One of my best friends and business partners Reid is finally buying “The House”. The one his wife actually wants. The one he can stuff a gaggle of kids and pets and toys and (ahem) visiting business partners into. The one by the country club & the good schools. I’m so happy for him.
Thanks to the region of the US he happens to reside in, he’s buying this property for the equivalent cost of my garden shed in Santa Cruz, CA. It is awesome. Part of the decision they face is whether to sell their current home or become landlords. So I decided to write an article for him. This should get you going buddy.
The Important Things I Won’t Get Into Deeply.
Normally I would kick it off with a huge discussion around defining your personal investment philosophy for real estate. Are you looking primarily for cashflow or equity? Long term or short term gains? How personally involved do you want to be? What time do you have / want to invest? What is your lifestyle and family situation and where does real estate investing or property management fit in? And so on… Reid, you should discuss all this with Darcie as it will guide many of the choices you make.
The next conversation(s) over beer would center on choosing the right property, in the right neighborhood, in the right MSA. And that discussion should not be neglected but I won’t hit it with the depth I might if you had a fist full of dollars and were looking to buy. After all, if your first house is a bad business asset, keeping it won’t make much sense. So how do you figure that out? You run the numbers.
Running the Numbers on Your Property
Ok this is going to get pretty mathy. Grab a cup of joe and slip a shot of ye ol good-time whiskey in it. It might hurt, but you’ve got to do it, so suck it up.
Peter & I created a spreadsheet a handful of years ago that I still use frequently when analyzing real estate investment opportunities*. You’ve seen it often. We moved it to google docs to make it easy to share. Make a copy of it for yourself. Definitely don’t put personal numbers in this one as I made it public.
For everyone else who isn’t familiar with it, there are some key items to fill in. Yellow fields are editable. Don’t touch the white ones.
* A quick note. I recently realized that using IRR would make more sense for measuring long term returns than using CAGR, but have yet to make the time to wrap my brain around it. It shouldn’t lead you to a wrong decision, this is just the math geek in me seeking deeper accuracy.
At the end of the day, I look at 4 numbers:
Cash Flow (H28): This is the positive or negative monthly dollars the property will throw off. Note that in reality, it never works this way as month expenses aren’t monthly and many items like maintenance are crystal ball predictions. Annual is probably more honest, but I find that I think in months naturally.
Cash Required (E24): The required amount of dollars I will need to invest to make this deal happen. In your case Reid, you already paid it, so the number is mainly useful as a benchmark.
Cap Rate (E27): Allows me to look at the return on my money across different properties without taking financing into account. It is the industry benchmark.
Rates of Return (E28-31): I like to compare return rates and risk. How does this look compared to the stock market (3.78% annualized return since 2007 with light / moderate risk)? To peer to peer loans (8.72% annualized return since 2008 with moderate risk)? Or to a bank account (0.5% with no risk under FDIC limits)? The values in these fields change over time. Modifying 34b (time horizon) may drastically increase or decrease return rates.
Purchase & Financing
Cells 4b-12b populate the cost of the purchase & the impact of your financing.
Reid, you will need to take your recent refinance into consideration when entering the “purchase” details. I would set 4b to the refi date, 6b to a calculated # based upon (original downpayment amt + loan value of refi + any equity paydown from original loan – cash out if you did that). Don’t be bummed out if it is higher than the honest estimated market value in 5b. That is often the case in personal homes and volatile markets. Next, 9b should be set to whatever % it takes to get the loan mortgage (e12) to the right number at the time of refi.
Some of the items like purchase fees & remodel cost could be interesting from a retrospective but aren’t necessary. Considering that you did a fairly extensive remodel, I would go to the remodel tab and put a quick couple line summary of the cost. Again, this isn’t required at all, but helps keep the investment in perspective for the future. It is a mixed bag because you did those for your family and might not have done so from a pure investment perspective. It’s up to you.
Projecting Rental Income & Expenses
Cells 13b-19b populate cashflow ultimately providing you the net operating income of the property.
Projecting Rents is always tricky. The first thing you should keep in mind is that you are subject to the forces of a market, and second that your home is in competition.
Timing has a lot to do with rents. In Santa Cruz, we get much stronger rents April – September that we do November – February. As the weather becomes more conducive to moving , demand goes up, and there is huge spike in June / July as we have a major university that floods the market with students (even in non-student properties). I do everything I can to try to get my properties to turn over in the optimal window as it could be worth $100-200 a month more. The other factor when comparing your property to others is to be aware of the value of key assets. For example, you have a smaller house, but a huge bad-ass garage, which we have found is a major attraction to the right tenant. Make a list of the core features your home has (garage, yard, # bathrooms …). Get to know the rentals in the neighborhood as each area has its own baseline.
