Many people have grand plans to develop passive income streams as part of their quest for financial independence. Some plan to retire very early (the FIRE set) and live on a strict budget once they’ve got their passive income rolling in, and some plan to retire more or less on time but to live well in retirement by using the passive income as a bonus on top of their other retirement income sources (that’s me!). Planning is only part of the battle, though. Many people form their plan and then sit frozen on the sidelines for years because they’re unsure of where to jump in. Becoming a landlord isn’t easy, and you should expect that there will be challenges along the way. But that doesn’t mean it’s not worth doing. In this post, I hope to give you the basic steps for how to become a landlord, to help you summon up your courage to get out there and do it.
The Benefits of Being a Landlord
You probably already know this, since you’ve likely been reading article after article about the benefits of owning rental property. But let’s briefly recap the reasons why you might want to be a landlord:
- Being a landlord will give you passive income. Your money will literally earn you more money as you sleep. This is assuming you do it correctly, of course, but that’s true with any investment.
- Being a landlord will give you flexibility. There are a number of ways that real property (i.e., land and buildings) is much more flexible than other types of investments. You can live in your investment, for example, which is something you can’t do with other investments. You also have the benefit of doing a 1031 exchange if you want to roll your investment into a bigger or different property without losing a large chunk of your investment to capital gains tax.
- Being a landlord gives you the benefit of a current income stream and capital appreciation. You can use the rental income to pay down the mortgage, and then eventually the mortgage will be gone, and you will have the cash flow and the increased value of the asset.
- Being a landlord will give you a tax deduction for depreciation, which can save you money now and make it easier for you to pay down your mortgage on your investment property. This tax break might give your budget enough wiggle room to take on a slightly higher mortgage than you otherwise would, which means you’re investing in a bigger slice of capital, which might compound your returns as the capital appreciates.
How to Become a Landlord, In Four Easy Steps!
Okay, okay, so you knew all that already which is why you have already decided you want to become a landlord. You just need to know how to do it.
First: Run the Basic Numbers
The first step is to run the numbers. It is absolutely mandatory that you run the numbers on every property before you purchase it to make sure that it will work for you. On your first run through the numbers, you can ballpark some of these things to see if you’re in the right range. Don’t worry about identifying a specific building. The goal with this step is to figure out the basic range of properties you might be able to afford. The real specifics will come in Step 2.
Start by doing a cursory check on Redfin or Zillow to see what’s out there that you might be interested in. If you’re interested in fourplexes in a moderate income area, look at the general price range, and go with that. If you’re interested in duplexes in a particular city, go with that. Just don’t get too bogged down in details, or you might lose your forward momentum. Here are the numbers I’m specifically talking about:
- How much of a down payment do you currently have?
- How much will it cost to buy the sort of rental property you would like?
- Is your down payment at least 20% (and preferably more like 30-40%) of the purchase price of the rental property? If not, go back to #2 and adjust.
- How much gross rent will the property generate? Compare average rent rates in the area. Don’t just use Zillow’s rent estimate. Look at actual advertisements for comparable apartments in the area and use those as guidelines.
- Did you reduce the gross rent to account for vacancies? For Step 1, assume that there will be vacancies of about 5% of the gross rents. When you get to this point again in Step 2, you’ll need to research the demographics for the city where you’re considering purchasing. In some areas (like where our current rental building is), the typical vacancy rate is around 2-3%. In some other areas, like the rougher areas of Long Beach, which is within 15 miles of our building, the vacancy rate is more like 10%. KNOW YOUR AREA. It requires just a little bit of online homework, but it can save you from making a bad investment decision.
- Calculate your expected expense ratio. This will vary depending on the size of the building, the age of the building, whether there is any deferred maintenance, and whether you are planning to manage it yourself. On the very low end, I would assume expenses of 35%. On the higher end, maybe 45-50%. Consider these factors when choosing a number:
- If the building was constructed in the 1970s or later, and if it already has a newer roof and updated dual-pane windows, odds are your expenses are going to be lower than if the building was constructed in the early 1960s, has galvanized plumbing that is about to completely disintegrate, and has an aging roof and all original windows. Take a hard look at the expensive stuff: roofing, windows, plumbing, concrete and asphalt. Look for foundation issues, cracked walls, things that scream “major dollars.” Paint is easy, vanity cabinets and countertops are easy. Ignore all of those. It’s the big stuff you have to pay attention to.
