Rental-Property Profits: A Financial Tool Kit for Landlords

INTRODUCTION

WHAT THIS BOOK WILL DO FOR YOU

The nature of real estate investing has changed from the certainty and safety of the past. When the first edition of this book was published in 2005, the real estate world was vastly different than it is today. In that book, statistics from the National Association of Realtors (NAR) showed that the average sales price of new homes had risen almost every year for many years.

Real estate was dependable.

The market for real estate investors was without question a safe and profitable one. It was cited as a safe alternative to investing in the stock market. The numbers look very different today, especially considering the devastating decline in real estate between 2008 and 2015. However, now that this cyclical decline has ended, real estate investing is better than ever. As the coming chapters reveal, the number of renters has increased to an all-time high, meaning greater demand for rental housing. Average rents have increased as a result, even as housing prices have fallen across the country.

By definition, a sound investment is one with low prices and excellent income-generating levels. This describes residential real estate today. And that is the primary focus of this book: the single-family home bought for the purpose of renting it to tenants with several goals in mind:

▲ Rents high enough to pay all or most of the home’s mortgage and other costs

▲ Increasing equity value over time, translating to a profitable investment

▲ Continued favorable tax advantages in owning rental property

The claim made in the first sentence of the first edition is true once again: Real estate investing is a practical alternative to the stock market for many reasons.

Serious investors may certainly beat inflation and earn profits in the stock market, without any doubt. But having real estate as an alternative does not mean abandoning stocks entirely in favor of rental properties. It does mean expanding an investment portfolio. Real estate is one of the few investments that can generate current income and cover mortgage costs each month, while enabling you to protect the investment through insurance and the maintenance of the property and its value.

The suggestion involves more. As a means for diversifying risks, real estate that is well selected and carefully maintained will gain value over time. Stocks might gain value as well, but there are no guarantees that this will occur. With real estate, the generation of monthly income does not provide such guarantees either, but it does cover the cost of borrowing the money to invest in rental properties.

With the combination of sheltered income and reduced income taxes, the true net cash flow of real estate—when calculated on an after-tax basis—is difficult to beat by any other market, including the stock market, where tax benefits accrue only if you have your shares in a tax-sheltered account such as an IRA or other retirement plan.

It is not a simple process, however. Real estate investing requires you to master tax reporting and filing rules, to set up complete and thorough records, and to establish fair and consistent methods for assigning expenses to properties. This is where this book helps. There is no reason to avoid real estate investments just because the tax and record keeping demands are considerable. You can hire a qualified expert to help with these matters, especially regarding taxes and how they have to be reported and supported with a set of books. However, even when you own several properties at the same time, developing a workable system is not as complex as it might seem. Even without expert help, you can develop an effective system for recording and tracking a range of costs and expenses. Real estate investing involves a large volume of transactions, including supplies to perform maintenance, hiring experts to fix broken systems, payment of utilities, and capital expenditures (buildings, autos and trucks, furniture, and improvements). These also involve calculations of depreciation, which is not as complicated as many people think.

You are not required to become an expert in accounting or tax law to succeed as a real estate investor. However, you probably will need professional help in some areas involved with real estate investing, including developing rental contracts, reporting taxes, and, commonly, the assistance of contractors, appraisers, real estate agents, escrow or legal consultants, and perhaps a management company if you buy properties far from where you live.

This book is not intended as a replacement for the expert advice you need; however, it will help you to become a more informed real estate investor. And the more informed you are, the more likely it is that you will succeed. The only area of expertise you should expect to develop is a focus on investment value, the ability to select good investments with growth potential, and a realistic understanding of supply and demand within the market itself (in terms of property value, rental demand levels, and mortgage lending).

This book breaks down the complexities of property selection, cash flow calculations and planning, and basic real estate bookkeeping. It is set up as a reference guide for anyone wanting to invest in real estate but who is not experienced in tax planning, bookkeeping, depreciation calculations, loss limits under the tax law, and the all-important considerations of finding a lender and working with an appraiser.