Now go hit the internets. I look at Craigslist primarily. It’s important to know your market and how things get portrayed on the net. Santa Cruz has A LOT of terrible properties. The good ones go fast and don’t stay on craigslist more than a week. Often when scanning Craigslist, I have to remind myself that many of the properties could the dogs and not the average. Our properties tend to be really solid (renter chic), so I typically pick in the upper range for the neighborhood / what craigslist is showing. The other site I have found useful is Rentometer, although it reacts very slowly to change (I think it may be census data) and is way low right now considering the rapid increase in rents I am seeing in Santa Cruz. Lastly, I would consider calling 3 different property management companies and mention that you are moving and would like to consider renting your home. Describe the property and then ask what rent would they estimate typical in the current market? Ultimately, when putting a spreadsheet together, I’m pretty conservative.
To get vacancy rate, you basically need experience. The only way you’ll get that is from local landlords or property managers. When you call the property management companies, along with the projected rents, ask them for the typical vacancy rates. When they give you the number, ask them if that is simply for periods with no tenants, or if they are factoring in non-paying tenants / evictions. Then apply that in 14b. The % can vary quite a bit. I have my vacancy set at 2.5% as they are amazingly low in Santa Cruz. There is a huge rental population and limited real estate. I have only had 4.5 weeks of vacancy combined between 6 properties since 2010 and some of that was intentional for planned capital improvements. On the other hand, when we were talking to David about his properties in Dallas, he said he is running a vacancy rate of about 7%, almost entirely due to non-payment, resulting in eviction. Each area & economic class has its own factors.
Average tenancy & turnover cost again come with experience. Julie & I have found that to be about 2 years in our places, with some much higher and one turning over yearly as it typically had students.
Turnover cost was the sum total of marketing & basic repairs for normal wear and tear / rental preparations that were not charged to the tenant. We’ve narrowed it down to about $500 a turnover, although it seems to vary a bit depending on how much of my own sweat I feel like putting into it.
A lot of people handle reserves differently. I like a couple months of fixed cost, one turnover, and enough to cover one major repair (large appliance / flooring / roof). Its wise to keep track of the state of each property and plan for obsolescence. For example, one of our properties has a very old furnace and we have been saving up for the day it ends it amazing 30 yr run. As a result, the reserves on that property are higher than usual. In our case, to make the projected amount easy in the spreadsheet, we use a multiplier, and figure it is about 3 months of rent (17b), which works in our area. That’s 8k for the 3br single family homes and 12k for the duplexes. Considering lower rents and labor in your area you may find a different multiplier. Ultimately, the condition of your home should be taken into consideration. Our reserves are relatively small as is our maintenance number since our properties are often newly remodeled or in great condition. An older house should have higher numbers.
The most common type of insurance is home owners, and it is slightly different for a rental than what you have today. You should call up your insurance broker and ask them for the cost of a rental rider and make sure it covers “loss of rents”. It is an additional element to a policy which helps protect you in case of a tragedy. Not only will they compensate for property damage, but they will covers the lost stream of income until it resumes (up to a point). You HAVE TO HAVE THIS. Additionally, you might consider a general umbrella policy. Landlords can get sued for all types of reasons. Many people put properties in LLCs to help protect their personal assets but for a single property of your value, it may or may not make sense ($800/yr minimum in CA). After talking to my lawyers, we concluded that it was quite cheap (I pay about $200 / yr) to carry an umbrella policy which would cover me in case of lawsuit. I’m definitely no lawyer, and don’t know the specifics of owning property in Minnesota, so you should look into the details.
Applying the Crystal Ball & Your Tax Situation
Cells 21b-34b cover making best guess predictions on the future performance of the market and your property, as well as your own financial situation regarding tax rates. I’m not going to dig too much into maintenance as I dived into it during the reserve planning, but ultimately, on an older house, think in dollars and work backwards.
Appreciation & Inflation
When looking at the future, it’s mostly guess work. There are both macro-economic and local forces at work.
