Read an Excerpt
Getting Started in Rental Income
By Michael C. Thomsett
John Wiley & SonsISBN: 0-471-71098-9
Chapter OneThe Traditional Approach Buy, Hold, Hold a While Longer, Sell
The creation of rental income is not automatic. It does not come into existence simply by virtue of an investor buying rental property and finding a tenant. Successfully generating a long-term income stream from your rental income depends on advance research; an understanding of your local market-and a keen awareness of the many alternatives you face in terms of opportunity as well as risk.
In the stock market, the well-known buy-hold-sell implies the possibility of quick turnaround. The stock market itself can be a fast-paced experience. Day traders go in and out of positions, minute by minute, often making huge profits or suffering huge losses before lunch. Real estate investors cannot have the same experience. In real estate, the prices of properties do not change in the liquid environment of an auction marketplace like the stock market. The cost and time involved in completing real estate transactions requires a different mindset from that of the stock market. If you want to generate rental income, you need to appreciate the differences between stocks and real estate.
In this chapter, we learn about the differences between real estate and other investments, setting the stage for how the traditional approaches to markets work; how your investing, financial and personal life are affected by owning rental income; and how to make sure that buying real estate is not only profitable, but enjoyable as well. It is unlikely that you will find many investments that give you high returns, safety, tax benefits, and cash flow to match real estate. At the same time, you also need to be prepared for the interaction with tenants, complexities in recordkeeping and taxes, and the need to tie up capital for a longer period of time than with stock.
Studying the Rental Income Market
There is an old expression that "the market rewards patience." While this was aimed originally at stocks, it is equally true of real estate. In the Internet world, the stock market may punish patience and reward high-volume trades in some instances. But even with the Internet, real estate transactions usually still take a lot of time.
You may be able to narrow down your search using the Internet. Many sites offer not only references to local brokers and agents, but also current listings of property for sale. This means that you can study a range of potential properties without having to spend time with a real estate agent and be shown properties beyond your price range, out of your desired investment region, or otherwise inappropriate for your needs.
The method you employ at the very beginning of the process largely determines the quality of the properties you review. A common method for finding property, whether as a primary residence or for investment purposes, is to visit a local real estate office and speak to the agent on the floor. This is often done with no references, prequalification, or other tests. Even the process of looking at properties may be flawed. The agent is likely to show you only listings held by that brokerage firm, which can severely limit what you are shown, in terms of location, price, and features.
Online sites can link you to state-by-state professionals as well as actual current real estate listings.
A wiser method (but one that requires more patience) is to begin by drawing up a list of features you need to know about before investing in property. These include:
1. Price. The first question on most people's minds is what properties cost. For some, this is limited to the question, How much do I need to make a down payment? It should extend far beyond this question, however. The evaluation of price should be made in context of typical prices in the area. Is this price a bargain? What are prices of similar homes in the same or nearby neighborhoods? Don't expect real estate agents to show you only the bargains; perform your own investigation.
2. Location. The location of the property is crucial to identifying properties that are likely to appreciate in value. Location extends not only to a specific neighborhood and its attributes, but also to the area of a town or city, economic status affecting real estate values, noise and other nuisances nearby, and availability of conveniences.
A neighborhood in transition can be either a plus or a minus. If you observe areas over time, you notice that the makeup of a specific neighborhood changes. As a generation passes, properties are sold to new residents, older homes may be renovated, and new features added. This positive transition is a good sign that property values are going to rise as well. A negative transition occurs when residents stop maintaining properties, when low demand leads to empty or boarded-up houses, where empty lots are left for long periods because no one wants to build in that area, and where deleterious social trends like crime levels or gang activity are on the rise. In these areas, property values tend to decline, and while many bargains may be found, the long-term investment value is going to be questionable. Some investors specialize in buying and holding "distressed" properties; this is not a specialization most beginners will want to enter.
3. Features. The specific features you seek in a rental property should be defined by the demand for rentals itself. For example, the greatest return on investment may be found in one- and two-bedroom homes or duplex and triplex units; you may discover that four-bedroom homes do not yield adequate rents to cover your cash flow and expenses. This analysis is going to vary from one area to another; but it is important to analyze local features as a starting point. Compare market rates for rentals with different features to get an idea of how you can produce the best return on your investment.
4. Age and condition. What market are you interested in? Do you want a no-maintenance property that you can just rent out the day after the purchase is complete? Or do you seek a lower-priced bargain property that will require cosmetic improvements? The cost of properties will reflect the level of work you will need to do, so you should first define whether you are interested strictly in buying and holding rental property, or whether you want to buy, improve, and sell at a profit. There are many ways to approach the market, and defining your preferences is an important step to go through before you start putting offers on houses.
5. Demand attributes. One of the most overlooked steps in deciding whether to develop a rental income investment portfolio is a study of local supply and demand features. Demand comes in at least three forms: financing, market, and rental.
Financing demand refers to the availability of money to lend. When a lot of money is available, when rates are low, and when lenders want to find borrowers, they offer attractive closing cost terms, low rates, and fast review. When money is tight, borrowing will be more expensive. Interest rates will be higher, lenders will charge more points, and closing costs will have to be paid just to process the paperwork.
Market demand is reflected in the prices of real estate. The real estate cycle is similar to all cycles; it has up and down times. When demand is high-meaning there are more buyers than sellers-prices are driven up and builders cannot complete houses quickly enough. When demand is low-meaning there are more sellers than buyers-it takes longer for housing sales to be completed, sales take place at discount from the list price, and builders do not begin new projects. This cyclical tendency is illustrated in Figure 1.1.
