If you’ve been following the presidential race and know anything about Donald Trump, you probably know that his family business is built on real-estate. And lately, there’s a lot of buzz about how Trump’s real estate businesses strategically applied the tax code to minimize taxes owed. Regardless of how you feel about the election, the candidates, and how they’ve built their own wealth, you should know that real estate can be a very lucrative means of wealth creation, and consequently, early retirement. Sure, there is some hard work involved, and there are tough lessons along the way. But as with anything, if you’re willing to put in the effort, you can expect big rewards.
I got into rental properties almost four years ago. A friend of mine had already started a real estate empire of four duplexes. He created his little empire over the span of about four years, while working a full time job and supporting a family. At first I thought this guy was nuts! That’s wayyy too much work on top of a day job and family commitments. Don’t the tenants keep you running around in circles? What about those dreaded 2 AM plumbing calls???
My misconceptions of what “landlording” involved persisted. It wasn’t until I read the book “Killing Sacred Cows: Overcoming the Financial Myths That Are Destroying Your Prosperity” by Garrett Gunderson, that I realized I had a lot of work to do to diversify my portfolio*. After this epiphany, I approached my buddy and asked him to mentor me in becoming a landlord…
The first step was to recruit my friend’s real estate agent, who specializes in income property. This guy really fit the bill too. He’s no non-sense, cautious, and an experienced landlord. We looked at probably a dozen properties before I found the house I’d eventually call “Rental A”. At showings, my agent would point out things I’d have never noticed, that would’ve been a code issue upon city inspection. For example, “Ummm, that basement ceiling needs to be at least 6′ 9″ to be a legal bedroom…” sigh. But the kitchen has stainless appliances! WAHHH…
I’ll admit, through much of the process of house hunting, securing financing, and closing, I was pretty nervous about the new responsibilities I’d be taking on. First off, I had to find a tenant. Second, I had to figure out the Minneapolis landlord rules and get my property licensed for rental use. So many boxes to check! This is when you start to wonder, “Should I just put that down payment into an index fund, no fuss, no muss??”
Without much hassle and without having to take more than a single day off work (for the closing), I got the house spiffed up and rented within six weeks of closing. Whew! Here’s the main thing to understand about the passive income nature of rental homes: 80% of the work involved with landlording occurs at the very beginning, in those two or three weekends of concerted effort, after assuming ownership of the house. Your time will be spent cleaning under appliances, cleaning the appliances themselves, painting, replacing fixtures, screens, and whatever landscaping needs taming. It’s a lot of grunt work, mixed with a sprinkle of design (the fun stuff, like putting knobs on kitchen cabinets, or replacing an old faucet.)
The other 20%? That’s to do the occasional maintenance work like clearing gutters, planting a new tree, checking in new and checking out old tenants, and cashing rent checks. It’s very manageable, once you’ve teed-up everything at the outset.
So what makes rental houses so great?
Let’s compare two scenarios where you have $30,000 to invest, and no credit card debt or auto loans:
- Stocks: Put 100% into a total stock market index fund with low admin fees, and assume a stable rate of return of 5% per year (after inflation).
- House, Then Stocks: Put 100% into a down payment on a $150,000 rental house with $1,400 monthly rents, then, sock all of the rental profit into the same total stock market index fund in option 1, year after year.
Here’s the 30 year projection of returns:
The spike for “House, Then Stocks” in Year 30 depicts the sale of the rental house, assuming no appreciation. In reality, you could expect a very decent return on the value of a well-picked, well-maintained rental over a period of time. Additionally, rentals have very favorable tax treatment that would further stretch the gap in the chart above.
Now just imagine if instead of option 2, you rolled your initial rental home’s profits into down payment purchases of a second, and then a third, and then a fourth rental home, and so on. You can see we’re generating a substantial cash flow snowball effect. Early retirement becomes that much more achievable.
How to Become a Landlord (and Make Money) in 10 Steps:
- Location is everything. Explore Craigslist to determine rents in neighborhoods you like. (Yes, I said “like”. If you can’t envision yourself living there, then don’t become a landlord. You won’t appreciate the property and it will show.)
- Know the market and set your income expectations. Cross-reference rent prices with Zillow.com to determine the spread between the monthly mortgage (property tax and hazard insurance included) and monthly rent. This spread is your cash flow. I personally target $500 per month, and that’s after factoring in about $1,000 per year in maintenance expenses. There’s other metrics you can use to decide if the property is a good investment, such as CAP rate and Cash-on-Cash, but focus on the spread for now.
- Set aside money for a down payment. You’ll need 20% (single family house) or 25% (multi-family duplex or quad-plex) of the purchase price up-front, or roughly $30,000 for a $150,000 single family house. A good place to start would be your tax refund (if you get one), as it is typically a large amount of money all at once. You can use a free income tax calculator to give you a better idea on what you can expect back.
- Get the right real estate agent. A good agent who has experience as a landlord and property manager is a must. Even better if he or she manages rentals in the neighborhoods you’re considering. An experienced agent will not be hesitant to walk away from iffy properties and will be able to point out all of the potential problems so you don’t have to learn the hard way. The agent will get you hooked up with the MLS online so you can check out new listings as they pop onto the market.
