Read an Excerpt
How to Make Money from Rental Properties
Excerpted from The Weekend Real Estate Investor by James O. Parker ©2006
There are three basic ways in which owners of rental properties can profit from their rental activities. Since realizing a profit is the primary-if not the only-reason for becoming a landlord, these three considerations should receive major emphasis in the rental property selection process. Historically, many U.S. taxpayers bought rental real estate because they could use losses that were generated from depreciation to offset their taxable earnings from employment and other sources. However, tax deductions for losses from rented real estate have been severely restricted by amendments to the Internal Revenue Code. Apart from any tax savings that might have formerly been available by taking tax write-offs on rental property, landlords have always had the opportunity to realize profits from rental income and market appreciation of their rental properties, and these are even more important today in light of those unfavorable tax law changes.
Buying for Rental Income
In order to realize rental income, a landlord must be able to collect rent in excess of the costs of ownership of the rental property. In addition to mortgage payments, property taxes, and insurance, landlords must also allow for the following:
? advertising and other costs associated with finding a tenant;
? periods of vacancy between tenants; and,
? sinking funds for long-term upkeep, such as replacement of the roof, painting the exterior, replacing furnaces and air conditioners, and preparing the property for a new tenant when it becomes vacant.
Even with the tax laws that prohibit some taxpayers from using losses from renting out property to offset other income, landlords are still allowed to take an allowance for the wearing out of their property, referred to as depreciation, and use it to offset rental income that they would otherwise have to report. The depreciation deduction is permitted, despite the fact that the value of the property is probably actually appreciating. As a result of the depreciation deduction, landlords often show little or no rental income on their books, and may even show losses, but are actually able to generate a positive cash flow that they can use to make improvements to their properties, acquire more rental units, or spend as they please.
To the extent that landlords are unable to cover their out-of-pocket expenses associated with rental property ownership, they will be forced to cover those expenses with income from other sources. Therefore, it is important for buyers of rental property to carefully analyze the rental potential for every property that they seriously consider buying.
Opportunities to buy relatively high-priced properties at attractive prices may become available from time to time, but higher-priced properties are usually difficult to rent out for enough money to generate a positive cash flow. (It is difficult to find tenants who are willing to pay rent that is considerably higher than average rents for a given locale.)
For example, for a house that costs twice as much as the average house available for rent in a particular area to generate the same return on investment as an average house in the area, it would have to rent for twice as much as one that sold for the average price. This is because the mortgage payments, insurance, taxes, and other costs associated with owning that expensive house should be about double those associated with owning the average-priced house. However, most renters cannot afford to pay twice the average rate of rent, and those who can pay that much rent would likely be able to afford to buy their own homes. Even people who are going to be in an area for too short a time to make home ownership practical are still likely to shy away from renting an expensive property, since they will be occupying it for only a relatively short time and will get no long-term advantage from renting the more expensive property.
Buyers who choose the least costly properties to purchase for use as rental property will be able to offer the cheapest rental rates, but still may not be able to attract desirable tenants. Tenants who rent housing in an area's worst locations usually do so because they cannot afford a better place to live. Those who can afford to pay at least the average rate of rent for a residence will usually see enough added value from living in an area with better schools, lower crime, and nicer housing that they are more than willing to pay the difference in rent between a house in an average neighborhood and one in a substandard area. As a result, landlords who offer low rental rates, but in unpopular neighborhoods, will probably attract only those applicants who are likely to have trouble paying even below-average rates of rent.
Investors who have chosen to acquire commercial properties to rent out will usually also find that their best choice of properties for generating a positive cash flow are those that are not rented too far above or too far below average rental rates for that type of property in that general area. Only a limited number of businesses can afford to pay relatively exorbitant rates of rent and still expect to make a profit, and properties in undesirable areas usually attract undercapitalized tenants who would like to be elsewhere, but cannot afford a better location, and may well have trouble paying even modest amounts of rent.
Before You Buy
Choosing rental property is not unlike Goldilock's quest for a chair, some porridge, and a bed. Rather than relying on trial-and-error, and perhaps making a costly mistake, aspiring landlords have the opportunity to enhance their chances for success by making an informed decision based on some pre-purchase fact gathering. The same features that make the location of a property attractive to prospective buyers will also make it attractive to prospective tenants. Therefore, before making an offer to buy a property for rental, the buyer should investigate the quality and availability of local schools, neighborhood crime rates, the level of fire and police protection, and the proximity of shopping areas and public facilities. Buyers of prospective rental properties should definitely find out what the property tax rates are for properties that they are considering, the history of rate increases, and whether a different rate will be imposed if the property is converted from an owner-occupied property to one that is rented. A similar inquiry should be made concerning the cost of hazard insurance on a property being considered for purchase as a rental unit.