- Are you planning to make some repairs by yourself, or farm everything out to a handyman or other repair person? If you’re moderately handy and have access to Youtube, you might be able to tackle some fairly simple repairs yourself and save yourself major expenses (like a 10-minute dishwasher fix I did a few months ago instead of paying $100 for a repairman to come and replace the latch). Youtube is great for looking up how-to videos. There’s also a great book that I have used as a reference for the past decade or so: Big Book of Home How-To. I lovingly call this my “How to Do Shit” book.
- Are you going to manage the property yourself? For smaller properties, say 1-4 units, it really doesn’t make sense (to me) to use a management company. They’ll charge you about 10% of the gross rents, and often a little additional amount for getting new leases signed or having to follow up and collect late fees. Plus, the management companies have to hire someone to fix everything. They may save some costs by having a maintenance staff that works on multiple buildings, but even that is going to be far more expensive than doing it yourself.
- Calculate the approximate mortgage payments for the loan you will be taking out on the property. I recommend creating your own amortization schedule rather than going on Bankrate or your preferred bank’s website to see what they say the loan payments will be. It’s just faster to tweak your own numbers in the amortization schedule than to go into those websites over and over again to tweak individual variables. Plus, you can use the amortization schedule to see how much principal you’re paying down, and how fast you can pay the mortgage down just by paying a little extra each month. (It’s all about that positive financial momentum!)
If you’ve done all of those steps, and you’ve determined that after collecting the rents, accounting for vacancies, paying expenses, and paying the mortgage, you will have a little positive cash flow at the end of each month, then you’re in good shape. If not, re-work your numbers. Figure out if you can buy a cheaper property and hit positive cash flow numbers. If not, figure out how much your down payment would need to increase and how much the loan amount would need to decrease to make the numbers positive.
Second: Identify the Specific Property You Want
After you’ve done the basic once-over on the numbers to make sure you’re in the right ballpark, now it’s time to research specific properties. Read this post on how to choose an investment property. You’re going to go back over all the steps in Step 1, but this time using actual numbers for each of the properties you’ve found.
You’ll need a big spreadsheet to compare the buildings you find. I know it sounds like a lot of work, but that spreadsheet is going to be your best friend when it comes time to choose a property and make an offer. When you’re comparing a dozen or more properties, it’s impossible to remember how much rent one building was generating, the year it was built, or whether it had adequate tenant parking. Putting all that information in one place will save you a ton of time.
In addition, the spreadsheet will help you when you’ve identified the key factors that matter for you (cash flow, for example), and you can easily sort your spreadsheet according to those key factors.
Even better than that, though, the spreadsheet will help you when you’re negotiating on price, because it will give you a handy reference to use when comparing cost per square foot, cost per unit, and cap rate. You can easily calculate the averages of each of those numbers to determine whether you’re paying a fair price for your new property or not.
Third: Make an Offer and Buy It
By now you’ve done your preliminary homework on the property. You’ve run the numbers and checked city-specific demographics. You’ve checked out the property by driving by at least once during the day (maybe on a weekend) and at least once at night. You know what the comparable market rents are, and whether this particular building has above or below-average rents.
While you’re in the early stages of escrow, during the contingency period, you need to do all of your final investigation. Look at all of the rental agreements on the property and make sure you can live with them. Check to see if the rent rates were increased dramatically in the recent past. If they were increased just a month or two ago, you might have some vacancies coming your way soon. You could talk to the tenants to see if they’re planning to stay, or you could ask the current owner/manager if any tenants have given notice that they are planning to move. Have the building inspected, and make sure you are okay with the results. Read the inspection report thoroughly, and preferably read it twice. Make sure that you’re aware of any major defects and that you have adequate financial reserves to cover them.
Also, pick up a book or two on landlording. My go-to book when I first started was the Nolo Guide: The California Landlord’s Law Book: Rights & Responsibilities. Read it during the early stages of escrow, or even before you put in an offer on a property, to make sure you understand the basics of what you’re getting into. You don’t need experience to become a landlord, but you do need to be smart about gathering information and treating it as a business. Also, get your forms ready. You can find some good landlord forms online for free, especially if you look at different law firms that handle evictions.
Now you have finally become a landlord. For the first couple of years, make sure that every penny of cash flow you get is saved, to build up a good reserve to cover major expenses. After that initial break-in period, you will probably have a better idea of the amount of reserve you need to keep for major expenses. If you get cash flow above and beyond that, I recommend paying down the mortgage a little extra each month, or building up another savings account for a new property.
That’s it! You finally made the big step! You will learn a lot in the coming years, such as how to identify bad tenants, when you might need to fire your manager, and how to resolve tenant disputes (part 1 and part 2), but all of that comes with time.
Have you bought your first rental property yet? Have you been sitting on the sidelines waiting for the right time to jump in? If so, what’s holding you back?