If you’ve ever been a renter, you may at some point declared “dang, our landlord is making a killing on us!” and concluded that being a landlord is the key to wealth and power. While it may not be as glamorous as it is sometimes made to seem on infomercials and seminars, owning a home as a rental can be a significant portion of your wealth late in life, and more importantly, an excellent source of retirement income.
The Basics
The economic gains in being a landlord stem from appreciation and cash-flow.
- Appreciation: A home appreciates when it increases in value. Historically, real estate appreciates (short term cycles may see dips, but the overall trend is upward). Some areas see more appreciation than others, but the 100-yr average is 3.5% appreciation per year (just a bit more than inflation). That may not seem like much, considering that stocks have returned an average of 8%+ over the last 60 years, but the key is that because you can finance the investment with a mortgage (at a relatively low rate), you realize the appreciation of the entire property/house, even though you only have a fraction of your own money invested. This is called return on investment (or return on equity, depending on how you look at it). As an example, I could pay $24,000 (as a down payment) to purchase a $120,000 home today, and in 30 years (when the mortgage is paid off) it would be worth $336,000. That’s a return on investment of 9.2% (on your original $24,000).
- Cash-flow: Cash-flow is the rent money left over after each month after the mortgage and other expenses are paid AND THE RESERVES ARE SET ASIDE (more on that later). Unless you get a killer deal on the home, don’t count on a lot of cash-flow in the beginning, especially if you have a mortgage (if you don’t have a mortgage, you will have more cash flow, but you’re return on investment from appreciation will be lousy). But, once the mortgage is paid off (close to when you retire), then your cash-flow will be significant. Your cash flow is heavily dependent on the rent market (which will fluctuate over time), but let’s say the $120,000 home mentioned before yielded rents of $825/month. Your mortgage payment, taxes, insurance, and reserves would total about $675/month, leaving you cash flow of $150/month for the first 30 years. Once the mortgage is paid off (assuming a 30-yr mortgage), your monthly cash flow would increase to $575/month. Even before the mortgage is paid off, your cash flow is $1800/year, or a cash return on investment of 7.5% ($1800/$24,000).
Combine the returns from the appreciation and the cash-flow and you’ve got a pretty good investment. You’ll be entering your retirement years with a $336,000 asset that pays you $575/month. That’s not bad…and it’s just one rental.
How it’s Done
“Great,” you may be thinking facetiously, “all I need is $24,000. Great advice, Kjell.” Buying an investment property/rental that is not your primary residence requires at least a 20% down payment and the underwriting requirements are significantly more stringent. Most of us don’t have that type of disposable income (at least starting out), but the most common way of acquiring rentals- at least in the beginning- is a form of “house hopping”.
The mortgage down payments for primary residences are far less than 20% (3%-5%). Once you’ve lived in the home for at least a year (I would plan on at least 2), then you can purchase another primary residence and move from your former home (now a rental). The down payment for your new house is still 3%-5%, since it will be your primary residence. You would need to save for that new down payment, but 3%-5% is a lot better than 20%. Many families will do this 2 or 3 times, building up a nice “portfolio” of rentals in the process without having to pony up 20% down payments for each one.
Warnings
This has seemed like a sales pitch up to this point. Now it’s time to temper expectations and point out some common misconceptions.
- Are you ready to be a landlord? You will need to vet applicants, manage tenants, keep up on maintenance repairs, deal with the legalities/taxes, and even occasionally evict people. There are smart ways to be a landlord that can reduce the amount of time required/stress required, and perhaps a property management company is the best solution (though they will take 8-10% of your monthly rent, which could be most of your cash-flow, in the beginning), but there is no way to escape at least some level of involvement.
- Buy the right property. The better deal you can get, the better your returns (in both appreciation and cash flow). The type of property is important as well. Large single-family-residences can be easier to resell (and have somewhat more reliable appreciation), but can also be higher to rent out. Condos are easier to rent and provide solid cash-flow, but sometimes have resale issues/complications. Neither are bad, but you have to consider all factors. Homes that have a lot of deferred maintenance and will require more money in the long run. You also want to have a long term plan. Know what income/down payment you will need to show long before you start looking for another home.
- Have the discipline to keep RESERVES! One of the most common problems new landlords have is not sufficiently identifying future repairs and maintenance costs and not setting aside the necessary reserved funds to cover those costs. It may seem silly to set aside 15% of your gross rent when everything seems to be functioning, but eventually the fridge WILL break and the carpet WILL need to be replaced. Plan ahead and be disciplined.
- Don’t buy into the Hype. Unfortunately, most real estate investment scams prey on those enamored by the idea of being a real estate tycoon. Don’t buy properties unseen, don’t buy them with credit cards, (just to name a few ill-advised practices) and be a sceptic. If it sounds too good to be true, it almost always is, especially when it comes to investing in real estate, no matter how good you’ve been made to feel.
This is just a snippet of the tome that could be written regarding rentals. If you think you might be up for it, let us know and we’ll run through your options. I (Kjell McCord) have significant first-hand experience with rentals and can vouch for their upside, as long as you practice prudence.