1.

THE NATURE OF

REAL ESTATE INVESTING

Real estate, over time, has been the most consistently profitable investment choice you can make. As long as you research ahead of time, know your market, and pick specific properties carefully, your investment should grow over time. This is true even in light of the depressed market since 2008. This period of time has been among the worst markets for real estate in many years. However, the market inevitably recovers from its negative cycles and comes back as strongly as ever.

This is why right now is a great time for investors to look seriously at the possibility of becoming a real estate investor. For most investors, the first question to ask is how much risk is appropriate. The answer to this question will help in the decision as to whether to proceed as a real estate investor or to look elsewhere.

Most people start out investing in residential property. A single-family house or small multiunit property (two to four units) is manageable and affordable, and you can always step up from there to buy additional properties or exchange your initial investment for larger ones. To get started, you want to define what you hope to achieve by purchasing real estate. Property is far more expensive than most other investments, so you will be making a commitment in most cases to a mortgage. The majority of investment value will consist of borrowed money, so you will depend on rental income to make your investment affordable. Given the potential affordability of real estate (with tenants essentially covering your mortgage payment for you), the consistent historical growth of real estate values, and the exceptionally good tax advantages, the benefits of real estate investing are significant. However, affordable is not restricted to net profits but, much more significantly, extends to the cash flow generated by the investment—that is, the comparison between money coming in and money going out. You need positive cash flow or, at worst, a breakeven form of cash flow in a majority of cases. Most investors cannot—and should not—afford to carry negative cash flow from their investments.

AN OVERVIEW OF THE MARKET

Since residential property is, by far, the most common real estate investment, examples in this book focus on single-family housing. Other choices (such as raw land speculation, commercial, and industrial properties) are much more advanced and beyond the interest of most investors.

The residential housing market can be easily studied in any given area. You can readily find information about the local population, employment, rental occupancy and vacancy rates, and the level of new construction under way. These factors add up to the supply and demand for real estate in your city or town. This, then, is the logical starting point if you are thinking of investing in real estate.

To find specific properties for sale in your area and to judge the market prices in great detail, even down to neighborhood or zip code, check the many online sources for current listings as well as for recent sales of homes similar to those you are targeting as potential investments.

VALUABLE RESOURCE For a local listing of real estate in your town, check these sites:

www.homefinder.com

www.homes.com

www.realtor.com

www.trulia.com

www.zillow.com

SUPPLY AND DEMAND

The supply and demand for residential property involves three distinct and separate markets. First is the market price trend of housing, the best known and understood market. In this market, buyers want to know, first and foremost, what a house will cost. The second market focuses on supply and demand for rental units. Third is the market for available sources of mortgage financing.

The first market can be evaluated in terms of how prices change over time. Are houses selling for more this year than last year? What is the percentage of growth? Housing prices have beaten inflation over many years, with the recent exception in this market beginning in late 2008. The longer-term trend places housing among the strongest of growth investments. Assuming, of course, that you’ve selected property on the basis of good research and sound market analysis, you can expect real estate to be less volatile than the stock market, consistent in its growth rate over time, and safer by far than other alternatives. In many regions, prices have remained flat or have declined, so using national averages is not a safe way to pick a market. You need to check the regional trend to ensure that real estate in your town represents a viable investment. In areas where employment is strong and the population is growing, real estate values tend to grow as well. The market value of property is only the first of three important markets in real estate.

The second market involves demand for rentals. What is the average vacancy level? A very low vacancy rate is a positive sign, but a fluctuating or high vacancy indicates that there is more supply than demand. If that is the case, then the timing would not be good for investment, at least not right in your city. The trend between 2008 and 2016 has been for housing prices to decline (over most regions), leading to more people renting than buying. This increased rental level has driven market rentals upward. So as housing costs fall and market rents rise, the market for real estate investors is ideal, consisting of low investment prices along with higher rents.