- Shop around for a good rate, but try to get pre-approved from a local mortgage broker. I prefer having a local mortgage broker I can meet with in person, if necessary. I’ve worked with the same guy for all four of our properties and we’ve built a good working relationship. Since the housing crash back in 2008, underwriters have really ratcheted up scrutiny on all loan approvals. Be prepared to provide a lengthy paper trail prior to getting the bank’s blessing. You’ll give that office fax machine all it can handle!
- Shop around. A LOT. You can’t be too picky, but you certainly don’t want to rush the process. You want to make sure this rental property hits all the key criteria:
- Close to amenities like markets, schools, mass transit options, playgrounds, parks, lakes, restaurants, etc.
- The foundation is SOLID. Spend most of your time in the basement. That’s where the money is lost if you start off with old mechanicals, collapsing foundation walls, and water seepage issues.
- Make sure the surrounding houses up and down the block are in as good or better condition than your rental. You don’t want the opposite, where your rental is the castle of the block.
- The roof is in good shape and has at LEAST five years of life left in it.
- Avoid funky configurations. Crazy bedroom dimensions of 14’ x 6’ aren’t all that functional. Neither are bathrooms right off kitchens. I just don’t get those. Ick.
- The windows are solid. You don’t need anything bright shiny and new, but you sure don’t want a house full of rotten windows to replace ($$$)
- Put in an offer, and light a candle. But be prepared to lose if you’re in a hot market! I can’t tell you how many times I’ve lost out to competing bids on properties. Easily a dozen, just in the last couple years. That’s not from coming in too low as much as sellers love cash buyers, and they also appreciate homestead buyers a bit more than us picky investors. With that in mind, be reasonable with your offer but never ever remove the inspection contingency. Ever!
- Find a QUALITY inspector. This is important. Unless you know the ins and outs of a house from electric, to structure, to plumbing, etc., do not take chances with your choice of inspector! Thanks to online reviews in Google and Yelp!, I was able to find a quality shop that earned every nickel with their attention to detail.
- Make sure your upfront repairs and improvements are minimal. I use a 3-5% of the purchase price rule since my rentals are more “turn-key” in quality. That’s about $5,000 – $7,500 in upfront expense. If I spend any more, my return on investment starts to take a turn south. You can get away with a higher per cent if the home is a rehab job or a foreclosure.
- List the house on Craigslist! We’ve come full circle from step 1. Get your post up as soon as you’ve closed on the house. Try to get a hold of the listing photos from the seller’s agent, and upload at least one photo per room, and include an exterior shot. Assuming they’re good quality images, you can re-use them over and over.
- Try to keep your rentals within a 10-15 mile radius of your home. This is especially true if you’re managing the property on your own, which I recommend.
- Create a pay-it-forward system where your soon-to-be leaving tenants show the home to prospective new tenants. This saves you, the landlord, time and travel, and saves the current tenants the hassle of having to clear out for showings. It also gives the current tenants incentive to show it well, to avoid having the hassle of showing after showing until someone signs a lease.
- Make your Craigslist listings the best of the best. Use good photos that rely on daylight and show a clean, clutter-free house. Pretend you’re writing a blog post – the more content and detail, the better tenant you’ll attract.
- Obtain lease agreement and lease application templates from other landlords renting in the same area. You can do this by conveying interest in a Craigslist post. Read each form carefully and be sure the lease is thorough and covers your interests, end-to-end. Nolo.com is a good resource if you prefer to start from scratch. I got my templates from my mentor.
- Put a provision in your lease allowing a lease buy-out. This allows a tenant to move out early, without having to owe for every remaining lease month. The tenant would pay a lesser “penalty” fee per month, but not more than a third of what rent would be. This softens the hassle of having to find new tenants, but also more importantly, provides an incentive for tenants to STAY PUT.
- Make sure closing occurs no earlier than late spring, and no later than early fall. You want to be able to rent this thing right away to avoid vacancies right after closing. Fewer tenants are looking for a place to rent during the holidays and winter, particularly in the colder, northern states.
- Treat your tenants like customers. Get back to them quickly and resolve problems quickly. Congratulate them on big events, like marriage, newborns, etc. The little things will build trust. You’ll be returned the favor when they tell future tenants what a great landlord you are at showings!
I owe a lot to my friend and mentor who helped me get started in the world of rental properties. He’s not so nuts after all. It’s a daunting thing at first, but after that first house, you will be a seasoned landlord. Just remember what I said at the outset. There are some hard lessons and it’s not all roses. In a forthcoming post, I’ll share some of my epic real estate fails and close calls. Maybe you’ll learn some useful nuggets, or at least be entertained in the process.
Now, who wants to be a landlord?
* I can’t whole-heartedly recommend the book, because I still invest in a 401K (stock index funds, low fee), and I don’t carry a whole-life insurance policy. The book is a worthy read, if for no better reason than to get you focused on the wealth-generation side of the early-retirement equation.