Up through 2008, the US had an average of 5% appreciation. Funny thing about averages. None of us own a house there. The west coast major cities tend to have bust and boom cycles. Up 70% over 3 years, crash 40% the next 3 years, Check that out, that 5% increase average! Depending on when you buy, you may see many fold returns, or losses. When I visited Rochester NY in 2008, the property prices had been stagnant nearly 20 years, and you only need to read about Flint, Michigan to see what a change in fortunes can do to a town. It is probably more valuable to project short term based upon local forces than any form of long term estimates. That said, my guest guess is that we have a strong inflationary period coming due to the number of economic easings the fed has performed. Those funds trickle down through the economy and eventually hit both rents and property values. It’s a real debate if those are actual profits or simply an inflationary hedge, but if your base costs remain fixed, then I see it as a win. If you plan for a long term hold, then leave it as something low like 3-5% in 21b and move on.
I tend to simply put inflation and appreciation at the same number unless I have a compelling argument as to why a local economy will surpass it. You could check net migration to see if more people are moving to the area than leaving. That is a legitimate predictor of demand. For the other direction, look at the volatility of economic infrastructure. If you are in a city that whose primarily employer was Blockbuster, that might be a sign that the economy will suffer.
Since you already own the property you should know the % basis. But just in case you don’t, it can vary by a lot depending on the location of the house, even within an MSA. Things like school bonds, assessments as well as city, county and state taxes all have an impact. The tax rate between my properties (all within 7 miles of each other) vary as much as .2%, which on our biggest duplex adds up to a whole lot of money annually (just under 2k). It could be the difference between cash-flow positive if you are on the edge and caught me off guard the first time (Live Oak has a hefty Melo-Roos assessment). Just call you tax assessor and get the tax rate for the address.
The property tax increase is an odd one. In California, prop 13 limits the amount which the assessor can increase the basis of your property every year to 1% of the previous price. So it goes up, just slowly. In other states there is no rate limit and your tax basis is at the estimators whim. I have no experience how that plays out, so I can’t really advise, but if I was to take a wild ass guess, I’d just tie it to inflation. Of course, this is another great question for a property management company.
Rates, Fees & Timeline
The tax rates are there to measure profitability after taxes. Since everyone’s rate is different, and each state plays a significant impact, they vary wildly and play a role. You should also take some time to get familiar with how passive losses can get applied to active income. That means if your rental home is losing money, or even is cash positive but depreciation makes it look negative, you may or may not be able to deduct that against the income from your day job. If your combined family income is under 100k, then you can apply the loses. It ratchets down to 0 by 150k. If you can’t apply them to active income, and you don’t have positive passive income then you have passive loss carry forward. That means they build until you have profits, then shelter those profits from taxes in the future until consumed. I have about 60k of passive carry forward losses left that I am eating my way through and therefore, my current cash-flow is going entirely into my pocket. There is a lot to learn and little smarts is with a lot of cash. Don’t let it overwhelm you, just find a good CPA who enjoys teaching so that eventually you understand what the heck they are trying to explain to you.
You really only need to fill this doc out once per property, but it will help set your expectations as to how this asset should perform. If you get it dialed in and the cash-flow is red, the returns suck, lets discuss it and see if we have any smart ways to either turn that around, or make a plan to dump it at the right time.
There are other tabs on the sheet, mainly longer term projections. they aren’t all that accurate but they have been useful in helping me to determine if I want a 3yr or 30 yr hold.
You all in?!? Let’s Rent it!
Renting is easy with the right property, when you keep it simple. I’ll break it down to a series of steps with a few tips.
Don’t Piss of HUD or Break Laws
There are national and local laws you should get familiar with.
HUD mainly wants to make sure that people have equal opportunity in housing and that as a landlord, you are not discriminating. You’ll like this, they just launched their first same-sex housing discrimination study. Choosing a tenant based upon race, color, national origin, religion, sex, disability, or familial status is against the law. You need to be careful in the wording of any ads (example GREAT FOR FAMILIES) as that might cause an issue.
On the local side, elements like rent control, rental deposit amounts and how the interest is handled varies city by city. It would be worth a phone call to the housing authority in your city (or check their website if it is useful) to get familiar with any local nuances.
Before you move out, stage the house. That means ditch your kid’s toys, old furniture and make it look as nice as possible. Get some good lights and take the very best photos you can. Those are worth their weight in gold and are often a huge competitive edge as most landlords don’t bother. I’ve found that photos with nice furniture get better responses than empty houses, but an empty place is better than having your property look like a college dorm. You guys have great cameras, so this shouldn’t be an issue, but don’t forget to do it in the mayhem of moving. Make sure to also get some solid shots of the yard, the house from the street and the garage as well. Get everything you need to tell a complete story. You will only end up using about 6-8 of them, but it has such a big impact its nice to have variety. In your case, as you get real winters out there, make sure to get photos from the summer season when things are in bloom. Even when looking at that photo in winter, it will inspire the dream.
