’re interested in buying.

Omitted from sample chapter: best investment chart

You’ll also need to budget around 2%–3% of the house’s price for closing costs, depending on what state you live in, what kind of mortgage you get, and what you can expect to pay in escrow fees, title fees, real estate agent commissions, and taxes and insurance at closing. So if you can put down $80,000 plus pay $12,000 in closing costs, you’re well on your way to buying a $400,000 property. If your cash on hand will likely buy a worthwhile rental in your area, keep reading.

CAUTION: Looking at a fixer upper? In that case, you’ll need even more cash on hand. Major home improvements always seem to take more time and money than originally expected, so think twice about this strategy if you’re not experienced with home repairs or construction.

How high a loan you’ll qualify for

You’ll probably be taking out a loan with which to buy your property (unless you’re among the approximately 35% of real estate investors who pay all cash). That means you’ll need to show a lender that you can afford the monthly payments. One of the tests that lenders use is your credit history and score, or your record of paying debts on time. We’re not going to discuss credit scores in detail here—for more information, see the free articles in the Nolopedia at www.nolo.com.

The other test that lenders use is the comparison between your income and your debt load, called your “debt-to-income” ratio. The more debt obligations you already have hanging over you, the less likely the lender is to let you take on more. In fact, the lender may be stricter than when you bought your first home, because lending practices have tightened and mortgages on investment properties are considered riskier.

CAUTION: Evaluate your monthly expenses even more strictly than your lender. What we’re discussing here is how much mortgage you’ll qualify for. But if you tend to spend everything you earn each month—and perhaps aren’t even sure where the money is going—you need to get your first house in order before taking on a second one. For help with household budgeting, see The Busy Family’s Guide to Money, by Sandra Block, Kathy Chu, and John Waggoner (Nolo).

The concept of “debt-to-income ratio” isn’t as complicated as it sounds. The lender looks first at your household’s gross monthly income (the amount you earn before taxes and other monthly withdrawals, plus income from all other sources, like rents, royalties, alimony, or investments). Then it makes sure that your combined minimum debt payments on the property—for your PITI (principal, interest, taxes, and insurance), plus any community association fees, credit card payments, car debt, student loans, and more—don’t eat up more than a certain percentage of that gross income. See the sample Debt-to-Income Ratio Worksheet below.

Omitted from sample chapter: Debt-to-Income Ratio Worksheet

How high can your debt-to-income ratio go? Traditionally, lenders have said that your PITI payment shouldn’t exceed 28% of your gross monthly income, and your overall debt shouldn’t exceed 36%. Although that formula was largely tossed out during the real estate boom of the early 2000s, it’s back in full force. With that ratio in hand, the lenders set your maximum monthly mortgage payment. Using the calculators listed below, you can arrive at roughly the same figure—and then decide whether that amount is enough to buy a rental property in your chosen area.

RESOURCE: Ready to run some real numbers? Find online affordability calculators at www.nolo.com/calculator, www.hsh.com, and www. interest.com. Make sure any calculator you use factors in the amount of your down payment, your income and your debts, and your estimated taxes and insurance.

Keep in mind that interest rates are higher on investment properties, so don’t run your calculations on the assumption that you’ll qualify for the rock-bottom rate offered to buyers with stellar credit who are buying primary residences. You won’t be offered these rates, because lenders know they’re in a riskier position when their borrower is paying two mortgages: If you hit hard financial times, you’ll pay the mortgage on your primary residence first.

Some investors with lots of equity in their primary residences get around these higher rates by doing a cash-out refinance (drawing out cash from their main home to pay for a second) or taking out a home equity loan. This strategy is beyond the scope of this book; in general, while you can use it to get a lower interest rate, the lender will subject you to the same financial evaluation discussed above.

Omitted from sample chapter: USA Today Snapshots: Using the net to buy a home graph

Fortunately, lenders will allow you to include your expected income from the property in your calculations. This is helpful because it will increase your overall income and help you qualify for a bigger loan. However, lenders will probably be conservative in estimating your likely income, for example by figuring a higher-than-expected vacancy rate.

You’ll need to know how much loan you qualify for so you can estimate what kind of property you can buy, how much it will cost you each month, and how much you can expect it to bring in. Later in this chapter, we’ll cover whether it’s profitable to buy based on these factors.

What Will Your Monthly Profit Be?

Earning steady profits from the rent stream should be at the top of your goals list. So don’t just guesstimate or hope for the best. Do the research and run through the analysis below to determine whether you’ll make money each month.