The history of real estate prices reflects changes in demand over time. This is shown in the summary in Figure 1.2 However, demand itself is local. So the conditions reflected nationally will not necessarily apply to condition in your city or town.
This summary of housing prices demonstrates the strong and consistent nationwide market demand. Over many years, average sales price for residential property have climbing upward steadily, outpacing the rate of inflation during most years. The dollar values and percent of annual change are summarized in Table 1.1.
Note that average prices declined in only two out of the 25 years in the Table 1.1. This demonstrates the historical strength of real estate values.
Rental demand is the least understood of the three types. It is unrelated to the better-known market demand in an area. Because market demand is usually driven by purchasers who will live in the houses they buy, the trend in supply and demand is reflected by local employment statistics, lifestyle, and other social attributes. Rental demand is driven by the number of people who cannot afford to buy or-who do not want to buy-they want to rent. In some areas, market demand can be strong but rental demand weak. In other areas, the opposite is true. The important thing to remember is: Market and rental demand are driven by different forces. For example, in a city with a large college population, rental demand is likely to be high, at least while school terms are active. However, if the permanent population of the same area is primarily retired, market demand could be relatively low.
To check housing statistics and trends, check the U.S. Census Bureau Web site.
6. Financing. In the stock market, it is relatively easy to get an investment program started. With a few thousand dollars, you can buy stocks directly-for as little as $100, you can open a mutual fund account. In real estate, cash investments are beyond most people's means, so the majority of equity value will be financed. This means that you have to address several questions in your initial analysis. Is your credit excellent? Good credit paves the way for more financing options, whereas a record of poor credit prevents many people from being able to get loans for a rental income program. Another question worth investigating is that of financing alternatives. Do local lenders offer a variety of programs? Are rates attractive? (Rates for investment properties tend to be higher than for owner-occupied housing, and down payment requirements are likely to be higher as well.)
If commercial loans are not available, what other methods can you use? You could seek properties in which sellers will carry all or some of the debt. The problem here is that when sellers offer to finance a sale, it often means there is a serious problem with the structure. If the seller knows it is impossible to get conventional financing, that could be a troubling sign. You may be buying someone else's problems when you deal with seller-financed properties. At the very least, you would want to get an independent home inspection before agreeing to accept a seller's offer to carry a loan.
7. Cash flow. When you have analyzed all aspects of your local market, demand, financing, and other aspects, you end up with the most important question of all: Do the numbers work? In Chapter 2, we explore the importance of cash flow and show how to make these important calculations. It is essential for you to determine whether cash flow is practical in your situation. For example, if you expect to make monthly mortgage payments of $1,100 per month but market rates for rents are only $500, it is obvious that cash flow doesn't work out. And it is not as simple as comparing rents to mortgage payments.
To whom do you go to find an independent home inspector? Stay away from contractors who will also offer to perform work or refer work to someone they know. Ethical home inspectors refuse to perform repair work or offer referrals. Use an inspector who is a member of the American Society of Home Inspectors (ASHI). To review performance standards and to find a qualified inspector in your area, check the ASHI home page.
You also need to consider nonmortgage expenses and payments; tax benefits; and the possibility of vacancies. How much cushion do you have between your monthly family income and expenses? If unexpected expenses or a period of vacancies would cause a disaster in your finances, you need to evaluate that realistically, and consider whether it makes sense to invest in rental income. Some alternatives include higher down payments (translating to lower monthly mortgage levels), seeking less expensive properties or multiunit properties, where the ratio between income and mortgage expense may be more favorable, or simply waiting until your financial picture is stronger. It makes sense to identify risks now, before you invest money, so that you know what risks you may face after you have closed on a rental property.
Advantages to Long-Term Investing
You may divide your investment into classification on several criteria: risk level, dollar amount allocation, or type of investment, are examples. You can also distinguish between investments by how long you plan to hold them. Traditionally, real estate has been thought of as a long-term investment, whereas stocks can be either short term or long term. This distinction has much to do with the liquidity levels of each market. You can buy and sell stocks or mutual fund shares with a telephone call and the transaction can be completed in seconds. Real estate purchases, in comparison, are expensive, complex, and take time. By this distinction alone, the cost of completing a real estate transaction makes the entire market far different than stocks. One advantage to real estate investing is that its long-term characteristics provide stability and safety, attributes that appeal to most investors. In spite of the illiquidity of the market, your inability to buy and sell real estate quickly or easily provides discipline to your long-term investment program and may be well suited to your personal financial goals.
Price appreciation is a second way to distinguish between investments, and also a second form of advantage to real estate investing. Both the stock market and real estate have performed well over the long term. However, stocks tend to go through highly volatile price cycles. Investors have often experienced months and, in some instances, several years in which prices were depressed or erratic. The same economic forces leading to stock market instability have also affected real estate values, but by no means as drastically. Figure 1.2 made this point; Census Bureau statistics make the case that on average, residential property values move upward with reassuring consistency. So while both stocks and real estate offer long-term price appreciation to investors, volatility-the tendency for market values to remain consistent over time (low volatility) or to change unexpectedly in either direction (high volatility)-can be viewed as one way to measure market risk. The low volatility of real estate, in comparison to stocks, makes it a safer long-term investment.
Another advantage to generating rental income is that, over a long period of time, rent-paying tenants provide funds to pay down your mortgage. The often-observed point that "your tenant pays your mortgage" is simplistic because, in fact, you also take on many risks when you create a large debt and come to depend on tenants to provide the cash flow you need. There is much more to it. However, assuming that you are aware of those risks and that you pick tenants and screen them diligently, the regular cash flow produced by tenants makes financed real estate viable.
Excerpted from Getting Started in Rental Income by Michael C. Thomsett Excerpted by permission.
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