The housing collapse that we just experienced starting in 2008 was devastating for many homeowners and investors. With real estate values, particularly residential, down some 40% plus in many markets, household wealth has been drastically reduced. Foreclosures, short sales, deeds in lieu, and loan modifications are common scenarios we are hearing about almost daily in the news. However, this correction in values has created opportunities for those with cash to invest and/or credit histories well enough to secure loans for purchases. You have heard about the banks, companies and individuals that lost significant amounts of money during the Great Depression, but rarely do you hear about the even greater number of investors that made it big by investing at the bottom of that market.
While it may seem simple to purchase a rental property at what appears to be the bottom of the market on residential, and while interest rates are at the lowest they have been in decades, being a landlord has many pitfalls that go along with the investment opportunity. Review the following common mistakes that new landlords make, and avoid problems that can cause you to lose money, time and sleep.
1. Not Running Credit/Background Checks: Not only should you obtain a current credit report on a prospective tenant to determine their credit score and any delinquencies, you should also run a background check for previous convictions and any previous evictions. Verifying employment is also recommended, along with receiving a copy of their most recent pay stub. Most rental applications will contain at the bottom the tenant’s authorization (when signed by the tenant) for landlord (or their management company) to check credit, banking references and verify employment. I also like to get a separate authorization to release credit form signed by the prospective tenant. Look for any negative trends in the credit history. An isolated case of delinquency, with an explanation, can be lived with if the overall credit history is positive.
2. Underestimating Necessary Repairs & Improvements: Before purchasing a property intended to be a rental, make sure that you go through a list of planned and necessary improvements. It’s typical to need new carpet, paint, window coverings, and other repairs. The property may also require new appliances, or an air conditioner/heater or a new roof. These items can add-up quickly and throw your budget way off track. Make a list of what improvements you need to make and the cost of each. Also keep in mind that your rental property will need ongoing repairs in the future, and budget an amount per year for estimated repairs. A nicely improved and maintained property will attract a better tenant, generally willing to pay a higher rent.
3. Not Counting on Vacancies: Vacancies happen. There can be a gap in time between the date a tenant moves-out and stops paying rent and the time a new tenant is found and starts paying rent. Be prepared to pay any property expenses and mortgage payments, if your property is financed. Having a savings account established to cover these expenses for a period of time, say 3 months, would be prudent. With an effective marketing plan for leasing your property, hopefully it won’t take that long to replace a tenant. But you won’t be caught short financially if it does take longer. Do a survey of similar units for rent in your area and determine the proper rent level for your unit. You can obtain area rental information at the following sites: www.realtor.com and www.zillow.com. Online versions of your local newspaper will also have rental properties listed.
4. No Rental Agreement or Lease: You shouldn’t rely on a handshake when renting real estate. Rental agreements or leases have important details that create an understanding between the landlord and the tenant and call for certain performances. If there should be a dispute, you want to have a rental agreement or lease to hand to a judge so that they can make a decision based on the provisions contained in the lease. Know your state’s laws regarding leases, and make sure you use the proper rental form for your state. You can go to www.findlaw.com to search for state-by-state lease samples.
5. Not Calculating a Cash-on-Cash Return: Calculating a cash-on-cash return before you purchase a rental property will tell you how much of a return you are getting on the capital invested into the property. Generally this should be done before you purchase a property, and it should play a role in your decision in choosing which rental property to purchase. If you have already purchased a rental property without doing this calculation, do it now to see where you stand. Frankly, if you will not be getting a decent cash-on-cash return on a rental property, I would not recommend purchasing it. Otherwise, you are counting on appreciation in value for your return, and that may be a long time in coming.
Here’s how to calculate a cash-on-cash return if you were to purchase a rental property today. Start by determining your cash investment in the property. If you are paying cash for the property, add the purchase price, any closing costs, and any planned repairs & improvements together. That’s your total cash position. Then take the monthly rent on the property less any monthly expenses including taxes, insurance, estimated ongoing repairs & maintenance, HOA dues, management fee (if there is one), utilities that you are responsible for, etc. This produces a monthly net income. Multiply the net income by 12 to get your annual net income. Now you divide your annual net income by your total cash position to determine your cash-on-cash return. An example is below for illustration:
$9,480 annual net income divided by $170,500 total cash investment = 5.56% cash-on-cash return
Compared to less than 1.0% offered by most banks today, the 5.56% cash-on-cash return looks pretty good. This is before depreciation and personal income taxes.
If you finance your rental property, determine your cash investment by adding the cash down payment (amount of cash you put into escrow to close) to the planned repairs & improvements to come-up with your total cash position. Include the monthly mortgage payment with the property expenses in determining the monthly net income. Convert the monthly net income to an annual net income and then divide by your total cash investment (like in the illustration above) to determine your cash-on-cash return.
6. Asking Illegal Interview Questions: There are many pitfalls here, and you don’t want to be sued by tenants that feel discriminated against. There are numerous laws including The Fair Housing Act along with state laws that are designed to prevent discrimination against a tenant based on their race, color, religion, national origin, sex, martial status, handicap or family status (i.e. if they plan on having children). Additional information on federal and state fair housing laws can be found through the Office of Fair Housing and Equal Opportunity website.
7. Neglecting the Property: The property that you are renting-out is your responsibility. If it is a single family residence, or an apartment building, you are required to maintain the interior and exterior of the property. If your rental property is a condominium, you are responsible for maintaining the interior of the unit with the home owners association maintaining the exterior and common areas. Many landlords are delinquent in maintaining their properties, which makes it difficult to attract and retain quality tenants. Give tenants proper notice for inspecting the interior of your rental property when determining any necessary repairs. Be prompt in responding to tenants’ requests for repairs.
8. Delaying Legal Actions/Evictions: Delaying legal action or the eviction process when tenants default on their lease obligations can be very costly. You may not be able recover unpaid rent from a defaulting tenant depending on their financial condition. If you are unsure about your rights as a landlord, or how to proceed with proper notice and an eviction, contact an eviction attorney as soon as possible. Attorney referrals can be received from your local apartment association.
9. Not Adhering to Local & State Housing Codes: As the owner of a rental property, you are required to make sure that your property meets local and state health and safety standards. Violation these standards puts you in a position of having liability to the tenants, and creating a situation whereby a tenant could break a lease. Research these requirements, and include them in your management plan for your rental properties. None of these standards should come as a surprise.
10. Not Enforcing the Lease Terms: Being consistent with your tenant regarding enforcing the terms of the lease is important and will help you avoid problems and miscommunications down the road. If the lease calls for no pets and your tenant has a pet, you can give the tenant notice to vacate or structure a new lease with either a higher rent in consideration of the pet, a higher deposit to cover potential damages caused by the pet, or both. If your tenant is late on paying the rent and the lease calls for a late fee, charge the late fee. Otherwise, delinquent rent will become more common.
Following these suggestions will help you avoid some of the headaches that new landlords often encounter.
Picking the right property management company, should you choose not to self-manage, will be a very important part of your investment decision.
William Fischer is principal of Lighthouse Realty Capital, a Licensed California Real Estate Brokerage Firm located in Orange County, California. With over $800 million in income property loans originated and funded, Bill has 25+ years of experience working for Banks handling commercial real estate finance, and is experienced in the management of residential income properties since 1985. Lighthouse Realty Capital handles the financing and management of income producing properties. California DRE License #00865007.
The opinions shared in this article are for general information only and are not intended to provide specific advice or recommendations. Any performance references are historical and are not a guarantee of future results.