How do You Make Money with Rental Property?
Being a landlord and collecting rent as a property owner is probably one of the oldest and most stable forms of business income. Everyone needs to have a roof over their heads, and quality landlords provide a necessary service to renters. Although it sounds simple (buy a property and rent it out), there are some tips and tricks to operating a profitable property rental business.
How do You Make Money with Rental Property? Don’t overpay when buying the property in the first place.
There is a saying in real estate:
“You make money on a property the day you buy it”
What does that mean?
It means that the amount you pay for a property affects your rental income returns and your future sale profitability.
Running a rental property business (actually any business) is all about positive cash flow. The more you pay for your properties, the less percentage return you make.
Using a simple example comparing Investor A and Investor B purchasing the same property at two different price points:
A residential apartment makes a net profit (profit after all expenses) of $10,000 per year renting to a tenant on an annual basis.
If Investor A pays $100,000 to purchase the property, he will be making a 10% annual income return from the renter on the property purchase price.
Property Price (Dollars)
Annual Net Income (Dollars)
Annual Income Return
This is known as the “CAP rate” (short for capitalization rate). This 10% return is for the life of the investment (assuming that Investor A doesn’t raise rents, have long term vacancies, etc).
Now lets look at Investor B.
Investor B pays $200,000 for the same apartment with a $10,000 annual net profit after expenses. Investor B’s return (5%) is half that of Investor A (10%).
Property Price (Dollars)
Annual Net Income (Dollars)
Annual Income Return
So for the life of this investment, Investor B’s return is locked in at 5% (assuming the above – i.e. don’t raise rents, have long term vacancies, etc).
Additionally, the more you pay to purchase a property, the less profit you make when selling the property in the future. If you hold the property for 10 years and sell it for $300,000, Investor A sees a 200% return versus the 50% return for Investor B.
How do I value properties?
I value properties a couple of different ways before deciding to make the purchase. I then look at all of the different valuations, and then decide how much to offer.
Property location means everything in real estate businesses. The three golden rules of real estate are:
Location affects how much you can rent your property for, the potential for future growth in value, and the stability of that value. Neighborhoods with a lot of crime and areas with low or negative economic growth will put a cap on your overall returns through higher vacancies, more maintenance and low or negative asset value growth. How do You Make Money with Rental Property? Buy rental property in great locations.
Property location is also affected by the zoning for that area. Could that residential rental be converted later for a higher and better use (a restaurant or doctors office)? Is it in a historic district that restricts use or renovations? Are there plans to build a garbage dump next door? Is the city growing? Is it a tax-friendly area?
Research your location carefully. You can change everything about the property (even knock it down and start over), except the location.
What condition is the property in? Does the current owner maintain the property well? Are his tenants happy?
Property repairs need to be accounted for in the purchase price. Additionally, I have seen that when acquiring a poorly-maintained property, costs are significantly more than expected to fix. Get professional estimates from contractors and create a budget for repairs accounting for everything (including lost rent) needed to fix up the property. Double this amount.
When looking at the financials, the first thing I look at is the asking CAP rate for the property. I use this to scan properties and remove properties that are overpriced.
What is the “asking CAP rate” for the property?
The “asking CAP rate” is the price the owner has placed on the property divided by the “owner’s reported net income”.
Why did I put “owner’s reported net income” in quotes you ask?
I put “owner’s reported net income” in quotes because I have always found when dealing with smaller property transactions that these numbers are inflated and missing critical expenses. Some of these omissions include:
The owners rarely include their time and effort in managing the property. Property management companies charge 10-15% of gross rents for management. This should be included in expenses.
Is the current owner the handyman as well? Then the reported maintenance expenses are lower than they actually are. Some owners tackle “How do You Make Money with Rental Property” by trying to do everything themselves.
This is a big one. Municipalities love to reassess the property at the new sale price. This can sometimes double or triple your property tax (especially in Florida). The current owner is showing their tax rate in the expenses, NOT your new higher tax rate. Make sure you find out the new rate and add it into the numbers.
Is the property currently insured correctly? If not, the cost for insurance is not accurate and is underestimated. I got hit with this recently on a commercial property purchase, and it added an additional $4,000 insurance cost to my annual expense. Not fun.
Get an insurance quote during inspections and if it’s incorrect, reduce your offer to the amount that equals the previous CAP rate at the end of your inspection period.
I always ask my broker (the one representing me in the transaction, not the seller’s broker) to run a comparative analysis of what other comparable properties are selling for in the same area.
This is a quick way to see if the seller’s price is reasonable compared to other properties in the area. The seller’s sales commission is being split by his broker and your broker, so the seller is paying for it anyway.
Your broker should offer this to you. If they do not, or if they try to charge you for this service, fire them and get another broker.
Comparison to REIT Returns.
Finally, I compare the anticipated returns from owning the property directly (with more work and risk) versus owning a REIT (with virtually no time expenditure and much less risk).
I ask myself –
Am I being compensated for the extra work and the risk?
If I am not being compensated for the extra work and the extra risk, I am overpaying for that investment. For example, lets take a look at Investor B from above again.
Property Price (Dollars)
Annual Net Income (Dollars)
Annual Income Return
I take this 5% return number and compare it to REIT returns. At the time of this article, Vanguard Real Estate ETF (VNQ) has a dividend yield of 4.09%. The question you want to ask yourself is that “does a .91% increase in possible returns for owning the property directly out weigh the risks?”.
Property Annual Income Return
VNQ REIT ETF Annual Income Return
Return Increase Versus VNQ ETF
From my perspective, this possible increase in return would not justify the work and the risk associated with direct ownership.
