Multifamily real estate looks awfully tempting as an investment these days. And that is prompting more Americans to consider joining the ranks of landlords.
Individual landlords, rather than corporations, own about 60 percent of all rental units, according to the last count by the Federal Reserve. The 35.2 million rentals nationwide account for one-third of all U.S. housing units.
“Evidence points to an increase in real estate purchases by individual investors,” said Doug Duncan, chief economist of the Mortgage Bankers Association.
The number of commercial Realtors, who specialize in income properties, has risen at the same time that more mainstream investors are finding opportunities via the Internet.
Becoming a landlord can be a way to earn extra income or to pay a chunk of a mortgage on a multifamily property in which you also live. But the income-producing potential of rental properties varies widely and novice landlords may instead want to more seriously consider the equity buildup possible by holding long-term.
“You don’t become a landlord to have a big cash flow,” said Bill Moore. “Most landlords, when they buy a property it’s usually losing money or breaking even. But over five to 15 years, you see the income.”
The path to real income involves plenty of due diligence and sweat equity, not to mention a sizeable down payment.
It generally takes at least a 10 percent down payment to purchase a one- to four-unit rental property; cross the five-family threshold and the banks usually ask for 20 percent to 30 percent before funding apartment loans.
The terms on apartment loans for investment properties are also not as forgiving as for single-family homes, particularly if you do not occupy one of the units in the building.
Start small
“I think the best place for a new landlord to start is to rent out a single family home or a duplex, because it’s more affordable and easier to manage,” Cain said.
Smaller properties have less complicated finances, which may ease some of the due diligence — that is, the homework that prospective landlords need to do to figure out whether a desired building will generate income.
“There’s no way to tell from the [classified] listings whether a property is losing money. A diligent buyer asks for the tax statements and inspects the property,” said Cary Brazeman, a spokesman for the commercial-property-listing site LoopNet.com.
He said that while his site’s information enables more consumers to enter the commercial real estate market, “you still need to work with a broker to find the right property.”
A few decisions must be made before hiring a broker. Geography and timing can mean the difference between profits and losses. However, just like playing the stock market, it’s difficult to predict which localities will appreciate the most.
And it might be difficult to forecast possible changes in the area’s real estate taxes, which could affect a landlord’s profits.
One rule of thumb about location: cities with a low rate of rental vacancies make for a better landlord experience. The easier it is to recruit tenants and diminish any time a unit is vacant, the better.
“Bad tenant selection is one of the most common pitfalls new landlords experience,” said Cain. “In addition to credit checks, you really need to check people’s rental history and references so you don’t get burned.”
Designating some cash flow to hire a Realtor or property specialist for on-site management, along with other responsibilities, might make sense.
“You have to decide whether you want to manage the property yourself, or outsource it to a management company,” said Moore of Landlord.com. “Paying someone else to do it can affect profits.”
Outsourcing is essential for landlords who don’t reside within a reasonable distance of their rental properties. The same usually applies to those with full-time jobs or who are otherwise strapped for time — or certain talents.
“Managing the property yourself not only requires that you be able to fix things, but you also need to have the disposition to deal with tenant complaints in the middle of the night,” Moore said.
Lots of liability
Speaking of complaints, becoming a landlord introduces a number of liabilities — the nature of which depends on the type of residences and their location.
“You need to find and retain not just any real estate attorney, but someone who really knows the local residential laws and specializes in your type of building,” said Celeste Hammond, professor and director of the center for real estate law at the John Marshall Law School in Chicago.
Municipalities each write their own set of quirks into tenancy laws and new regulations crop up frequently enough to keep the continuing legal education business afloat.
Some jurisdictions mandate licensing of landlords, said Hammond. Other cities require periodic building inspections and safety certifications.
Still other areas tell the landlord to put security deposits in an interest-bearing account and pass the income to the tenant. Other overseers say a landlord can be fined for not keeping tenants’ security deposits in a separate account just for that purpose.
“A lawyer can also verify zoning laws and permits,” said Hammond. “Sometimes people have apartments that turn out to be illegal.”
That calls for a lawyer’s involvement before the property is purchased. Leases and insurance should also be addressed beforehand.
“Ask the lawyer what liabilities apply in your state, and have a lease drawn up based on that,” said Eric Goldberg, assistant general counsel of the National Insurance Association in Washington. “Bring that lease to an insurance broker and inquire about what kinds of policies are needed to go with that lease.”
Insurance premiums
Doing all of this ahead of time gives prospective investors a much more accurate picture of a building’s true costs.
“Premiums could easily eat into your profits, which is why you need to figure everything out before you buy,” said Goldberg. Worse yet, “some properties and landlords turn out to be uninsurable.”
Landlords might be turned down if they have a history of making too many insurance claims on a homeowner’s policy or even for bad credit.
Similarly, a property may be rejected for safety violations. For instance, the building is sitting on an earthquake fault line, near a toxic waste dump or in an area subject to flash floods, hurricanes or fires.
The amount of insurance the landlord buys may impact the terms of the mortgage offered by the bank; the lender may intervene if a landlord hasn’t bought enough coverage.
The more tenants, the more insurance required to stay out of hot water. Goldberg said that the ideal insurance package for a landlord is the commercial liability policy, or a scaled-down version of that for smaller buildings.
Such a policy covers damage to the building and to tenants’ personal property, injured residents and guests, any kind of equipment used to maintain or heat the building, workman’s compensation for anyone doing upkeep and storm or earthquake coverage in areas prone to such disasters.
Also, “since real estate values keep going up, you need to keep your insurance agent up to date on the value of the property to make sure you’re covered,” said Goldberg. “As home equity increases, so do your premiums.”
Tax consequences
So do taxes, depending on which state you’re in. Then again, landlords get to itemize more deductions than homeowners do.
“Mortgage interest, insurance, utilities [for hallways and common areas], repairs and renovations become deductions,” explained Anne Magro, assistant professor at the Price College of Business at the University of Oklahoma.
“The landlord can deduct depreciation of the property and losses,” including gaps in occupancy,” she said. (Even in tight rental markets, appraisers always factor in at least one month of vacancy per unit per year.)
Most states impose limits on tax deductions, and the ability to make these deductions fades out once the landlord’s personal income reaches $150,000.
Sometimes a landlord can push down the taxation rate by incorporating the rental operation. At the very least, forming a company shields the lessor’s personal property from lawsuits.
Excessive costs can easily turn landlording into working for free; red ink often drives lessors to put their properties up for sale. Assume that’s the case when analyzing a prospective real estate investment, and then you can be pleasantly surprised if the opposite proves true.
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