35

I can see a 2 bedroom, 2 bathroom $100k property on Zillow (est. mortgage $375/mo) next to a university so rent prospects are good. Rent estimate by Zillow, confirmed roughly by Craigslist: $972/mo. That's just crazy.

What's the catch in this?
Obviously there's maintenance costs but still.

  • 9
    What are the property taxes, condo fees(if applicable), insurance and other costs you'd have besides the mortgage in owning the property? Those could add up in some cases. – JB King Oct 9 '14 at 22:19
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    Remember that "next to a university" may mean renting to students... One of the pieces of homework you need to do before you go into this business (and it IS a business) is to understand how laws from zoning to fair-housing to landlord obligations will affect it. – keshlam Oct 9 '14 at 23:51
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    Is there local rent control? – jjanes Oct 10 '14 at 1:24
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    Not to mention that if you rent to students you may have vacancies for 3 months each summer that may be hard to fill and having multi-year tenants isn't as likely. Turnover kills profit margins on rentals. – JohnFx Oct 10 '14 at 17:43
  • Government regulations (taxes, etc.) and especially the tenants. As @JohnFx mentions, there may be some local condition that might not be immediately apparent (school schedule, etc.), but the two things I mentioned are a problem (in varying degrees) everywhere. – zxq9 Oct 11 '14 at 4:14
35

Several, actually:

  • Maintenance costs. As landlord, you are liable for maintaining the basic systems of the dwelling - structure, electrical, plumbing, HVAC. On top of that, you typically also have to maintain anything that comes with the space, so if you're including appliances like a W/D or fridge, if they crap out you could spend a months' rent or more replacing them. You are also required to keep the property up to city codes as far as groundskeeping unless you specifically assign those responsibilities to your tenant (and in some states you are not allowed to do so, and in many cases renters expect groundskeeping to come out of their rent one way or the other). Failure to do these things can put you in danger of giving your tenant a free out on the lease contract, and even expose you to civil and criminal penalties if you're running a real slum.

  • Escrow payments. The combination of property tax and homeowner's insurance usually doubles the monthly housing payment over principal and interest, and that's if you got a mortgage for 20% down. Also, because this is not your primary residence, it's ineligible for Homestead Act exemptions (where available; states like Texas are considering extending Homestead exemptions to landlords, with the expectation it will trickle down to renters), however mortgage interest and state taxes do count as "rental expenses" and can be deducted on Schedule C as ordinary business expenses offsetting revenues.

  • Income tax. The money you make in rent on this property is taxable as self-employment income tax; you're effectively running a sole proprietorship real-estate management company, so not only does any profit (you are allowed to deduct maintenance and administrative costs from the rent revenues) get added to whatever you make in salary at your day job, you're also liable for the full employee and employer portions of Medicare/Medicaid/SS taxes. You are, however, also allowed to depreciate the property over its expected life and deduct depreciation; the life of a house is pretty long, and if you depreciate more than the house's actual loss of value, you take a huge hit if/when you sell because any amount of the sale price above the depreciated price of the house is a capital gain (though, it can work to your advantage by depreciating the maximum allowable to reduce ordinary income, then paying lower capital gains rates on the sale).

  • Legal costs. The rental agreement typically has to be drafted by a lawyer in order to avoid things that can cause the entire contract to be thrown out (though there are boilerplate contracts available from state landlords' associations). This will cost you a few hundred dollars up front and to update it every few years. It is deductible as an ordinary expense.

  • Advertising. Putting up a "For Rent" sign out front is typically just the tip of the iceberg. Online and print ads, an ad agency, these things cost money. It's deductible as an ordinary expense.

Add this all up and you may end up losing money in the first year you rent the property, when legal, advertising, initial maintenance/purchases to get the place tenant-ready, etc are first spent; deduct it properly and it'll save you some taxes, but you better have the nest egg to cover these things on top of everything your lender will expect you to bring to closing (assuming you don't have $100k+ lying around to buy the house in cash).