Buying VNQ is just buying the index. It takes no work to buy the real estate index and your risk is limited to just your investment (but to lose your investment would require the entire collapse of the US real estate market nationwide).
I put a little bit of work and research my REIT investments, so my portfolio is returning about 7.5% in dividend income annually. For me, I would need to see 14-15% returns to compensate me for the risk of direct ownership.
These deals are out there. I have seen 25% annual income returns on some of my rental properties. Be picky. Have the cash available to jump on an opportunity.
I see this all of the time. Property owners don’t maintain their properties.
I have toured some apartment buildings for sale that I couldn’t even walk into the apartments. Holes in walls, rotting floors, broken appliances, mold and other horrible living conditions. The current owners have just taken the money out of the building or haven’t had enough cash flow to pay for repairs. (See the “overpaying” section above).
Inexperienced property operators think the answer to the “How do You Make Money with Rental Property?” question is by extracting every last cent from the properties. They do not see the downward spiral that the property is taking over the long term.
Low quality landlords attract low quality tenants. It makes perfect sense. If the landlord doesn’t care about their property and their tenants, why do you expect the tenant to care about the property?
From an buyer’s standpoint, I love when property owners do this. When the current owner runs the property into the ground, they reach a point where the the property is losing money and they are constantly being hit with big repair expenses ($50,000 to replace a roof for example).
They put the property up for sale to reduce the bleeding, but quickly realize that any buyer is going to subtract repair costs from any offer. Additionally, most real estate buyers want “turn-key” income and avoid big renovation projects, so these beat-up properties receive far fewer offers. Since banks only lend on verified income, most of the offers will be all-cash offers.
There are very few people able to make these types of cash offers who are interested in distressed properties. These buyers understand the seller wants out of the property and frequently offer way below asking price, accompanied by a fast closing.
I have made my best purchases following this “distressed property – lowball offer – all cash – quick close” formula. You are able to secure huge discounts on the seller’s asking price, making this a good business venture.
You would never go on a cross county drive without knowing that there were gas stations along the way. You know that you need gas. Same thing applies to real estate operations. You need tradespeople to keep your properties in tip-top shape.
Plumbing will break, roofs will leak, appliances will need repair, AC units will need maintenance and replacement. This will also occur in the most inopportune times like holidays, weekends and during your vacation. Be prepared in advance.
Set up accounts with plumbing companies, electrical companies, AC companies, and other contractors before you get started. Make sure they have 24/7 service if possible.
Another tip is that certain companies have “maintenance plans”, meaning that they will come out for servicing equipment at various times during the year. This is great for keeping equipment running, but even better is that I have found they want to give the best service to clients on those plans, responding to those repair calls first. This is a huge plus when there is huge demand (like after hurricane damage in Florida). Good luck getting a roofer unless you have a pre-existing relationship with them, when all of the roofs in town have been blown off.
Interview and have eviction attorneys on retainer. Make sure you negotiate a standard price for a standard eviction before you need to engage your attorney to process an eviction.
Operational processes are critical for running any business, and real estate rental businesses are no exception. You need to create procedures to handle issues and to treat everyone equally. There are a lot of laws dealing with how you can treat tenants. Making processes at the beginning will keep you out of trouble in the long run.
I try to automate all of my businesses as much as possible. This includes setting up “automatic drafting” of rent monthly versus getting a rent check in the mail. Offer a slight discount for your tenants if they sign up.
Automate how your tenants communicate with you. Implementing forms on your property’s WordPress website is very simple to allow them to report damage. Using cloud telephone systems, you can create emergency numbers, route calls to multiple recipients, or have the system transcribe voicemail into an email for you or your team.
If possible, automate and streamline how you deal with your vendors. They will appreciate direct deposit into their accounts, having company credit cards on file, and how it all eases their daily operations.
First and foremost, your tenants are your customers.
You are entrusting your tenants with your property and relying on them to make timely payments. It makes sense to carefully screen your tenants, including a credit check and criminal background check.
For residential rentals, Zillow has an incredible tool that you can list your property for rent and run background checks on prospective tenants. Best of all it is free for the property owner.
Don’t Accept Partial Rent Payments
This isn’t legal advice, but don’t accept partial rent payments. This sets a precedent and “course of conduct” and may make future eviction more difficult. Your lease has stipulations regarding late rent. Follow your contract (your processes) since you are going to hold your tenant to the contract.
Act Quickly to Remove Problem Tenants
It may seem counterintuitive, but you are helping your tenants when you act quickly.
Removing tenants that break the rules and disturb other tenants shows that you care about your property and your tenants. Acting quickly and decisively shows that you are a professional company that has processes and follows them.
If they cannot afford to stay in that apartment, communicate with the tenant to get them out quickly. If you need to proceed with eviction, contact your lawyer and get started quickly.
I hope these tips help answer “How do You Make Money with Rental Property? “ and give you concrete steps if you decide to build this type of business.
Over the years, being a landlord has been a profitable business for me, especially when I could acquire the property at a great price or convert a property to a better use (turning long term rentals into a vacation rental property for example).
Owning and operating rental real estate is a great Income Lever and has Lever Rank, it is definitely not passive. There is risk and work involved and you can still lose money every year. It is a great way to build wealth and income over time if operated properly and purchased at the right price.
I have been transitioning more toward owning real estate through REITs and Crowdfunding, but I am always looking for a great deal. If I was going to leave you with one thing from these tips on making money with rental properties, it would be not to overpay when you buy the property.
Great properties, in great locations, that deliver great returns, and are for sale at a great price, do not come along often.
How do You Make Money with Rental Property? Be picky.
Take your time and choose your properties wisely.