The Pet Conundrum & Duration
Most landlords in Santa Cruz do not allow pets. They can cause tons of damage and are a liability. On the other hand, I see that as an opportunity. There are a lot of pet owners, and very few pet-friendly rentals. It gives us the opportunity to hand pick from a higher caliber of renter. Also, as they know that opportunities are more limited, it is likely that they will remain longer at the property. We allow pets in all our homes, at a surcharge. We have an increased deposit and charge an extra $100/month to the rent. Check out how many rentals allow pets in your area when making a decision. It is another good question for the property managers.
I like to turn over in the prime rental period. Here, that is between late April – September. To ensure that, I set my lease durations to end during that time frame. That means they aren’t always your typical 12 months. I also like to offer a one-time discount for longer leases. I often give $200 off the first month for a one year leave over a one year lease. I know my turnover cost is on avg $500, so I can share some of those savings with a long term resident. We don’t offer month to month as I want to minimize any potential vacancies in winter.
A Nice Listing Template
Use a service or grab a simple template from somewhere of the net. You can use mine if you like. It is pretty fugly, but Craigslist isn’t a fan of html / css and strips out so much that I had to hack and slash something together through a lot of trial and error. The difference between a nice template and raw text ads is huge. It says professional. It pops when you look at 100s of them. It also helps me when listing items to make sure I remember to put everything critical people might ask.
Open Houses, Not 1-1s
If you have a popular listing you will gets lots of interest. I had over 42 families come through one of our 2 bedrooms one weekend. First off, DO NOT GIVE OUT YOUR PHONE NUMBER. People are intense and will give you no peace. Offer dialog through email and to start it off, set up two open houses. I like to do one after-work for a short window (5-6pm on Friday) and one longer weekend slot (1-3pm Saturday). There is no point in doing more than 2 hours, and I often find that 1.5 is probably enough. During the open houses, talk to people. Gage interest, learn their stories, and ask “Why are you leaving you current place” a few times. The other question I like to ask if they indicate an interest, “Is there anything I should know, that you want to explain, when I read through your credit history?” It’s nice to get the low down in person. I also like to bring a print copy of the listing so people can review the basics of the lease. I tend to tell the story of the place when I chat with people. I would talk about the remodel, your kid growing up there, the cool places to run and bike etc. Sell it as only someone who has lived there and loved it can! Make a personal connection.
It is pretty common for people to reach out and state that they are not able to make the open house times you have set. The proper reply is, “Hi XXXX, thank you so much for reaching out. If we don’t fill the property during the open house, we will schedule another next week. I’ll be happy to let you know if that is the case. In the meanwhile, definitely drive by the location and make sure you are interested.” One on ones are a huge waste of time and to make it worse often result in no-shows.
You can either use as printed application or a digital one. For a long time I simple used the CAR forms. I wouldn’t be surprised if your local realtor association had something you can use. The other option might be a tool like Cozy or Buildium. You could always make a gdocs forms that dumps into excel. The key elements you need are as follows:
A nice hello message to remind you who they are
Basic overview of each tenant including kids
Financial viability including active income, any alt income, savings / checking & investments, debts.
Cosigner info (if applicable)
Rental history + why they left each one
Pet overview (if applicable)
SS# + Approval to run credit / criminal report
I definitely prefer a digital application over paper and paying for a SaaS might make sense to keep things organized, but it’s kind of pricey per property. Cosy seems to do a really nice job supporting digital payments which is a plus. I don’t accept applications from people who have not seen the property. I used to encourage it (as you can see in the Craiglist template I shared) but it turned out to be a huge waste of time.
Identifying the Right Peeps
Who is the right tenant? One who will pay on time, take care of your property and be there forever. You might have other criteria and as long as they don’t violate the HUD discrimination policies, it is up to you. We review rental applications and look for stability, accountability and anything that triggers a warning of inappropriate behavior. That is mostly gut feeling. Things like responsiveness, clarity of communication during our conversation at the walkthrough, why they left their last few homes and other things are scored. I’m looking for patterns. I’m trying to make sure they aren’t really looking to buy a home and will give notice in 4 months breaking the lease mid-winter.
When looking at finances, we have a ratio of after-tax income to rent that we look for. Ideally, the rent costs 33% or less of their income. 25% is great! On a few cases, we have accepted as high as 40%, but that is where it starts to become sketchy. Over 50% is dangerous, no matter how good their story is. They have to eat as well. I also like to see a few months saved beyond the rental deposit. I know a lot of people live month-to-month, but given the option as a landlord, a good tenant with a 3-6+ months rent in a savings account is far more likely to survive financial turbulence.
