The decision to become a landlord is certainly exciting – the search for a property, marketing for a tenant and potential to bring in money every month.
But before you go buying the first empty house you see – or worse, a house you didn’t even look at – know that your investment is better made when you’ve carefully run the numbers.
Even when you’re just renting out a single-family home or duplex, real estate investment isn’t as easy as it may seem. A smart investment requires a look at market rents, a calculation of income potential and consideration of additional costs to both prepare a property to rent and make long-term repairs.
That’s not to mention factoring in costs you would have to absorb if the property sat vacant for any period of time. Bryan M. Chavis, a property management consultant and author of “The Landlord Entrepreneur: Double Your Profits With Real Estate Property Management,” says the potential for failure is often overlooked by excited rookie investors.
“A lot of people get anxious to participate in a deal, so they’ll take on more risk than what is necessary or they’ll jump into a deal just because it’s listed or they feel it’s a good deal … and they’ll rush into an investment that doesn’t make sense,” Chavis says. “And that’s are where the mistakes are made.”
Every investment property requires a careful assessment of the value of the property, amount of debt you’ll take on, expected income and other operating costs. Those property-specific numbers are also dependent on the local rental industry. Here are four things to consider as you look for the right rental property.
Find the market and submarket. A property in your neighborhood may seem like the most convenient investment option, but that doesn’t mean it’ll be worth your time and money. You first need to identify the best market for your investment, plus the submarkets – often broken down into neighborhoods – where a rental property will be most fruitful.
If you’re planning to manage the property yourself, your local market makes the most sense. Now, narrow down submarkets based on where renters are more likely to search – for example, near public transportation or within easy access to highways. Regardless of the tools you use to find and purchase available properties, a more general search on a site like Zillow, Apartments.com or Rentpad could show you where rental properties are most common and at various price ranges.
“The process begins with evaluating a targeted area,” Chavis says.
An ultra-luxury neighborhood nestled far from downtown might leave you hard-pressed to find renters, but on a street where new renters are always moving in you might have found a submarket to focus on.
Off-campus student housing is an easy-to-identify type of rental property that excites investors. Woody R. Fincham, vice president and Virginia regional manager of appraisal company The Trice Group, resides in Charlottesville, Virginia, home of the University of Virginia, and says investors tend to keep much of their attention on properties within walking distance to campus because the increased demand allows for a higher rent.
“If they’re within walking distance of [University of Virginia grounds], that generally is a premium, so investors are generally looking for that,” Fincham says.
Weigh property class options. As you identify the submarket that will yield the most demand among renters, also consider the quality of the property you’d like to own based on what you can afford and what renters flock to.
Property classes are typically broken into three categories: A, B and C. Properties in Class A will be the top quality in that market, typically new and higher priced. Class B properties tend to be a bit older but well-maintained. Class C properties are older still, often in need of renovations and repairs and located outside the prime real estate locations.
Age, architectural style and renovation specifics can vary based on location. A Class A building in New York City isn’t going to compare with a Class A building in Huntsville, Alabama, simply because they attract two different types of residents.
You may be better off focusing your investment toward a Class B or C property, because while there may be some required work on the property, you avoid narrowing the pool of potential renters with an expensive rental rate.
“Typically investors are looking to buy low, and they’re usually looking to buy stuff that’s not in the best condition,” Fincham says.
For that reason, Chavis says, you’re also less likely to feel the negative effects when real estate trends shift. If you rent only to the super-wealthy, they have the flexibility to choose to buy a home fairly easily, which shrinks the demand for luxury rentals, compared to other renters, who rent for longer since they have to save up to become homeowners.
“I see a lot of risk and a lot of volatility in those [Class A] sectors – more so than do the B, C, middle-class demographic assets. I feel those are a tad bit more stable,” he says.
Know the most likely renter. Closely paired with the property class to buy is the renter most likely to be interested in becoming your tenant. That person is a key component into the kind of renovations and upkeep you’ll need to maintain the home.
For off-campus student housing, for example, landlords often don’t have to be as concerned with providing new appliances or newly painted walls as they would with a family recently relocated by a major corporation.
“Students are not as persnickety, per se, as the average consumer,” Fincham says.
When it comes to identifying the most likely renter, it helps to be familiar with the area. Arik Kislin, a real estate investor and developer and CEO of Linx Industries, says it’s important to have a solid grasp on the typical renter in a neighborhood, or at least work with someone who does. Not knowing the regional and ethnic makeup of a neighborhood like Jamaica, Queens, in New York, he says, could mean that people simply don’t want to do business with you because you’re viewed as an outsider.
“You don’t want to be the odd man out … because it’s not going to be accepted well,” Kislin says.
Plan for the worst-case scenario. Whether it’s a recession that hits or even an increase in homeownership rates, there’s a possibility you’ll have to lower rents at some point to attract renters. If the city or neighborhood you live in undergoes serious changes, your rental property may even sit vacant for months.
It’s important to know how long you’d be able to afford fronting the costs of a vacant rental space or how low you could make rental rates before you’re no longer profiting.
Even with the current rental climate in most markets, with high demand and rents outpacing affordability in places like San Francisco and New York, Chavis says landlords shouldn’t expect rents to continue to climb at the rate they have in recent years. Median rent for a one-bedroom apartment in San Francisco currently stands at $3,390, according to rental information company Zumper. While it’s a high rent to be sure, it hasn’t changed much going back to the same month in 2015, when the median rent reached $3,530, a new high after increasing more than 13.9 percent from the year before, per Zumper’s monthly national rent reports. With affordability being a significant problem in the Bay Area, landlords shouldn’t expect to see major increases in rent going forward, and they can even expect more dips.
“These high, ridiculous rents are going to eventually reach a ceiling … which could cause some problems and issues,” Chavis says.
As you weigh the potential profitability of a rental property, include the possible scenarios of a plateau in rental rates, decline in demand and the occasional big-ticket repair that could take money out of the bank rather than putting money in. They’re not the numbers you want to think about when you picture yourself as a landlord, but they’re the numbers that can keep you from taking on a bad investment.