ByCHRIS TAYLOR
By Chris Taylor
October 16, 2002
Below you'll find:
Intro
Finding: Where and What to Buy
Financing: A Few Salient Points
Renovating: How Much Is Enough?
Insurance: Get Ready for Sticker Shock
Taxes: Your New Best Friend
Tenants: Can't Live With 'Em...
Owning Up: The Payoff
"SO YOU KNOW WHAT DAY IT IS?"
Marianne asked him the question slyly, knowing his response in advance.
"I have no idea," he admitted. Kaufman started to worry that he'd missed a birthday or anniversary.
"It's a Tuesday and look where we are," she answered. "We're the only ones on this beach."
Kaufman smiled and made a major life decision. A seventh-grade English teacher, he was two months into a sabbatical. He was also a part-time landlord, who over the years had bought and managed a few local rental properties with his wife. Now, walking along that beach in the middle of the day, it all became clear to him. Even though he'd loved working with kids for 26 years, the freedom the rental business offered him was too much to resist. It was time to quit teaching and become a landlord full time.
"That was one of the best decisions of our lives," Kaufman says today. Eight years later his family owns eight properties in the Hamptons for weekly or monthly rentals, little pictures of perfection with their weathered cedar shingles, oak flooring and beach-resort-style white interiors. Each property brings in from $1,250 to $5,150 a week. The family runs a bed-and-breakfast as well and even their son and daughter have left their jobs and apartments in Manhattan over the past year to help run things.
Kaufman won't say exactly how much the rentals bring in annually, but it's two to four times his former teaching salary. Plus, the whole family now lives on their own clock, and every winter they go away for months at a time to Australia and New Zealand one year, to Italy's Amalfi coast another. "Where else can a guy get up for work, walk two seconds to the office and be greeted by his wife and daughter and son?" asks the ebullient 58-year-old. "I think I'm the luckiest guy in the world."
Of course, it wasn't really luck. The Kaufmans saw an opportunity, ran the numbers and made the leap. And while you may not be ready (or ever want) to become a landlord full time, rental property can still be a tremendous investment to make while keeping your day job, an asset that appreciates while pumping out steady monthly income. Just think of it as a nice annuity, only this one comes with a barbecue pit and walk-in closets.
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"People have this Three's Company, Mr. Roper idea of what landlords do," says Robert Griswold, head of San Diego's Griswold Real Estate Management and author of Property Management for Dummies. "But if you do it right, the tenants will be paying for the building for you, you'll be building equity and getting positive cash flow plus you get great tax advantages."
Landlord living looks even better in tough economic times like, say, now. While stocks in the S&P 500 have slid 38% in the past two years, second-home values nationwide have leaped by 27%, according to the National Association of Realtors (prices of primary residences rose 11%). Rents have ratcheted up 6% a year on average from 1997 to 2001 for multifamily units, according to Reis, a New York City- based commercial real estate data provider. Vacancies, though edging up, are still at a tight 5.8%. And interest rates have remained extremely low, making real estate cheaper to own.
Sound better than weeping over the stock pages and watching your 401(k) erode to nothingness? No doubt. But keep in mind that the Kaufmans' idyllic stroll notwithstanding, being a landlord is no day at the beach. Even successful investors can get nasty surprises like the one New Jersey landlord Tony Reaves got when he inadvertently bought an apartment building that turned out to be "the biggest crack house in Newark." (No wonder it was such a good deal.)
And unlike most other investments, real estate is far from low-maintenance. You can't just sit back and wait for the monthly statements. From fixing leaky faucets to getting deadbeat tenants to pay up, you're going to get your hands dirty. Maybe even taking that 3 a.m. phone call from a renter whose roof has just caved in. Hey, it comes with the territory.
To help you master this tricky but potentially lucrative business, we've broken it down into major areas where you'll need expertise: buying the right property, doing the renovations, lowering the insurance bill on your new asset, exploiting all the tax benefits and dealing with tenants (which can be a euphemism for evictions). Ready for some positive cash flow? Here are the keys.
Finding: Where and What to Buy
Sorry to disappoint, but finding a worthy property ain't so easy. Not least because every yokel who's ordered books and tapes from infomercial king Carleton Sheets is out there bidding up prices. Listen to the pros, who give the same ironclad advice for first-timers: Buy close to home, in an area you're supremely familiar with. Best of all, live on the property yourself. "I recommend that [novice landlords] look at two-family houses, where you live there and rent out the other unit," says real estate columnist Ilyce R. Glink, who's bought and sold several rental properties and is the author of 100 Questions Every First-Time Home Buyer Should Ask. "Over time, as you raise the rent, the share of the other unit covers more and more of your own expenses, until you're living rent-free."