  • 3
    @Escrow payment can double the monthly housing payment over principal and interest? That sounds outrageous... I've never seen it increase it more than about 20-25%. – Michael Oct 9 '14 at 23:14
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    That's what every Realtor I've ever worked with has used as a rule of thumb. In my own circumstance on 140k, P&I is about $670, plus PMI, taxes and insurance make it about $1200, which is about 1.8x P&I. And our PMI isn't that much, in case you were going to point to that as the difference. I would also expect that insurance on a rental property is significantly more expensive than for the owner's residence, as the risk is higher and renter's insurance only covers the renter's own backside, not the landlord's. – KeithS Oct 9 '14 at 23:16
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    Oh, and in my case property taxes make up over 75% of the taxes+insurance sum, so even if insurance is 2x it isn't disproportionally large. Guess it just depends on where you are! – Michael Oct 9 '14 at 23:30
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    Property taxes vary dramatically from location. My property taxes are very high, so the double is right - I do actually pay more in property taxes than my mortgage payment some years. (Fortunately that's in some ways worked into the cost of the house, so it actually helps since property taxes are deductible!) Other states/counties/cities have much lower property taxes. – Joe Oct 10 '14 at 16:29
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    Could I suggest you add to this a very important one: "Vacancy Risk: Remember, you still have to pay the mortgage, even when the rental unit is vacant!" – Affable Geek Oct 14 '14 at 17:07
27

There are those who are knowledgable in real estate who offer rules of thumb:

  • Don't pay more that 50X the rent for the house. Here, $972 x 50 is $48600.

  • Assume half the rent goes to expenses. So from $972, you net $486, and after that mortgage, you have $111 in profit. Zillow usually assumes 20% down, here $20K. So you are seeing a 6.67% return on your 20K. (Plus appreciation and principal paydown.)

For the record, I just bought a 3 family, under renovation now. Expecting total cost to be $160K, and total rent $2500. I missed ratio a by a bit, but $1250 to go toward a $120K mortgage works out fine. $550 profit/mo on the 25% down ($40K).

(By the way, a turnover of tenants can cost (a) a month of no rent, (b) a cost to the real estate agent, if you use one, and the cost to paint/repair. This is generally considered 10%. So if the 50% of rent seemed high, here's 10 of it.)

  • 12
    Can you even find one such property in the US that's worth less than 50*(prospective rent)? – Clark Henry Oct 10 '14 at 2:29
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    @nsw Sure. You just need to look for it. Housing prices are way higher now than they were 3-4 years ago, but back then - it was really easy to find those even with much better ratios than what's Joe is suggesting. – littleadv Oct 10 '14 at 3:11
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    @CQM - absolutely. In my case $6600/$40000 is a 16% return. Unleveraged, $15,000/$160000 is just over 9%. When analyzing any real estate purchase for investment, the leverage is often what makes the deal viable. In the OP's case, his deal may be worth it, but he's clearly not listed every expense I'd expect. – JoeTaxpayer Oct 10 '14 at 7:32
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    Where does the 50x number come from? As someone with no background in real estate investing (but a background in finance), that seems staggeringly low. – Chuu Oct 10 '14 at 14:08
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    @Chuu - Sorry, rules of thumb are just that, known targets people use. You can search for the origin. If you see the numbers I shared, I missed the target by a bit (If 64 is a bit higher than 50). 50 is not cast in stone, just a target. Above 100, I wouldn't go near it. – JoeTaxpayer Oct 10 '14 at 16:31
17

The other thing to remember is seasonality.

Just because monthly rent is $900/month doesn't guarantee that you'll bring in $900/month.

Plenty of university towns have peak demand during the months of Aug/Sept when students are moving in, but you have to beg//plead//give discounted rent to keep units full during 'off-season' times.

Assuming vacancy during 3 months/year, your average monthly rent is only $675. ($900 * 9 / 12) This may change the economics of your investment.

  • 3
    Even in uni towns, you usually rent for 12 month lease. I've never heard of a 9 month lease that wasn't extortionate... but of course check out the culture of the particular area. – Joe Oct 10 '14 at 16:36
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    My first apartment was in a uni town (Actually just 3 blocks from the university) and they offered both 6 and 9 month contracts. While I ended up paying $480/mo for a studio, whereas the 9-month was $565/mo. From what I saw around the area, that's pretty standard. – Thebluefish Oct 10 '14 at 23:03
14

More possible considerations:

  • Comparability with other properties. Maybe properties that rent for $972 have more amenities than this one (parking, laundry, yard, etc) or are in better repair. Or maybe the $972 property is a block closer to campus and thus commands 30% higher rent (that can happen).

  • Condition of property. You know nothing about this until you see it. It could be in such bad shape that you can't legally rent it until you spend a lot of money fixing it. Or it may just be run down or outdated: still inhabitable but not as attractive to renters, leading to lower rent and/or longer vacancy periods. Do you accept that, or spend a lot of money to renovate?