The third market is that for mortgage money. In 2016, rates were lower than they had been for many years, in the range of 3 percent. This is an extraordinary opportunity for investors, with the cost of borrowed money lower than it has been for many years. However, the rate is not the entire story. Qualifying for a mortgage involves a combination of lending rules and standards, your personal credit history, and the level of equity (your down payment) versus the percentage you would like to borrow. If you do not have money for a down payment or if your credit score is poor, you will face difficulties in getting a mortgage at a desirable rate.

THE BASIC EQUATION

More details on these essential ideas are covered in later chapters. As an overview, however, a basic equation is an important starting point. The short-term market attributes of rental property are going to affect how well you can afford to invest money now. The whole market is likely to look different in a few years, but you want to make sure you have a reasonable expectation of keeping tenants in the property each month. The equation worth keeping in mind is a balance between how much money you receive (in rent) and how much you have to pay out (in mortgage payments and expenses). For that equation to work, you want to keep the property occupied as consistently as possible. Any time the property is vacant represents lost income, but your mortgage payment continues from month to month.

AN INVESTOR’S POINT OF VIEW

The market for residential real estate is not difficult for most people to understand. If you own a home, you know all about mortgage payments and the importance of being able to afford the payment each month. Anyone who has not yet bought a home knows that landlords expect rent to be paid on time. So the basic economics of real estate are familiar to everyone and are not as mysterious as the market forces at work in other markets, such as the stock market.

In evaluating investments, though, you need to look at properties from a different perspective. When you shop for your primary residence, you are interested in the comfort features, condition, and size of the property. As a real estate investor, you might be willing to buy property that would not interest you as a primary residence but that is ideally suited for rental purposes.

EXAMPLE: You have a growing family and need a house with several bedrooms for your own use. However, you have discovered that relatively small houses make excellent rentals. A two-bedroom house in modest condition is relatively inexpensive compared to other types of properties and is easy to keep occupied. A married couple or single person is drawn to such rentals and can afford what you will need to ask in rent, so such properties are easier to keep occupied than more expensive, larger homes would be.

In this example, your revaluation of the market would be made with rental income and payments in mind, rather than from the point of view of a homeowner. The investment attributes of your decision are going to be far different from your personal requirements.

The real estate market has grown in value over time, even though recent trends have been negative. This is a national average, of course, and all real estate is local. This means that it is essential to understand the local features of supply and demand before investing. You cannot depend on national averages or even on local trends for the long term. If local property grows in value over fifteen or twenty years in the future, that is a promising feature. At the same time, you need to ensure that rental demand is strong right now, in order to cover your mortgage payments. As you look for potential rental investments, try to locate properties that are affordable, most likely to maintain value (and grow in value), and appealing to likely tenants.

REASONS TO INVEST

IN REAL ESTATE

There are many good reasons to buy real estate. Among the most important reasons—assuming the local market conditions make it a viable choice—are the following:

■ Diversification and Asset Allocation. Sound investment requires spreading capital over dissimilar investments. You would not want to put all of your capital into a low-yielding savings account, or into a single stock, or into real estate. You are better off diversifying your capital. You may wonder: If real estate is sure to grow over time, why not put all of your money into rentals? Diversification is important because different investments have different attributes. The stock market is volatile and you can make or lose money quickly; however, your money can be invested or taken out quickly. Savings accounts are safe but yield very little. Well-selected real estate is going to increase in value over time, but it is very difficult to get your money out if you need it for an emergency. You need to diversify your capital so that you have some funds available as you need them, some funds in very safe investments, and some in investments likely to grow over time.

A more sophisticated view of diversification is called asset allocation. This is a strategic planning technique in which a portfolio is spread among many different markets or segments. While diversification usually refers to spreading risks within one market (buying many different stocks), asset allocation is broader. For example, you may want to have some money in ready-cash accounts as an emergency reserve fund; other capital invested in stocks, whether owned directly or purchased through a mutual fund; and yet more of your capital invested in real estate. These three markets represent completely different levels of risk and opportunity, and each is going to perform according to very different market forces.