That's what David Lavoie did twice. The first time was in 1986, when he bought a four-family home for $64,000 in Nashua, N.H., fixed it up, moved in and rented out the other three units. He charged $500 a month each for two of them; with the mortgage at $1,073, those rents alone almost covered that nut. The third rent, $430, went toward taxes (about $3,000 a year) and insurance ($800).
Then he bought another two-family farmhouse in Nashua, moved in and rented out the other half. Now the fourth rent from the first property virtually pays the mortgage for the new house. The surplus cash from both homes more than covers his total $2,000 to $5,000 maintenance costs every year. Plus he's on track to pay off his mortgage faster than required. "I like having a cushion, in case I fall on hard times," he says.
How do you find a place like Lavoie's one that prints money? Don't look automatically to the hottest neighborhoods, where the premium you'll pay will often outstrip the rent you'll be able to charge. Instead, focus on cheaper areas some pros call "backfill," neighborhoods on the upswing, often bordering those overheated areas. A tip from George F. Donohue, president of the William B. May International realty company in New York City: Ask the local paper where its newest routes are, which indicate a surge in the yuppie population.
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see www.auctioneers.org and the National Association of Bankruptcy Trustees site, www.nabt.com. But you're taking risks there, such as getting stuck with old liens or unpaid property taxes. So do a full search of the property's history at the title insurance company.
from the National Association of Home Inspectors, for instance, at nahi.org. "Always, always, always use a home inspector," says Bob Cain, a landlord himself and publisher of the popular newsletter Rental Property Reporter. "If not, you deserve to lose your shirt."
Financing: A Few Salient Points
The bad news first: Banks are much more stringent if you're buying a home to rent. You'll need a heftier down payment; Freddie Mac requires 10 to 20% for a pure rental, as little as 5% for owner-occupied rental property and as little as 3% if it's just you living there. And you'll obviously have to demonstrate how your income, plus the rental bucks, will cover a new mortgage. So you'll have to run the numbers like the hard-nosed CFO you're going to become. No off-the-books partnerships, please.
www.transunion.com and Experian (www.experian.com to get a copy of your credit report and go about correcting any errors. Next, look at your FICO score, the number that lenders use in evaluating whether you're a credit risk. Check it at sites like myFICO.com; if it's low, boost it by making all bill payments on time and wiping out existing credit card debt.
But enough about you. The house's finances will get as much scrutiny as yours, so get the previous year's financials from the owner. Property taxes, insurance bills, utility usage any and all expenses associated with owning that property. Many first-time landlords stop there; don't. Find out from the local tax office if a home sale triggers an automatic reassessment. In many places it does, and that one fact could change your numbers entirely.
Then scan the local papers and sites such as Apartments.com to check going rents for comparable offerings in that particular area. Be conservative and budget for property management around 5% of the gross income even if you plan to be Mr. Fixit yourself. That way, says Institute of Real Estate Management Vice President Fred Prassas, if your hands are suddenly full with other things, "the numbers are in there."
By running the numbers back in 1998, Tony Reaves saw how he could transform a small four-apartment building in Irvington, N.J., into $1,100 a month in positive cash flow. Formerly in telecommunications law, now a full-time real estate investor, Reaves was eyeing an unassuming brick building that could be had for $124,000. That would mean a monthly mortgage bill of $1,500. Reaves saw that two damaged apartments were going totally unused. Factor in those two $700-odd rents alone, and he'd easily make the mortgage. The other two would go toward taxes (around $7,000 a year) and the $1,400-a-year insurance tab. Reaves did the deal, then put some of the profit toward down payments for more properties. Last year he and his wife sold the brick building for $160,000; they now own 14 other properties. "These are places I wouldn't be able to buy if I was working the old-fashioned way," he says.
If your numbers make sense, go forward and approach a lender. (Insider's tactic: Approach the institution or broker you don't want the loan from first, for a dress rehearsal.) One way to get a running start on the financing is for you or a family member to live on the property. That's an opportunity Huntsville, Tex., mom Dee Dee Dretke took in September 2001 when her daughter was going away to Texas A&M. Instead of throwing money down the rental hole, she figured, why not buy a $100,000 three-bedroom, two-bathroom townhouse for her daughter and two rent-paying roommates? With family on the premises, "We got a low down payment, at only 2.5%," she reports. With each roommate paying $400 a month and a third of the other bills, "we're coming out ahead," Dretke says.
