By Christine Giordano
April 18, 2016, at 9:12 a.m.
As winter blustered through his Cleveland hometown, Steve Novotny may have been a world away, pulling his sailboat up to a dock in sunny Florida on his way to the Bahamas.
Four years ago he plunged into the rental business as a handyman by buying a house that had a decent location but needed huge repairs. “It took all of my savings to buy it,” he says. “I actually lived in my truck while I was renting houses out for the first two years.”
Now he looks for so-called “handyman specials” – houses with at least three bedrooms that are in nice locations but need repair. He now owns nine houses and the rental income allows him to sail around the country.
Many investors like Novotny are seeking to get into the rental market to create passive income to fuel their lifestyles, and the rental market in the United States is still rising.
Since 2005, the number of households that rent has hiked to 37 percent, a jump of 9 million and the largest increase by decade since 1965, according to a December study by Joint Center for Housing Studies of Harvard University. This is on track to be the “strongest decade of renter growth ever recorded,” according to the study, and hikes in rent are outpacing inflation.
Traditionally, investors have looked for quick returns by flipping houses after a swift remodeling. “While flipping can be lucrative, it can also tie up your money if the home doesn’t sell immediately,” says Corey Brinkman, market vice president of Renters Warehouse, a property management company in St. Louis.
“Plus, it’s a one-time benefit once the house sells. Renting out a property can provide income month after month and free up your cash flow to invest in other places,” he says.
But investors should enter the market with caution because it is easy to underestimate the costs of repairs and upkeep on your rental unit. “A good rule of thumb is to calculate anywhere from 7 to 15 percent for these unforeseen repairs, depending on the age of the rental property,” Brinkman says.
Here is some advice from experts to keep your rental money flowing in the right direction.
Keep your goals in mind. Investors need to know why they are in the rental market and what they want to accomplish financially, says Wendell De Guzman, chief executive of the real estate investment firm, PCI in Chicago.
If the goal is to live passively off the rental income, then investors should know how much income they’ll need. The tax rate changes as income becomes passive, says De Guzman, and “your tax rate can be zero percent” because you can deduct the depreciation from your taxable income.
For example, an investor who pays $275,000 for a house would divide it by 27.5 (years) for depreciation and shield $10,000 in income annually.
Put your financial house in order. Knowing your income and expenses will help you get loans and, subsequently, buy more property, De Guzman says. Don’t forget to include taxes, insurance, maintenance, management, utilities and the reserves for major repairs, like a new roof.
It also pays to learn financing and talk with mortgage brokers to find programs to buy the property with as little money down as possible. First-time homeowners might buy a four-unit apartment building, get an Federal Housing Administration loan with a 3.5-percent down payment, collect the security deposit and, if you close early enough in the month, use the first month’s prorated rent toward the down payment, De Guzman says.
Learn your market’s vacancy rates and property ratings. There are areas rated A through F, and they all sell and rent for different rates. Keep your vacancy rate to 5 percent or less, De Guzman says, so you won’t be stuck with an unrented property for months at a time.
If you don’t want to be a property babysitter, avoid the areas with the lesser ratings. Areas with F ratings often have the most violent crimes in the neighborhood. “It’s tough being there. You have to watch your investment like a hawk,” he says.
A-rated areas often mean higher sales prices but lead to higher rents and more regular tenants. “You’ll have fewer headaches if you’re dealing with renters who can afford a more expensive rent. You don’t want to be dealing with the bottom-of-the-barrel (properties) if you plan on being an absentee landlord,” Novotny says.
Look for real estate with great potential. Properties that tend to do well are near schools, expanding retail or trendy points of interest, local transportation, or surrounding malls, says Daniel Sanchez, commercial associate partner of Partners Trust Commercial in Beverly Hills, California.
Once it’s yours, maintain the exterior and keep your costs down with desert landscaping, low-flow toilets and tankless water heaters, he says.
Keep your options open. Consider smaller markets within secondary markets, how well the house was built and how much people are paying rent in the neighborhood. “I want to be in the $800-to-$900 range in the secondary market,” says Yariv Bensira, owner of Hyde Capital in Memphis, Tennessee, who came to the country to attend college and now who owns and handles 4,000 units with a private investment fund in Israel.
Before buying, he checks how well the house was framed, who the tenants would be and what he can add to the property to reasonably increase the rent. “You’re not going to change the demographic or bring in completely new people. The question is whether the existing tenants can pay a little more for a better product,” he says.
Don’t be lured by low interest rates. If a property is already 30 years old and would cost the same to build it, then don’t buy it, Bensira says. Make sure your home has enough value to get the returns you want when you eventually sell the property.
Renovate the kitchen and bathrooms to get higher rent. Quality granite in the kitchencould save you resurfacing costs, and bring in an extra $50 to $90 per month, Bensira says. Be sure to know how much renovations cost so that you know if you’re getting a fair bid.
Screen the tenants. Have an application process and use a service such as National Tenant Network to look for civil and criminal lawsuits, recent collection activity and credit scores above 600, says De Guzman. “Look for people who were down financially, but now are on their way up with a good job and some savings, who have been paying their bills for the past four years,” he says.