Calculate rental income

Wouldn’t it be nice if you could just add up your expenses for the property, tack on a little extra for profit, and call the result your monthly rental amount? Unfortunately, it doesn’t work that way (except by coincidence). The local rental market largely sets the prices, based on how many properties are available and what amount tenants are willing and able to pay. That’s why many landlords must settle for rental amounts that don’t actually cover their costs, hoping that long-term appreciation in property value will make their investment worthwhile.

As a first-time landlord, your safest bet is to rent out your property only if the rent you can charge will cover your expenses (unless you have no other realistic choice). To figure out whether that’s feasible, look at local ads for comparable properties of the same size and condition, in the same neighborhood and school district.

If the house is already being rented, the existing landlord will of course tell you what the monthly rent has been—and will continue to be, if the tenant has a lease that lasts beyond the property transfer. (You can’t raise the rent until you renew the lease.) But if the tenant will be leaving, your outside research will come in handy, because the landlord may have kept the rent below market rates, perhaps in order to keep a good tenant. And even a tenant who wants to stay may have only a month-to-month rental agreement, which you are free to either terminate or renegotiate (unless your state or local laws add restrictions).

For more on rentability, see “What gives a property ‘tenant appeal’?” above. And see Chapter 3 for ideas on how to spiff up your house for added appeal. When setting your rental policies (which we’ll detail in Chapters 3 and 5), consider whether you might be willing to, say, allow pets or charge a lower security deposit in trade for a higher rent. Depending on who your likely tenants are, a furnished property might also allow you to raise the rent—for example, if you’ll be renting out a downtown condo to busy young professionals. This will be particularly handy if you inherited a fully furnished property.

Also visit other rentals (say, during open houses) to see how yours stacks up. There’s no need to be undercover about it—identify yourself as a new landlord researching the market, and you may find a fellow landlord who’s eager to share tips and stories.

Omitted from chapter: USA Today Snapshots: Pay raise may not match cost-of-living rise graph

TIP: Consider setting your rent slightly below market rates. In the experience of Gordon, a landlord with a single-family property in San Jose, California, “It’s important to not charge as much as you can get away with. If you charge top dollar, you’re more likely to have a tenant not take care of it. But if you give them a fair rent and they feel you’re treating them fairly, they’ll return the favor by taking care of the place.”

After figuring out a likely market rent, your next task is to check into the local vacancy rate, usually expressed as a percentage. A real estate or property management company should be able to tell you how many rental houses like yours are sitting empty. You can also get a sense of likely demand for your house by considering factors such as whether your area is growing economically (so that new employees need housing), whether there’s a steady stream of likely renters (such as students), and whether home prices are out of reach for the average local resident, who will turn to renting instead. Nationwide, a vacancy rate of up to 10% of the year is not uncommon, according to U.S. Census Bureau figures. Of course, this is just a ballpark, and you can lower this rate by using some of the methods in this book to find and keep longterm tenants.

Putting it all together, you should be able to come up with a monthly and annual dollar figure that your rental is likely to command—the monthly rent figure times twelve, minus expected vacancies. Assume that your vacancy rate will be the same as the average where you live, even if you expect to have a long-term renter.

Subtract expenses

If you’re already a homeowner—most people are before becoming a landlord—you know that keeping up a home isn’t cheap. Your regular annual expenses will include the mortgage (both principal and interest, assuming it hasn’t already been paid off), homeowners’ insurance, property and other taxes, and property management services if you decide to use them. You’ll also face less predictable or lower expenses, such as maintenance and improvements, accounting fees now that you’re in business, and more.

Now’s the time to draw up a budget, estimating what it will cost to keep your property. The worksheet below will help with this task. We’ve broken it down so that you enter monthly figures—of course, you’ll need to fiddle with some of the numbers, for example dividing your annual property tax payment by 12.

Caution Double the amount you think you’ll spend on maintenance. If you base your likely maintenance figures on what you usually spend on your own home, you’ll probably come out low. Tenants tend to be harder on houses than owners, and blind to minor maintenance issues until they become major.

If the property is already being rented, the last owner is a valuable source of financial information. Ask for:

• a copy of the lease or rental agreement
• details on security deposits (location, amount, and whether the old owner will be returning them to tenants, in which case you’ll need to recollect them)
• service contracts (such as for gardening—these can be canceled, but you might not want to if the seller is getting a good bargain)
• utility bills and maintenance and repair records for at least the last year (preferably longer), and
• all other paperwork relevant to the property.

And if the current tenant plans to stay, figure out which expenses you can cut out of your budget accordingly. Advertising and screening are the obvious ones, but you may be able to reduce the number of repairs and improvements you otherwise would have done before a new tenant moved in.

