What’s Keeping You From Becoming a Landlord?

Good things often start with dreams. Imagine this: you save up a down payment for a rental house. You find a great house, and are able to finance the balance of the purchase price (after your down payment) with a fifteen-year term loan at a fixed rate of interest of 4.25%. You can cover debt service from the rent that comes from the property. This means in 15 years, there is no more mortgage, and the rental income from the property (less taxes, insurance and maintenance expenses) goes into your pocket.

Now imagine doing that three times.

Can you make this dream part of your reality? Why shouldn’t you?

Capital market volatility has continued to turn individual investors away from stocks, bonds and mutual funds and toward real estate investments. Even the big Wall Street players are buying single family homes for rental now. Unlike capital market investments, investing in rental real estate may give the individual an uncommon degree of control over his or her investment dollar.

Notwithstanding the surge in popularity in investing in single family homes, we frequently encounter people who, when we tell them what we do, respond by saying “Oh, I have been thinking about buying a rental house, but I’m nervous about

1)                  knowing whether or not I’m buying a good rental property,

2)                  getting a “bad tenant,” or

3)                  the time involved with managing the property.”

These three concerns are frequently voiced to us, and we understand why, as we were worried about these same things before we purchased our first rental home. However, as with any other important purchase, we found that doing a little up-front research and due diligence greatly reduces the risk of any significant problems arising from these common concerns.

Before we explode some of the myths surrounding these fears and explain how you can radically reduce the probability that you will make a mistake in your life as a landlord, we want to make one thing absolutely clear. There is no free brunch! It takes money to make money. You must have enough money for at least a 25% down payment.  If you want to attract the types of tenants we discuss below, the so-called “good tenants,” you must have the money to make the house immaculate and in tip-top shape (read this to mean the kind of house you would live in with your family). Finally, you must have a substantial amount of money in reserve so that you can both cover the mortgage in the event you have vacancies (otherwise, you may become motivated by your lack of reserves to rent to whoever comes along) and to cover any projected and unexpected repairs. If you are not in a favorable financial position now, you will probably need to wait until you get into that kind of a position before launching into the purchase of your first rental property.

Fear of Picking the Wrong Property. The “wrong” property is different for every investor. It is a property that does not produce close to or in excess of the expected rate of return. A property can be a disappointment for a number of reasons. For example, you can buy a contemporary house or a stucco house in a market where those properties won’t sell. The property may be a fine rental, but when it is time to sell the property, you may be disappointed to find that your expected appreciation was one percent (1%) per annum instead of the three percent (3%) you might have expected. You may have excessive unexpected repairs or vacancies. We like to see a projected after-tax rate of return of at least nine percent (9%), and do not buy houses that are projected to fall short of that.

For each property you consider, you should think about market rents in the area, vacancy rates, the age of the house’s systems and the expected replacement costs, property appreciation rates, types of loans, closing costs and other transaction costs, and much more. Depending on the rate of return you expect, you might have to look at a lot of properties before you find one to buy. That’s fine, and the time involved in finding the right property shouldn’t deter you from looking for it. It is part of your education, and is a necessary step. To successfully see properties, you must build a relationship with a real estate agent who understands what you are doing, the areas of town you are looking at and the types of properties you will consider. The agent should be able to prescreen homes in your targeted geographic area and e-mail the listings to you weekly. Your agent should be willing to make phone calls to the seller’s agent to get any additional information you might need to analyze the property. If you plan to manage the property yourself, consider buying a rental property close to where you live. If you are not working with an agent, please see our services page.

Finally, one thing is universal: no one wants to overpay for a home with major defects. Although it should be easy to avoid unknowingly buying a home with a mold, water, foundation, or structural problem by hiring a thorough property inspector, we have not found this to be the case in our market. Unfortunately, many home inspectors we have seen seem to think that their jobs involve testing electrical outlets to see if they work and making sure that the hot and cold water faucets aren’t reversed. We frankly could care less about the small matters, and so we use a property inspector who is also a structural engineer. Our inspector will squeeze himself into a tiny, damp, bug-laden crawl space to check for water and structural issues, and quite literally leaves no stone unturned, revealing all of the big issues at a time when you still have the opportunity to pass on the investment. He is not much more expensive than the inspector who spends his time making sure all of the light fixtures work, and he has saved us from many homes with major water issues, foundation problems, improperly installed stucco and structural defects. Have we had an investment property under contract, paid our inspector $450 to inspect it, and then walked away from the property? Absolutely, and on more than one occasion. While no property is perfect, you need to build a relationship with a trustworthy, independent inspector who will look at each and every investment property you are considering to make sure the imperfections are minor ones. For an inspector to be independent he or she should not be in your real estate agent’s or the seller’s agent’s pocket, as inspectors recommended by agents may have an incentive to “pass” a bad property in order to help the deal close.