It would also be advisable, before purchasing properties for use as rental units, to determine the rental income that they would likely generate. This information will not be as readily available as tax and insurance information, unless the property is already being rented. Buyers who already own similar properties in the neighborhood will likely be able to gauge what an additional property in the neighborhood could be expected to generate in rent. (This is one of the reasons why it is advantageous for landlords to acquire relatively homogeneous properties.) However, those who do not have rental histories of similar properties available to them can still get useful information to help them estimate a property's rental value by checking newspaper advertisements for similar rental properties, calling the landlords to inquire about the properties, arranging to see some of the properties, and monitoring the properties to see how long it takes to rent them. This sounds easy, but a buyer who has gotten excited about a property will have a hard time waiting to make an offer on that property in order to thoroughly investigate its rental potential.
Buying for Market Appreciation
Although real estate prices have generally risen over the long-term, some properties have appreciated far more than others, and some have even declined in value. Properties with the greatest potential for appreciation may be too costly or otherwise unsuitable for use as rental property. However, there will be properties available that are viable rental units and offer good potential for appreciation. The successful landlords will be those who buy properties that appreciate faster than the average property, while avoiding those that decline in value or lag behind the market in their rate of appreciation.
Landlords who place a high priority on potential for market appreciation when they are looking for rental property to purchase should focus their attention on factors such as:
? quality and availability of neighborhood schools;
? low crime rates;
? adequate police and fire protection;
? proximity to shopping areas; and,
? good local government that maintains stable tax rates while providing adequate services.
These are the same things that the landlord should consider in determining whether or not a property will appeal to prospective tenants. However, unlike the evaluation to determine whether a property will rent well, the determination of a property's potential for future appreciation should be based on the outlook for the future as it pertains to these factors, rather than their current status.
In essence, the landlord should attempt to determine what the area where the property is located will be like at the point in the future when he or she is likely to want to sell it. In making this determination, the types of things that should be considered are whether new businesses move in when old businesses close up, whether properties in the area are being maintained, and whether new development is taking place in the area (and if so, whether the newly developed properties are better or worse than existing developments).
Of course, historical data concerning the rate of appreciation of property in an area will always be available, and it may be of some value in predicting future appreciation potential, unless the character of the neighborhood has changed. Rarely do the shabbiest of areas undergo a transformation and become desirable places to be.
However, it is not uncommon for areas that are conveniently located, but have become somewhat run-down, to experience a renewed level of interest that drives up property values. Indications of a rebirth in a neighborhood are such things as rapid sales when properties are put on the market, expensive renovation projects on homes in the neighborhood, and an influx of businesses that tend to cater to more upscale customers. The rejuvenation of a neighborhood will tend to have ripple effects that spread to adjacent neighborhoods. Therefore, the landlord who can recognize which neighborhood has just begun to make a comeback, and then anticipate which neighborhood is likely to benefit next from that area's renaissance, can get ahead of the market and position him or herself to profit from the future redevelopment.
Buying properties in a neighborhood that is an emerging hot spot requires some boldness. Buyers must decide whether recent price increases that such areas will have already experienced have pushed prices of houses in the area beyond their reasonable value, or if those increases are simply a prelude to larger further advances in prices of properties in the area. However, as with properties bought for a personal residence, a rental property of only mediocre quality and condition in a desirable location is far preferable to a rental property that is of outstanding quality and condition in an undesirable location. The difficult part of the equation for successful property selection is finding properties in good locations without having to pay too much for them.
Although it is not impossible to find properties that can produce a positive rental cash flow and still have good potential for market appreciation, there is a degree of a trade-off between the two. Fortunately, properties that were too costly to permit them to initially generate enough rent to produce a positive return can eventually do so, as rental rates rise with inflation and increasing popularity of a neighborhood. Some investors feel strongly about a property's potential for appreciation, and can do without immediate net rental income from the property or can even afford to subsidize a negative cash flow from it for a while. These investors should not rule out the properties in better neighborhoods with above-average appreciation potential, despite the fact that there is no real likelihood that the property will generate a positive cash flow for a while. Even properties that are not appreciating rapidly and are not generating net rental income will, by virtue of the fact that the balances on the mortgages on them will be reduced with each payment, still add to the owner's wealth. This is provided that he or she has not made such poor choices that the value of the properties declines or the properties cannot be rented out for at least enough to cover the costs of owning them.