If you're not going to live there yourself and don't have huge cash on hand for a down payment, less prominent lenders are likely to give you easier terms than the big banks. Check with the National Association of Mortgage Brokers (www. namb.org) for a registry of 13,000 members. You can also try for seller financing. If the property holder owns the house outright (the most common scenario), you sign an agreement promising to pay him in installments. That way your own finances won't be pored over quite so closely, and terms can be better.
Renovating: How Much Is Enough?
A little renovation can bring big returns. For Tony Reaves's Irvington building, it took only $2,000 to get the two fire-damaged apartments up to speed. Suddenly, he had $1,400 more a month coming in, which paid for the work in two months.
Unless you're the second coming of Bob Vila, you'll need contractors to get the work done. One way to minimize those headaches is by joining or going through a local apartment association. (These are like trade groups for landlords; the umbrella group is the National Apartment Association, at www.naahq.org). Contractors affiliated with these groups usually get a lot of work from them, and "they don't want to screw anything up and get people talking about how bad they are," says Bob Cain. "That can be the end of their business."
Don't get too ambitious with your rehab plans, though, or your numbers could be busted right from the start. Brian and Sharon Stark found that out when reconstructing the interior of a nice Cleveland Victorian in 1999. To speed things up, the Starks added workers until they had 22 men milling around. "It was ridiculous," says Brian's brother, Paul Stark, a co-investor. "The guys were constantly yelling at each other and getting into fistfights. I got calls every hour." The job cost $80,000 double what they'd estimated.
Do minor repair work yourself to keep costs down; you may even learn to like it. When Donna Gricus bought her first rental property a rambling 1890s Victorian in Jamestown, R.I. she was down to her last $5,500. Afterward, "I couldn't afford to hire anybody [to do maintenance]," she says, "so I bought handyman books, borrowed circular saws, and got good at wall-patching." Gricus saved a couple thousand a year on painting, and a couple thousand more on carpentry and roof repairs. That was back in the mid-1970s. Since then, she's acquired nine more properties, rents have more than quadrupled and she can pay others to do the dirty work.
Insurance: Get Ready for Sticker Shock
This is likely your most problematic area right now. Sept. 11, weather and fire disasters, mold hysteria and dogs biting litigious postmen have driven rates for commercial coverage up by about 30% this year alone, according to P.J. Crowley, vice president of the New York City-based Insurance Information Institute. And the rates for rental property were already about 25% higher than for primary residences, according to independent agent Charlie Nusbaum, president of S.L. Nusbaum in Norfolk, Va. (Another good reason to live on-premises.) Indeed, many insurance firms are shying away from covering rental properties at all. "This issue is taking a lot of people by surprise," says Prassas. "When they're closing on a place, people are calling their insurance agents and getting the scary shock that they might not be able to [get insurance] right now."
Once you get coverage, keep your premiums down by taking a big deductible, hiring a property manager and suggesting or requiring that tenants get their own renter's insurance. And if you already have a policy with a particular company for your primary home, say, or your car go back to the same well.
Once you buy, keep tabs on your tenants. Illinois landlord Allen Bailey recently flipped out when he was driving by one of his purchases in little Metropolis, along the Ohio River, and saw a construction sign for "Aloha Pools" in the front yard. Since the place didn't have a pool, Bailey's jaw dropped. "The worst scenario is if someone drowned in that pool," says Bailey, 28. "And then the family could sue for millions." He had the swim-happy tenants sign papers giving them full legal responsibility for the pool.
Taxes: Your New Best Friend
rentalprop.com and owns half a dozen properties in Arizona, says saving on taxes is one of the main attractions. "When I bought rental property, I went from having to borrow money to pay my taxes every year to getting a refund," he says. "That was pretty cool."
Where are all these savings coming from? Just as with residential property, you can deduct the interest on your mortgage. As a landlord, you get an added bonus, in that your sewage, water and heating bills are all deductible, as are any maintenance expenses you incur, such as repainting an apartment or fixing a hole in the roof. In addition, the Internal Revenue Service allows you to deduct the depreciation of the house, co-op or condo for a period of 27.5 years. So if you have a $300,000 house that sits on land worth $50,000, you can generally deduct 1/27.5 of $250,000, or $9,090, every year not too shabby.
Let's take a hypothetical a little further, courtesy of CCH tax analyst John W. Roth: A guy who makes $50,000 at his day job buys a $200,000 home and rents it out for $25,000 a year. Let's say the mortgage interest and real estate taxes are $10,700, the insurance premiums are $1,300, management fees are $500, repairs and maintenance costs are $3,500, and the depreciation allowed is $6,500. So even though Joe Example is now earning 50% more money, all those deductions make the extra $25,000 practically tax-free. His IRS bill will be a whopping $6,075 less than if he earned $75,000 from wages alone. (In contrast, if Joe didn't rent the house but lived there, the mortgage-interest deduction by itself would cut his tax bill by only $810.)