Narrow it down to a couple front runners. Run credit and criminal reports. I only do this for the finalists and pass on the cost to them ($12) through Buildium. Don’t worry so much about the credit score. It is helpful but far more important is the actual account histories. Do they have a history of late payment. Any delinquencies or bankruptcies indicating problems. While these aren’t always a disqualification, they merit explanation (divorce, loss of job…).
Call their references. It is really a pain, but it is important. Don’t trust the current landlord as they might say anything to get rid of a bad tenant they are stuck with. Call previous landlords, they are more likely to give it straight. A lot of property management firms will require you to submit a request via email or fax and will only tell you if they paid on time. It is better than nothing, but often when I push a little I’ll get more. Call their employer to confirm that they do indeed work there. Also, google the employer to make sure they aren’t about to go out of business or anything odd like that. The personal references are helpful at times. They help validate stories.
For our lease, we use the CAR rental contract. It is nice and thorough for a boiler plate. I don’t know if it would work out of state. You should look to see if an agency in Minnesota has created a defacto form that your can count on. The rental contract covers:
* type of agreement: lease or month to month
* duration / end date
* people who have the right to reside
* restriction on access (storage, attic …)
* responsibilities (gardening…)
* payment terms, late fees
* landlord inspection rights
* the funds required
* and quite a bit more.
There are other forms, such as lead paint disclosures, that are wise to include. I also like to find out if they carry renter’s insurance and work out a referral arrangement with a local agent. It is amazingly cheap and is some of the best protection renters can have.
Along with a completed rental application, they will need to submit a cashiers check for the safety deposit + 1st months (sometimes pro-rated) rent. I like to make sure the check clears before I confirm that the place is their or provide access.
Once you have the money, the lease and they get the keys, you should do a walkthrough together. This is basically a form you fill out with notes on any defects or damage throughout the property. It is to protect both parties. Keep those notes somewhere safe where you can find them later. Once they move out, you will use them to identify any damage to the property during the stay of the tenant. There is a list of rules regarding what is considered “normal wear and tear”. They vary state by state, but here is California’s list. Things like paint (2yrs) and carpet have an expected life span and must be pro-rated. It is worth learning these come move out time.
Managing Your Property
You did it! There are really only two parts until you next turnover, getting paid and keeping the property in good shape. There is a lot more on what to do when things go wrong, but just buy me a beer and we can co-write that article when the time comes. =)
I like to get paid digitally. I never go to the bank for personal finances, so I don’t need to add monthly trips for this reason. There are a number of ways this can take place. You could use a service like Cosy to facilitate, or you can take my approach and open a new checking account, give that number to your tenants and tell them that funds must be deposited in that account as of the rental due date. They could use ACH, bill pay, or even walk over to your bank and deposit it manually. I also have rent due the 27th and late the 1st. I have mortgages to pay and don’t want to find myself late if someone is lagging. It is unusually, but it has worked well for me.
I don’t have a lot of forgiveness for late or non-payment and immediately start eviction procedures. We have had two tenants go through hard times, but they had the accountability to call and discuss the situation so that we could work out a plan. This is not a charity and I can’t afford to mess it up as the mortgage and taxes on the property have to get paid.
Maintenance can be super stress or a since. The secret comes down to reserves + a team. If you have the money planned, then its part of the business and you won’t freak out as long as you have someone capable on hand. The fact is that you should NEVER have to get out of bed to go deal with a property. Pay someone else to do it. It has taken me a few years but I have my list of vendors and this is who you will need, in order of important:
Ready to Go
* Handyman x2 (in case one is on vacay)
* Landscape / Gardener / Tree Trimmer
* Painter (although handyman can do most of it)
* Mold / Termite Expert
* Flooring Hookup
* Locksmith (although handyman often is enough)
Don’t wait to get this list together. Nothing makes a tenant feel more cared for than a rapid response. A good relationship with your vendors is also another set of eyes and ears on the property. They will warn you of any funny business they might discover.
It Is Worth It
Real estate is phenomenal in its ability to create long term wealth. You are putting a major check in the assets column of your family balance sheet and I am so proud of you! Be patient with it, but also don’t feel like it has to be in your portfolio for life just because it was your first home. Pay attention to local and macro trends.
Being a landlord is work, but it isn’t all that much if you are organized. A good system and a certain amount of emotional detachment is the difference between a good investment and a weight around your neck. I look forward to doing a deal with you some time in the future!