I often have business colleagues, family, and friends who ask me about real estate investing and want me to let them know when I see a "good deal”. As with any other investment vehicle, being a landlord comes with its own inherent set of challenges. Three of the most common are known as the “3 T's”: Tenants, Termites, and Toilets.
You can screen tenants to the best of your ability, and on paper they might seem perfect. But in reality, until you know how someone lives, you can’t really know them. In time, you might come to realize that those perfect tenants are much less than ideal. Now what?
And then there are the frequent maintenance issues, late-night plumbing calls, and the responsibility to provide a habitable, peaceful space for your tenants. Yes, the role of the landlord is demanding and it may seem a bit daunting. But if you do your research, educate yourself, and prepare a solid business plan, real estate can be an excellent addition to your investing portfolio and become a stable source of passive income.
Here are three big questions to ask yourself before taking on the role of landlord:
To decide if rental property is a good investment vehicle, you need to look at two sets of requirements: capital requirements (how much you need to have saved) and management requirements (how you will meet the needs of your tenants).
- Capital Requirements. Generally you'll need about a minimum 25% down-payment to finance a 1- to 4-unit rental property, plus closing costs. So if you were planning to purchase a property for $1 million, your down payment would be $250,000 cash. If you’re buying a property that needs repairs, you’ll need to factor in those expenses as well. Once you’ve acquired the property, there are costs for ongoing repairs and maintenance, which would normally be covered by your rents. Also, you’ll more than likely have some vacancy time, so it’s customary to set aside a 5% reserve to cover lost rent.
- Management Requirements. Are you ready to take the phone call at 1 a.m. when a toilet is backed up? What will you do when you receive a notice from your city's building code enforcement department? What will happen if your tenants get into a conflict? When you become a landlord, you become a problem-solver, mediator, and ultimately the person responsible for everything that happens with and on the property. You can hire a property manager and outsource a lot of day-to-day responsibilities, but ultimately you are the decision-maker and the person responsible for managing the manager to ensure that everything gets done properly and in a timely manner. Hiring a property manager is also an additional expense, which, depending on your margins, you might or might not want to take on.
To get started, you need to educate yourself about a few real estate basics and figure out your immediate short and long-term investment goals.
- Education. First, the basics. Residential “Income Property” includes properties with 2 to 4 living units. There is one real estate parcel number for the property, and you own the entire thing. You can also invest in single-family property, which can include a house or condominium. Although a condominium could be a part of a multiple unit building, each unit is owned separately and has its own parcel number. You should also educate yourself on the neighborhoods you're interested in to see if the pricing is aligned with your budget. Generally speaking, "Class A" neighborhoods provide lower cash flow and greater long-term appreciation. As you venture into Class B and Class C neighborhoods, you can usually achieve greater monthly cash flow. You also will want to know about any local rent control restrictions.
- Long-term and Short-term Goals/Investment Objectives. Determine the minimum cash flow you want to achieve each month or year. Your cash flow is calculated by subtracting your total property expenses from your total property income. Once you have your minimum return requirement, you can filter through properties to see which ones meet your criteria or have the potential to.
A property might is a good fit for you if it matches your management and capital requirements and looks like it can meet your short and long-term objectives. If you determine the property meets your investment objectives, you still want to make sure that it’s still a “Good Deal” for the area that you are purchasing in. To make these determinations, compare income properties “apples to apples”, you can refer to some commonly used metrics for calculating return on investment: Capitalization Rate (a.k.a., Cap Rate) and Gross Rent Multiplier (GRM).
- Cap Rate. This is calculated by dividing the Net Operating Income (NOI) by the purchase price. In general, the higher the Cap Rate—e.g., 4%, 5.5%, or 6%—the better.
- GRM. This is calculated by dividing the purchase price by the gross income. In general, the lower the GRM—10, 9, or 8—the better.
Your realtor can assist you with calculating these commonly used return metrics, but you still want to have a general understanding of them on your own as well. Keep in mind that, just like real estate prices, these metrics vary from area to area, so you and your realtor should plan to compare several properties to understand if the property is a “Good Deal” for the area.