Real estate is a superb market for asset allocation because of its strong historic attributes. Your ability to allocate capital among dissimilar markets protects your capital from cyclical changes. In times when the stock market is weak or falling, real estate may be strong. In fact, it is likely. Offsetting profit and loss effects of stocks and real estate occur time and again.

Diversification within a single market and asset allocation among many different markets are sensible portfolio management techniques. Real estate is a good fit for strategic asset allocation. It is different from the stock market, however. Investors wanting to get out of stocks for the moment but who plan to go back in a few months later have to decide where to place capital, either in other stocks or in different markets. Real estate is a longer-term investment, though. So if you plan to employ real estate in your asset allocation plan, it should be treated as a longer-term decision. You do not want to buy real estate in March and then look to sell it in June in order to put capital back into the stock market. That would be an expensive and, given closing-cost levels, a difficult move to make profitably.

■ Cash Flow. With most investments, you place cash in someone else’s care, then you receive dividends, interest, or capital gains. You are 100 percent invested, and there is little or no question of cash flow. With real estate, you usually make a down payment and finance the lion’s share of the investment; so cash flow becomes critical. Most real estate investors depend on rental income to cover their mortgage payment. The bad news: If you do not keep the property rented every month, you have to make the mortgage payment from your other funds. The good news: If you keep the property occupied, then tenants’ rental payments are used to make those mortgage payments. In this situation—and given no unexpected extra expenses—the property pays for itself. When you purchase properties at the right price for your local market and when rents are high enough to cover your mortgage payment, you will have a positive cash flow. When you consider the tax benefits of reporting losses (which are created because you are also allowed to depreciate your rental property), it is possible to have positive cash flow and, at the same time, a net tax loss. This seemingly contradictory situation is quite common. When the tax benefits from net losses with depreciation create monthly tax savings, you can enjoy the best of both worlds: having tax losses to deduct while you collect more cash than you pay out.

■ Leverage. Most individuals cannot afford to buy property outright and pay cash, just as most homeowners cannot afford to pay for their own homes all at once. One attribute of real estate investing is the need, in most cases, to finance 70 percent or more of the purchase price. As a strategic approach to investing, leverage is recognized as an important and advantageous method to use. Leverage means employing a limited amount of capital to purchase and control a greater value in investment. You would not be likely to borrow money to buy stocks because the stock market is an uncertain and risky place. However, properly selected and researched real estate is far less likely to lose market value. Not only does real estate tend to grow in value over time when other economic factors are positive; it is also insured through a fire insurance policy, and investors have direct control over the investment. Ownership in stock is uncertain and less tangible, but, given the features of locally owned and managed real estate, leverage makes a lot of sense.

WEIGHING THE PROS AND CONS

The overall benefits of investing in real estate—combining growth, safety, and tax features—make it a choice worthy of serious consideration. You cannot expect this beneficial combination from any other investment. While cash invested in real estate is difficult to take out (because it can be removed only through refinancing or selling in most cases), the overall benefits of real estate make it worthwhile, especially if you balance your capital between real estate and other areas.

Even with all of the long-term benefits of real estate investing, however, you should expect to face some problems as a real estate investor. The need to borrow money to buy property is a significant risk, so you must be prepared to live with debt. There can be unanticipated expenses, such as for repairs, property tax hikes, or utility rate increases. Neighborhoods can change for the worse, the local economy can fall apart, or a large employer may close down or move away.

Another potential problem area involves dealing with tenants. The landlord–tenant relationship is usually amiable and fair. It is occasionally emotional or illogical. As a landlord, you accept the risk that some tenants will not be pleasant to work with. This is one feature of real estate that discourages many people from proceeding. If your temperament is inappropriate for dealing with tenants, then you should not buy real estate. At the same time, if the risk of problems can be mitigated by checking references, and if you are willing to go through those steps, then you will increase your chances for a positive, enjoyable, and profitable experience.

THE IMPORTANCE OF TAX PLANNING

The benefits of real estate are difficult to ignore, and they make a strong case in support of including real estate in your portfolio. Equally important, tax