One of the greatest tax perks comes when you sell. When cashing in an investment property, you have to pay tax on your capital gain. But if you make your investment home your primary residence for just over two years before selling it, you can keep up to $250,000 in profits for an individual or $500,000 for a couple (minus the depreciation you've claimed).
If you want to sell your rental property but aren't ready to get out of the real estate business, you can use a tax-deferred exchange (also known by its tax-code number, 1031). The 1031 allows you to defer your capital gains from the sale of your property as long as you buy another property of equal or greater value. But it's a little tricky: You need a qualified intermediary (banks are often willing to do this for a fee) to sell your house and buy the new one, among other technicalities. So be sure to consult with your accountant or tax attorney.
Tenants: Can't Live With 'Em...
Concern for humanity is all well and good. But when you're a landlord, playing the nice guy just isn't going to get it done. "If you're willing to listen to how their parakeet died, how Junior has the flu and how their latest paycheck got eaten by the postal worker, you're probably not cut out for this," says Griswold Real Estate Management's Robert Griswold.
Experience taught Brian and Sharon Stark to temper their tender mercies. When one of their Cleveland tenants fell behind on the rent on her hair salon, the Starks tried desperately to get her up to speed extending deadlines, printing up fliers to promote the salon, paying visits to boost the tenant's morale. "You get sucked into their lives, and it's hard to extract yourself and say, 'You have to pay the rent,'" says Sharon. "But if we kept coddling them, we'd go out of business."
Their new policy: Miss one month and you're out. Soon afterward, when one tenant announced that God had told her to stop paying the rent, they didn't hesitate to initiate eviction proceedings. That's how it's been ever since. "And it's surprising how many times, after we post a three-day notice, tenants magically come in with the rent," Sharon notes.
But some tenants never do and having to evict is every landlord's worst nightmare. David Lavoie figures one time it landed him around $3,000 in the hole, factoring in lost rent, damages and legal fees. Even if an eviction goes smoothly, it'll usually take at least a month to get someone out sometimes a lot more.
Your best defense is screening out the tenants from Elm Street before they move in. While many new landlords think to contact only an applicant's last landlord, don't you be one of them. Why not? "If you have a really bad tenant and you want to get rid of him, what are you going to tell me?" asks Paul Gellert, a manager at New York City-based mortgage broker IPI Skyscraper. Instead, get in touch with previous landlords to ferret out the real deal.
Before you hand over the keys, hire a screening service to check out every plausible renter. First American Registry and RentGrow are respected national outfits. "No service I know costs more than $30," says Pat Callahan, president of the Washington, D.C.-based American Association of Small Property Owners. "When you're talking about a $1,500-a-month unit, that's a very smart investment." A crucial warning from the pros: Always use updated forms and contracts for leases, not some old sheet that's been kicking around for 10 years. "If you're evicting a tenant and you show an out-of-date rental agreement," says Bob Cain, "a judge can say, 'This isn't even legal' and the tenant gets to stay rent-free." On the other hand, tenants have rights too, and you'd best respect them. Rejecting someone for an inappropriate reason race, say, or religion is not only wrong, but it could have you swimming in legal fees. For guidelines go to www.fairhousing.com or www.hud.gov.
Owning Up: The Payoff
You can be careful, you can be smart, but even the best-prepared landlord will encounter the unforeseen. Like Andy Johnson of Fruitport, Mich., whose tenant somehow came upon a live hand grenade. Police exploded it on the front steps, which Johnson then had to pay to fix up. "Expect the unexpected," he says dryly.
Despite the surprises and late-night calls, you may still sleep better as a landlord than someone whose retirement was riding on WorldCom stock. In fact, some investors are very happy to consider real estate their own personal 401(k)s. "When we retire, [the rent from] one building will cover my wife's retirement, and another will cover mine," says Tony Reaves. "By then those buildings will be owned free and clear. When my kids go to college, I can either sell a house or refinance and use the money for their education."
Even if the white-hot appreciation of recent years means that some real estate values and rents will fall, well, you still have the house. Or three.
You'll get no argument from Bob Cain, lounging at his Tucson, Ariz., home with a gorgeous view of the Catalina mountains. He's also counting on his rental property for retirement income, and he feels pretty good about that move. Cain sums it up this way: "Every month you get a check. And boy, do I like it when that check comes."
Additional reporting by Noah Rothbaum and Anne Kadet
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