Tip: If you want existing tenants to stay, encourage them. During a transfer, tenants may worry that the new landlord will be difficult to work with and will raise the rent or change other lease or rental agreement terms as soon as legally possible. Some will start looking for a new place, just in case. As soon as you can, meet with the tenants to explain your policies and establish some personal rapport.

Our expense worksheet also includes some categories that you may not be able to estimate yet, such as gifts (for example, flowers to your tax accountant for dealing with your shoebox of receipts). Leave these blank if you can’t imagine paying them—but use them as a reminder of possible unexpected expenses.

Omitted from sample chapter: "Monthly Property Expense Estimate" chart

Caution: Costs can mount if you’re unable to make regular visits to the property. Amy explains, “My property tax bill recently went up significantly, and I decided it wasn’t worth the time and expense to fly from California to Texas to appeal it. But if more surprise costs like this come along, I’ll probably have to either raise the rent or sell.”

Estimate short-term profits

Continuing with the simple calculations, let’s say you can afford to buy—or you already own—a house that’s suitable for renting. Now you need to estimate whether the rent will cover your costs. Do that by filling in the chart below:

Omitted from sample chapter: Estimated Monthly House Profit or Loss chart

This chart will tell you whether you stand to make money on such a property in the short term. If the income comes out ahead of the costs, great. But remember that if you’re buying, you’ll probably have put in a large down payment, and may eventually want to sell the place. That’s why it’s worth figuring out the ultimate return on your investment, which we’ll discuss next.

If the property’s expected income isn’t enough to cover its costs and more, we recommend walking away (if you can—see our discussion for people trying to avoid foreclosure, below). Sure, the place might make a good long-term investment if and when property values rise, but that’s a different ballgame—we’re assuming you picked up this book because you wanted to earn regular money as a landlord, not aim for one-time profits.

Caution: This calculation doesn’t include tax benefits. These benefits— depreciation and other tax deductions—can reduce your tax liability by thousands of dollars. If your calculations look borderline, skip ahead to Chapter 6, where you’ll learn more about what these tax benefits are and how they help you increase your profits.

Another thing worth considering is the value of your own time. We can’t calculate that for you, but we will discuss some of the tasks that go into being a landlord in this book.

Omitted from sample chapter: USA Today Snapshots: California cities with highest foreclosure graph

Added financial concerns when trying to avoid foreclosure

It may be that you aren’t trying to make a profit, but are just trying to avoid losing a home that has become unaffordable— perhaps one you don’t think you can sell for what you owe on it. In that case, you might avoid foreclosure by renting the place to someone else. Most likely, you’ll rent another place of your own until the situation changes.

In that case, you should continue your calculations as follows:

Omitted from sample chapter: profit/loss from rental chart

Example: Samuel’s monthly mortgage is $1,000, but after paying his other bills, he has only $800 with which to make the payment. By renting out his house for $1,200, he covers the mortgage and other expenses so that he breaks even, neither profiting nor losing money on the rental itself. If he can find a smaller place to rent for $800 a month, he may be able to pay the bills and keep his house.

Added financial concerns when buying for a college student

Buying a house for a college-bound child has become an increasingly popular option, with dorm costs often prohibitively high. The average annual room and board for public, four-year schools rose to $7,404 in 2007–2008 (up 5.3% over the previous school year), while private school room and board averaged $8,595, (up 5%). (Source: the College Board.) But before you assume buying a place for your college kid will be cheaper, make sure you’ll truly come out ahead.

Step one is to find out what the actual room and board at your child’s college will likely be. Then research both the rental and the real estate market in the area. If you’re lucky, your child will be attending school in an area where average rentals are high enough to offset average mortgages and other costs (the reverse may be true, although the demand for housing in college towns has a tendency to drive up rents). By renting out some rooms to other students, you may come out ahead even before your child graduates. When this book went to print, for example, parents of children going to school in Lawrence, Kansas were looking at a potentially good market to buy into, with average single-family home rentals at $1,162 and average monthly house payments at $859.

Omitted from sample chapter: USA Today Snapshots: High cost of learning graph

Of course, citywide averages may not be enough. You’ll need to look at property values right around the college, which will naturally be affected by student demand for housing. With a couple of sample home prospects in mind, run the profit-or-loss calculation described under “Estimate short-term profits,” above, then compare it to how much you’d be spending on room and board. If it comes out about the same, then you should buy the property only if you like the idea of a longterm investment, or think it will bring in a high return when you sell (as discussed next).

What Will Your Long-Term Gain Be?

