Buying a Home to Rent

Buying a Home to Rent

The business of rental property investing changed with the federal tax act of 1986. Before the income tax law changed, you could use losses from rental properties to take your taxable earned income to zero. That allowed you a profit from tax savings, even if the property had a negative cash flow. Today, you must plan on a positive cash flow because low inflation means that it can take years to get much appreciation in value. Of course, in some areas of the country homes are increasing in price because of demand created by low interest rates. I would not count on low interest rates over the long term to create equity increases. Even with the changes to the tax laws, income producing real estate is the best long term investment for active* investors.

The fastest method of increasing your net worth using rental real estate is to buy fixer uppers, and gain the sweat equity.

Rental real estate offers multiple ways to make money on each deal, here are a few of the ways. The rest of this web site will outline them in a little more detail, and offer a few more ways to make money using real estate, plus some profit secrets.

* Check the IRS pamphlets for passive loss rules. http://www.irs.gov/
The IRS says you must materially participate in the management of the investment to use a paper loss on rental property to reduce your earned income.

Ways rental real estate can make you money

1. Monthly positive cash flow from rental income

2. Income tax savings, from depreciation.

3. Equity increase from buying for less than the market - (appraised value) or from improving the property.

4. Protection from inflation by increasing rents over time.

5. Increase in the properties value, over time, from appreciation.

6. Equity builds up from paying down the principal mortgage balance with the rental income.

7. Interest income if you later sell the home and carry the note.

8. Equity increase from raising rents and appraising the property based on net income
If your personal adjusted gross income is over $150,000 per year consult your CPA about real estate loss deductibility limitations.

How much money do I need?

The dollars you need to make real estate investments range from zero, up to 30% of the purchase price. That is the nice thing about single-family homes; they are everywhere, in all price ranges. The dollar amount of investment cash needed depends on where you get the money to finance the purchase.

If the homeowner is acting as their own sales agent and they have a vacant property with payments due, they may let you buy with no down payment. Zero down deals are hard to find and personally I do not like them because the seller would have to bring a check with them at the closing to cover their closing cost.

If the mortgage money comes from a bank, the bank will want 20% to 30% down on rental homes. There are also homes with assumable notes. There are deals where the seller refinances the property they own to get some cash out, and then they sell the property with owner financing. There are contract for deed notes, rent to own, bank repos, and many more methods to enable you to put a deal together. (See creative financing).

Which House to buy?

The one that will provide you with the most net monthly income - (positive cash flow). The more monthly net income you end up with, the easier it will be to buy the next house. You also need the positive cash flow to do repairs, to cover vacancies, and to increase your net worth. The price of the home by itself is not important. What is more important is the monthly rent amount, length of the lease, condition of the home, length of time to get it rented if it is vacant when you buy it, the overall condition of that area of town, and the interest rate. You will find each deal is different and you must keep in mind your total monthly cost (in a ready to rent condition), and how that compares to the rental income. If you cannot make the numbers work - (a positive net monthly income) - do not do the deal.

What price to pay:

If the numbers do not work, any price is too high. By the time you make an offer on a home, I would hope that you have looked at 50 or more houses to get a feel for the values, the neighborhoods, and the markets (current) rental rates. Do your homework because it will save you money, and/or make you money. A good deal is one where you end up with a net positive cash flow each month. Remember, you make your money when you buy right. You are not looking for the perfect deal, only the profitable deals.

At what Interest rate:
That depends on the deal. A low interest rate with a large down payment is not as good a deal as a higher interest rate with very little down payment. This is true because, if you have a lot of cash tied up, you have less interest deduction come tax time, you will not be able to do as many deals, plus the loss revenue on the large down payment. A lower down payment is better if everything else is good. You can always refinance if rates drop. I would rather have two homes where I paid $5,000 down each - (assuming positive cash flows) - than one home where I paid $10,000 down.

Payment amount:

You want, at a minimum, a payment that is 20% less than the monthly rental income on single family houses. That would allow for a 20% vacancy factor. If the house is vacant 2 months a year you would at least break even, and you still have your tax savings and equity build up from paying down the loan. Isn't that nice? Even if you break even from cash flow, you still get a little richer long term from increasing property values, future rent increases, and paying down the mortgage with the rent money.

Down Payment:

The less money paid down the better. I try for 4% down. That is $1,000.00 down per $30,000 financed, with as low an interest rate as I can get. My favorite deal is one where the owner finances the house with $1,000 down at 6%, up to 10%, interest. I then refinance as soon as I have paid down the loan by 10% or more - (that can take five plus years).

I find the house, cut a deal with the seller, call the title company for an estimate of my and the seller’s closing cost, and I then raise the down payment enough so that the seller does not have to write a check at closing to sell their home. That way, they do not ask me to pay their closing cost. And that helps to keep the sellers in a positive mood. The sellers will also be more inclined to work with me as I am going to ask for access to the house before closing so that I can get it ready to rent the day after closing. That way I collect a deposit from the renter, and the first months rent money, weeks before I have a payment due. I set the mortgage up so that my first payment is not due for 45 days. I collect the second month's rent to make my first payment with. If I do this correctly my cash flow covers my down payment, or a large part of it.

Property Condition:

This depends on your investment style and your available cash. The closer the house is to being in a rentable condition, the better. The longer it takes to get a renter in the home, the more money you will need to carry the deal. If the purchase price is low enough, I would take a fixer upper and gain the sweat equity. Look at each deal on its own merits and consider your abilities, and your available time.

Location:
If you want to charge a high rental rate to attract a better class of renter, you will want property located in good neighborhoods with good schools. Otherwise, you will need a low priced home that allows for cheaper rents to offset a less than desirable location. The longer someone stays in your house the better. People will stay in a home year after year for lots of reasons. One of the primary reasons is because their kids are in school. If the area is not the best, and the schools are not the best, you will need cheaper rents than are available elsewhere in town.

Buy rental properties in the city where you live as you will be more familiar with the area and management will be easier.

Finance terms:

If cash flow is your goal or resale in the near future, then 30 year mortgages, preferably with assumable loans, are best. If you plan to hold the home until it is paid for and then sell the house and carry back the mortgage yourself, then a 20-year mortgage will pay the home off faster. Avoid balloon notes of any kind - (notes where a large balance is due in a lump sum) - unless you are an experienced investor and have the assets to get a loan under any conditions prevailing at the time the lump sum comes due. The longer the term, the lower the payment, and the larger the net cash flow. The shorter the term of the loan, the faster equity builds up as the mortgage is paid down and the lower the net cash flow. See the section of this web site "where the profits are".

Multi-Family Homes

Multi family homes are better than single-family homes because they produce more cash flow but they are harder to resell as most buyers prefer single-family homes. Look for duplexes or homes with garage apartments, or apartment buildings. Be very careful when considering large homes that have been converted to apartments as they tend to be poorly converted with a lack of sufficient parking and very hard to resell.

Unless you get into buying large apartment complexes, you will find that what applies to buying and renting single-family homes also applies to multi-family. The biggest advantage to multi-family properties is that more than one renter on a property can improve the cash flow. Check for adequate parking space when buying multiple dwelling units on the same property parking problems are the number one complaint of tenants.

Check the helpful links for web sites that might help you locate bargain properties.

"Earned success arrives on each hour, is this your hour?
Jim Glasgow