Fear of the “Bad Tenant.”   Everyone has heard horror stories about the tenant who stopped paying rent, trashed the house, wouldn’t leave for months despite default notice letters and eviction proceedings, and then finally left taking with them all of the light fixtures, the refrigerator, the door knobs and anything else not nailed down. First and foremost: two words – credit check. A family with extremely good credit is highly unlikely to destroy his or her credit by failing to pay rent or trashing a house. Credit checks have become extremely easy to conduct – there are numerous on-line tenant screening services (we like www.myrental.com) – and you can get great information about tenants in a matter of minutes. Yes, there is a charge for the service, in the $35.00 to $75.00 range, but the price is well worth it. Many landlords charge an application fee to recoup part of the cost of the credit check. Be aware that you must get the prospective tenant’s written consent to conduct a credit check before doing so. We do this as part of the lease application process, which also gives us a chance to preview the tenant-provided information about the prospective tenant’s employment, rental history and financial status. If the tenant-provided information is not favorable, we won’t spend the money to conduct the credit check. For our form of lease application, click here.

Do we hold out for tenants with perfect credit? Just about. If a particular tenant has had any credit problems within the prior twelve to eighteen-month period, we will decline to lease our investment to the potential tenant. Have we held properties vacant an extra month or two waiting for the right tenant? You bet. One or two extra months of vacancy followed by occupancy by a tenant who pays on time every month is better in our book than a quick lease to someone who pays for two months and then has to be subjected to a costly eviction process for non-payment of rent.

Another way to keep a decent tenant from turning into a bad tenant is to avoid becoming friends with your tenant. We maintain very formal relationships with our tenants, and we believe that this reduces the frequency of minor service calls and late rent payments. One of our partners handles showing the property, getting the lease signed, and any repair requests, while another handles any written correspondence relating to problems with the tenancy. This allows us to employ a “good cop, bad cop” approach, and one member of our landlord team is able to take an extremely hard stance about lease violations while the others can handle civilly any ordinary communications with the tenant.

Finally, our rental properties are really nice, absolutely immaculate, and rent for not less than $1500 per month. Generally, people who actually go to the trouble of seeing the house have income that can support the rent (although their credit does not always pass the test). Nightmare tenants come from bad landlord decisions. You must be willing and financially able to wait until the right tenant comes along.

Fear of the “My Toilet is Stopped Up” Calls. Service calls are a part of life as a landlord, but the frequency of these calls can be reduced substantially if you follow a few simple guidelines. If you have absolutely no appetite for dealing with tenant calls, then hire a property manager to handle month-to-month operations. But if you choose to hire someone to manage the property for you, expect to pay from eight (8) to ten (10) percent of your monthly rent as a management fee. We recommend that you try to manage the property on your own, using a good pool of service providers to handle those repairs that you cannot, and if it proves to be too time consuming for you, then hire a property manager.

Our first tenant service call came when all three of our partners were on vacation together. A single female tenant had her pilot light go out on the water heater. Obviously, this is a call we would have handled ourselves. Having a plumber handle the call was relatively inexpensive (about $95.00), but we had to find one while we were out of town and arrange for payment. It pays to build relationships with various vendors who can quickly handle any service calls you don’t want to or aren’t qualified to handle on your own before you need them.

One key to avoiding frequent and costly service calls is building a relationship with a good, tough property inspector, and having your investment property inspected before you buy it, as discussed above. Once you and your inspector find a rental property that is a keeper, you need to make the property absolutely immaculate and in tip-top shape for your first tenant. All systems that are in need of replacement should be replaced or repaired before they expire. You should be evaluating system ages and planning your property maintenance program as part of the evaluation you make when deciding whether to purchase a particular property, and we suggest that you err on the conservative side and plan on incurring the expense of repairing or replacing systems slightly before it becomes imperative to do so.

Additionally, we give only a cell phone number to our tenants, and our e-mail address. We do give tenants our home address for purposes of mailing rent, but have considered a post office box for greater anonymity.

We also insist on one month’s rent security deposit, and $250 – $300 per pet for a pet deposit. Your deposits should be collected when you have the lease signed and when you collect the first month’s rent, and should be put in a separate bank account held specifically for tenant security deposits. We conduct a careful inventory of the house during a walk-through with each tenant right before they move in, note any and all defects in the property on the defect inventory form, and have the tenant sign the form. This way, if there is damage to the home upon move-out, we have a crystal clear picture of how the house looked upon move-in, and it is unlikely that we will have a dispute when we keep all or part of the security or pet deposit to pay for any damage that might have been done to the property during the tenancy. Although we don’t go to the trouble of doing it, it would be prudent to take the time to prepare a dated video inventory showing the condition of the property prior to move-in as evidence of the move-in condition of the property in the event you do have to keep all or part of the security and pet deposits.

Feel better yet? We hope that this article eases some of the most common fears about becoming a landlord. It does take some time to find a property that will produce the kinds of returns most investors want, so we encourage you to stop sitting on the sidelines and start looking for your first rental property investment opportunity.