Whether you’re an accidental landlord or are actively looking to buy a house to rent out, your research so far will help you analyze your house’s worth as a long-term investment—taking into account upfront costs, ongoing costs versus income, property appreciation, and profits from the sale. Now you can:

• estimate the house’s likely appreciation, or increase in value over time, and
• calculate the likely return on your investment (RO I), or the expected value of your investment in your property.

Appreciation: Will your rental property rise in value?

We’ve already discussed the general tendency for homes to rise in value over time. But to get a true picture of your home’s prospects, you’ll need to look at local home prices. Ask your real estate agent to calculate the change in median prices for the past ten or more years, or call or visit the town clerk or assessor. The more local your research, the better— one neighborhood’s house values may rise or remain steady while another one’s drop.

If the price trend looks to be heading upward, you’re probably on safe ground buying. If it’s heading downward, you’ll have to make a tougher decision—will you be getting a bargain just before prices tick upward again, or will you be entering a depressed housing market in which you’ll have little choice but to hang onto the property for years trying to make the most of your rental income? Talk to your real estate agent and read the local media before making your decision.

Also remember that falling real estate markets sometimes increase demand for rental units, since people are skittish about buying, or have left a house due to foreclosure. And if you can charge enough rent to offset the purchase price from the beginning, it’s a solid investment by any measure.

To figure out the actual amount by which your house is likely to go up in value year by year, take the appreciation rate that you researched above and use it to create an analysis like the one in the chart below. (It looks complicated at first, but is actually quite obvious when you follow it line by line.) The example shows the projected appreciation of a $400,000 house over a five-year period in an area with 5% appreciation.

Omitted from sample chapter: Sample Projected Appreciation on $400,000 House

Return on investment: How much will you get back?

Let’s look years down the road, to estimate whether your total investment in the property will be worth it after paying all the associated expenses. The term to describe this is “return on investment,” or “RO I.” It’s usually expressed as a percentage. You can calculate RO I on other investments as well (such as stocks and bonds), and see how they’re all doing relative to one another.

The basic idea is to take your estimated annual profits (including rents plus home appreciation—which are only paper profits until you sell, but that’s okay), and divide it by your total investment in the property (down payment, annual costs, total mortgage principal paid that year, and anything you spent for major home improvements). That means filling in the following calculation (simplified to leave out tax deductions and depreciation):

Omitted from sample chapter: ROI calculation

Example: Kira bought a house for $400,000 (putting $80,000 down), and began renting it out immediately. In her first year she earned $2,000 in income (after expenses including mortgage interest, plus maintenance, utilities, and the rest), plus another $5,000 in home appreciation (paper profits until she sells). Dividing that by her investment amount (her $80,000 down payment plus $5,000 in mortgage principal payments over the year), her ROI would be approximately .082 or 8%.

So, what does the RO I percentage mean? It means that, continuing with our example, if Kira sold her home after the first year, she’d have earned an 8% return on her initial investment. She’s probably doing pretty well compared to the returns on her stocks and other investments. Of course, we’re using artificial numbers, and your returns may be far less.

At this point, we suggest you do the RO I calculation using projected numbers, for the first year as well as later years that you plan to own the property. If it’s positive, that’s another green light—but again, don’t be too swayed by the prospect of home appreciation if your actual profits are negative. An RO I that’s lower than you could get with other investments after several years may be a sign to look elsewhere.

Return to the ROI calculation once you have actual numbers, to see how reality compares with your projections. It might actually be a source of comfort if you’re not earning a profit on your rents but home prices are appreciating. You may still come out ahead.

Setting Your Goals

It’s decision time: Having explored some of the basics of owning rental property, you must decide whether it’s truly right for you. To help you in this process, answer the following questions:

• How committed are you to holding onto the property? If you’re hoping for, say, a year’s trial run, it’s safest if you already own the property. Buying a property that you might not keep for at least three to five years is a recipe for loss (especially because of the transaction costs: 5%–6% for the real estate agent’s fees alone).
• What are your short-term financial goals? After running the calculations above, decide what amount of property income will make it worth your while to pursue this project. Balance this against your long-term goals, below.
• What are your long-term financial goals? At some point, you may want—or need—to sell the house. What amount of profits are you expecting or hoping to make? If your sales profits aren’t likely to be high, then it’s even more important that you’re satisfied with the anticipated monthly rental income.
• How much time are you willing to put into this project? If being a landlord will take precious hours you can’t spare, then it may not be worth prioritizing right now.

Take a careful inventory of your objectives as a landlord and property owner, both in the short-term and the long-term. Discuss them with your family, especially if you expect them to help maintain the property, deal with your absences, or travel with you for that purpose. Then keep track of where you are vis-à-vis those goals from year to year. We’ll help you track your profits and expenses in Chapter 6.