Investing in Rental Houses

By Steve Gillman - 2006

If they have positive cash flow, rental homes are a great long-term way to make money in real estate. It is an inflation adjusted retirement plan, since rent - and so your income - goes up with inflation. The downside? Landlording really isn't much fun, and you typically wait a long time for the big pay-off.

Many investors confuse making money from rental homes with making money speculating on price appreciation. You can certainly get do both with rental homes. However, this desire to gamble on rising prices leads many to buy rental homes that have more money going out than coming in.

It's difficult to argue that you shouldn't do this if you just sold a home for $120,000 that you bought for $90,000 two years ago - even if you had negative cash flow of $3,000 per year. This is risky, however. You could quickly find yourself in trouble if you own several such investments and they don't go up in value.

Another important point is that there is a limit to how many negative-cash-flow homes you can own. At a loss of $3,000 per year, how many can YOU afford? On the other hand, if your rental homes are paying for themselves and even throwing off some real cash flow, you can own any number of them, right. The more the better!

Obviously, then, my number one recommendation is to buy rental homes that will have positive cash flow from the first month you own them. Think about this for a moment. If you bought a home for $90,000 and thirty years later it DROPS in value to $60,000, but meanwhile you paid off the loan and had cash flow the whole time, you're doing great. You have $60,000 cash whenever you want to sell, and better cash flow now that the loan payments are done. That is much more secure than gambling on appreciation while losing money - but you still get any appreciation gains anyhow.

Rental Houses - Avoid These Mistakes

Being a landlord and making money with rental homes is a big job. There are many great books that can help you avoid the hardest kind of learning - learning from your own mistakes. I recommend getting educated. In the meantime, here are some common mistakes that investors make with rental homes. Watch out for these.

Mistake : Not accounting for all expenses.

You hear something like this all the time: "The mortgage is $800, and the rent is $900, so my cash flow is $100 per month." You even see real estate books and course that fall prey to this kind of fast and sloppy accounting. Cash flow is what you have (or hope to have) after all your regular expenses, which include taxes, insurance, maintenance, repairs, water bills, utility bills between tenants, garbage collection, advertising costs, and anything else that it costs to have that home.

Mistake : Assuming too much income.

If the rent is $1,000 per month, the rental income for the year will be $12,000, right? Only if you are very lucky! You have to plan on some vacancies. If tenants in the area stay around for a year on average, and it takes a month to clean and re-rent a home, plan on $1,000 less, or $11,000 annual income.

Mistake : Saving money by not repairing things or making necessary safety improvements.

This short term way to increase cash flow is often referred to as slumlording. Long term, it means not just lower rental income for you, but more problem tenants. Consider the math and you'll see the logic of having a nice place. New carpet and repairing a dangerous porch might cost $3,000, but if you roll it into a refinancing (let's say a 7% 30-year loan) it adds just $20 per month to your expenses. Even on a credit card it might cost you only $60 per month. You might be able to get that much more in rent for a nicer place, and you'll have fewer problems.
Mistake : Not doing a background check on prospective tenants.

I once rented to a woman who admitted to doing jail time for driving without insurance. She seemed very honest and up front about it, so I didn't investigate further. I later discovered that she actually had been arrested for writing bad checks - a lot more relevant information for a landlord. She ended up in jail again, and was of course unable to pay rent. I could have gotten a simple criminal background check and avoided the problem. Check out those tenants.
Mistake : Trying to do too much by yourself.

If you want to have just a few rentals and you enjoy fixing toilets and arguing with late-paying renters, you can do everything yourself. However, if you want to be a real estate investor and really make some money, your time is better spent finding and buying new properties than repairing broken windows. How many properties could you handle if you did everything yourself? Hire help when you need it.

Cash Flow?

Probably the biggest problem with buying single-family homes is that it can be tough to get positive cash flow. This has become a bigger problem recently, because for years now the prices of homes have been rising faster than rents. What can you do about this?

Avoid the common practice of buying properties that lose money every month on the assumption that you can make your profit when you sell them in a couple years. This strategy is about to get a lot of investors in trouble soon, because home prices in many areas have stopped rising or even started falling (I'm writing this in December of 2006).

Also, how many negative income streams can your regular paycheck support? This is always a problem with investing in properties with negative cash flow. With positive cash flow, you can own as many as you want.

One way to get that positive cash flow is to invest in mobile homes on land. These often rent for close to what small homes get, but cost less than half as much. Other ways to get positive cash flow involve either finding ways to reduce expenses or increase income, or both. Here are some ways to do that:

1. Lower payments.

If you can't get a lower interest rate from the bank, see if you can get seller financing. Also, amortize the loan over 30 years, not 15.

2. Lower operating costs.

Look for any unnecessary expenses that the property has,but which can be cut. These might include getting a cheaper management company, finding cheaper insurance, and getting the property taxes lowered if the property is over-assessed.

3. Raise rent.

Check area rents to see if an increase is feasible. Make improvements that will enable you to raise the rent more than enough to cover the cost of financing those improvements.

4. Lease it with an option.

You can often collect higher-than-market rent when you lease a home and give the renters an option to buy it.

Buying rental houses is one of the easier ways to get started in real estate investing. If you do it only when and where you can get positive cash flow, it is also a very safe way to invest. Another big advantage it has, is that you have two markets for your properties when you are ready to sell them - both investors and regular home buyers.

If you found this useful or interesting, please share: