The Real Costs of Being a Landlord
NEW YORK (MainStreet) — Prices of existing homes continue to slip, construction of new homes is off, the homeownership rate is declining, and in many places, rental housing is in short supply as well. Perhaps it’s a good time to invest in rental housing, especially if you’re a few years from retiring.
On Monday, the National Association of Realtors reported that sales of existing homes had fallen more than 9% in February, a bigger drop than most experts had expected. Home prices also fell to their lowest level in nine years, reflecting weak demand.
If fewer people are buying homes, the population is increasing and construction of rental properties is slow, which it is, the imbalance between supply and demand will drive rents up. That can shorten the time for a new rental property to move from the red to the black, which underscores one of the chief problems with buying an investment property: It’s almost impossible to charge enough rent to make the property profitable from the start. Typically, it takes five or more years to raise rents enough to cover all costs, though that time can vary widely from market to market.
Unless you’re a professional real estate investor, it can be very difficult to project the numbers. Your gains or losses would depend on prevailing rental rates, your mortgage rate, your tax bracket and the changing costs of real estate taxes, insurance and maintenance. Then there are curveballs, like the furnace conking out or a multi-month gap between tenants. The unexpected can upend even the most careful calculations.
The ideal candidate for a landlord is someone with patience, organizational skills and the financial wherewithal to weather the rough patches and hang in for many years. If the finances just barely work at the start, owning rental property probably doesn’t make sense.
Also, it can be very difficult in today’s market to get a loan to buy rental property. It’s hard enough to get a loan for a primary residence, but lenders are especially leery of rentals because a hard-nosed owner is more likely to walk away from a rental that his own home if the venture starts to fail. While you might need a 20% down payment to get a mortgage on a primary residence, you might have to come up with much more for a rental.
Today, the ideal candidate for an amateur rental purchase is someone a few years from moving to a new home for retirement. If you’ve paid off your mortgage, or it is very small relative to your home’s value, you might be able to take out a new mortgage on that property and use the cash to buy the retirement home, renting it out until you’re ready to move.
In a few years, you could sell the current home, use the proceeds to pay off the loan and move into the rental. After you’ve been there a couple of years it will count as your primary residence, allowing you to escape capital gains tax if you ever sell. Up to $500,000 in profit from a primary residence is tax free for a couple filing a joint return, while a single person can shelter $250,000. After selling a rental, in contrast, you’d be taxed on any gains.
With this strategy, you might have it both ways: buying a rental while prices are still relatively low, and keeping your primary home until it will fetch more in a better market.
Aside from carefully examining the financial assumptions, prospective rental owners should think about their tolerance for headaches. Tenants have little incentive to put up with leaky faucets, squeaky hinges and similar problems that many homeowners willingly endure, and late-night and weekend calls from the tenant can make your stomach churn.
You can hire a professional property manager such as a real estate agent, but the cost will push your break-even date back even further. And a manager might not save you all those hassles, as you’d probably want to be consulted on any significant expenses he or she wants to make.
This isn’t to say owning a rental property is all that bad. Many people have made good profits by allowing tenants to pay for a property that eventually sold for much more than was paid.
But investing in a rental isn’t like putting money into a mutual fund that can be dumped with a few clicks of a mouse. If you decide the landlord life isn’t for you, it could take years to break free.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.