  • Collecting the rent. Tenants don't necessarily always pay their rent on time, or at all. If a tenant quits paying, you incur significant expenses to evict them and then find a new tenant, and all the while, you collect no rent.

  • There could be a tenant in place paying a much lower rent. Rent control or a long lease may prevent you from raising it. If you are able to raise it, and the tenant doesn't want to pay, see above.

  • Maintenance and more maintenance. College students could be hard on the property; one good kegger could easily cause more damage than their security deposits will cover.

  • Being near a university doesn't guarantee you an easy time renting it. It suggests the demand is high, but maybe the supply is even higher.

  • Renting to college students has additional issues. They are less likely to have incomes large enough to satisfy you that they can pay the rent. Are you willing to deal with cosigners? If a student quits paying, are you willing to try to collect from their cosigning parents in another state? And you'll probably have many tenants (roommates) living in the house. They will come and go separately and unexpectedly, complicating your leasing arrangements. And you may well get drawn in to disputes between them.

  • 3
    We have a property we rent out, and tenants not paying rent (so I'm still paying the mortgage and agents fees whilst I'm trying to evict them) and tenants trashing the place when they leave (causing many times more damage than the security deposit (the last tenants did over $15000 damage, we're not getting rent while the repairs are done, and even if we could track the tenants down I doubt they have assets to that value so we couldn't recover the costs from them) mean I run at a significant loss. Our only hope of a profit is if we finally sell it for significantly more than we paid. – digitig Oct 10 '14 at 12:25
8

There are several things that are missing from your estimate:

  • Taxes
  • Insurance
  • Condo/Home owners fees
  • Maintenance

The terms for the mortgage for a rental property will be different. You may be required to have a larger down payment.

When approving you for the mortgage they will not count all the rental income as income, they will assume periodic vacancies. This difference may impact other credit you will be getting in the near future.

2

There is a positive not being mentioned above: the depreciation vs your regular earned income. Disclaimer: I am not a tax attorney or an accountant, nor do I play one on the internet. I am however a landlord. With that important caveat out of the way:

Rental properties (and improvements to them) depreciate in value on a well-defined schedule. You can claim that depreciation as a phantom loss to lower the amount of your taxable regular income. If you make a substantial amount of the latter, it can be a huge boon in the first few years you own the property. You can claim the depreciation as if the property were new. So take the advice of a random stranger on the internet to your accountant/attorney and see how much it helps you.

  • 3
    Depreciation is linear, so it's a factor over 27 years, not just the first few. But with a 27.5 year duration, the 100K house only offers $3000 or so each year, and $750 in tax savings at the 25% rate. If this makes or breaks whether it's a good deal, then the numbers are too tight. If the numbers work, the $750 is gravy. – JoeTaxpayer Oct 11 '14 at 1:58
  • Hey, I made the 2% floor one year because of the rental depreciation and net loss (and new carpet on 7 year depreciation). Not big bucks but it's a clever tool for engineering AGI if you find a phase out edge case to want to do so. – user662852 Sep 8 '15 at 23:34
-1

It is easier to get a loan on a rental than a flip, which is a huge advantage to rental properties. Leverage allows you to increase your returns and make more money off appreciation and higher rents. I use ARMs to finance my rental properties that are amortized over 30 years. I have to put 20 percent down, but my portfolio lender lets me get as many loans as I want. Because I put 20 percent down on my rental properties and they still have great cash flow I can buy three times as many properties as I could with cash purchases. Buying more rental properties amplifies the other advantages like cash flow, equity pay down and the tax advantages.

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    Brian - welcome to Money.SE. Please use your account profile if you want to link to your work. Posts (whether questions or answers) should not include sig lines. – JoeTaxpayer Feb 20 '15 at 13:16
-4

Don't over analyze it - check with some local landlords that are willing to share some information and resources

Then analyze the Worst Case Scenarios and the likelihood of them happening and if you could deal with it if it did happen

Then Dive In - Real Estate is a long term investment so you have plenty of time to learn everything.....

Most people fail.... because they fail to take the first leap of faith !!!

  • Welcome to Money.SE. Please use your account profile if you want to link to your work. Posts (whether questions or answers) should not include sig lines. Your answer is getting downvoted because of the promotion and the poor quality of your answer. Feel free to update it with more quality information. – Alex B Nov 12 '15 at 17:13

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