I received the following response via email to yesterday’s question about purchasing rental properties. The sender gave me permission to publish it in full, and since it’s so full of great insights, I decided to do just that (with minor edits for readability).
I bought a mid-50s vintage 5-plex in North Everett with water views from 3 of 5 units and unit sizes ranging from 480 sq. ft. to 700 sq ft. in mid-2001. I did not read any books on the topic before investing. But I did speak with several experienced landlords. Based on my experience over the past 11 years, I would share the following with potential rental property investors.
The math of evaluating a rental property is simple. The art comes in making appropriate assumptions about what numbers to use. Some of the trickiest ones in my opinion are vacancy rates, market rents, appropriate cap rate, maintenance reserves, and maintenance expenses
There are a number of decisions that you have to make before you can make appropriate assumptions.
Which activities associated with running the business are you capable and willing to be involved in?
You’ll need time for accounting, tax prep, marketing, advertising, maintenance work, process development, surveillance, banking, landscape maintenance, cleaning, etc.
How much time do you have to be involved in the above activities? When I started out, I was single and had a job as an engineer. At that time, I did everything except heavy duty plumbing and flooring installations and it took most of my free time. Now I have a young family and am a Project Manager and so have no free time. I hire professional help in most of those categories now. That changes my costs. Fortunately, rents have increased and costs have dropped over the last 10 years and so I can absorb that.
Don’t forget taxes.
I’m sure I don’t need to remind an accountant of this, but for others it’s important to run your analysis on an after-tax basis. See what taxes do to your projected “profit” and also what your “profit” does to the tax rate on your other income.
Are you going to be a cash buyer or are you using financing to buy?
Be sure to consider the fact that fixed-interest rate loans are generally not available for properties that have more than four dwelling units on them. Variable interest rates can put significant variability into your expenses. How high might rates go? How soon? My timing was lucky and so my rate has dropped significantly since I bought.
Also, banks usually expect much higher down-payments for properties with more than 4 units and especially if they are not owner occupied. I lived in one of my units for a number of years while I was single. This limits write-offs in some cases.
What quality level do you want to provide your tenants?
On one end of the spectrum, you can be a slum lord, minimize cash out for maintenance, but at some point end up getting a lot of calls in the middle of the night for sewer floods, etc. My job wouldn’t allow for unscheduled interruptions, so I chose to reverse all the deferred maintenance and upgrade as many items as possible to low-maintenance configuration. That took time, money, and some trial and error until I found the combination of products/configuration that held up well. On the other end of the spectrum, you can reinvest all your profits (and more!) into maintaining/improving your property and build equity (to a point) and usually have a more stable business and predictable income. A third option is to buy something nice and then just ride it until you can’t stand the hassle anymore and then sell for whatever you can get.
What kind of tenants do you want to deal with?
You can fill your units quickly if you have no limits on who you take. Lower vacancy rate, but probably higher eviction/collections rate and you’d better have a degree in psychology to keep up with all the mind games they will play with you. If you have tenants who have money but bad credit, you will still have lots of fun trying to collect from them if they cause damage. They don’t have a credit rating to lose so no incentive to cooperate. If you take tenants with long and clean credit histories and good rental references, you may wait longer to find them (higher vacancy rate) but will find them more cooperative if push comes to shove over damages because they don’t want their clean 20-year credit history tarnished. Pre-bubble, those individuals usually bought houses. There are more of them out there now and more inclined to rent (thanks in part to the fantastic data published on Seattle Bubble by the Tim!).
Location is a huge factor.
As with a house, make sure you have checked for undesirable factors before buying. Your proximity to things like busy/noisy streets, noisy industry, train tracks/yards, pollution/odor sources, high crime areas, high tension lines or pipelines, are all factors that should affect your assumptions
Conversely, things like a view, “nice” neighborhood, or convenient access pay dividends over the long run in being able to command comparatively higher rents, having lower turn-over, higher quality tenants, and less hassle. Of cause this may come at higher initial cost.
Consider not only what the condition of the neighborhood is but the direction it’s heading and the rate of change.
Consider the home’s layout and internal features.
Make sure that the property you buy contains units whose layout and furnishings are what most people are looking for (size, storage, appliances like dishwasher or washer / dryer). If the units are quirky in some way, it will be a continual drag on the business. I have two units that have an entry configuration (90 degree turn) that prevents bringing any large furniture into the unit. Harder to find tenants. I have units with small kitchens and no D/W and no room to add one. Not popular.
How much deferred maintenance is there on the property you wish to buy?
Try to identify all the systems elements (roof, gutters, plumbing, water heaters, exterior paint, doors, appliances, HVAC, etc) that generally have a shorter life than the structure. Estimate how old each one is and identify the typical life and cost for each. Then you can create a graph showing your expected outlays by year. As an accountant, you know that some of these can be written off against income in the year incurred while others (like a roof) must be written off over a very long period (Capital Improvements). I learned this lesson the hard way. Knowing what I do now, I would try to get the seller to take work orders for as many of the Capital Improvements as possible before buying. They can write them off against their gains in the year of the sale. If you pay for them after purchase, you may not recoup that money for 27.5 years (and after considering inflation, you never will).
How much insurance will you want to carry?
Umbrella (excess liability) is highly recommended for landlords and relatively inexpensive. Earthquake (or DIC) can be very expensive and tends to be more expensive or unavailable with certain types of architecture (like brick exterior or not secured to foundation, or post-and-pier foundations). But consider that fact that you may be on the hook to provide temporary housing for your tenants for the remaining term of their leases in the event and EQ damages your building too much for habitability…and that available temporary housing may come at a premium cost in the event of a substantial EQ.
Know the law.
Before buying rental property, read RCW 58.19 (aka Landlord Tenant Act) in it’s entirety and decide whether you can be successful doing business by those rules.
Subscribe to one of the major rental housing news letters such as On-Site. These journals contain articles which can fill in any gaps in your knowledge. For example, these articles often contain advice on how to handle some of the difficult and/or uncommon issues faced by landlords (fair housing questions, tenant fatalities, bedbug or mold infestations, etc) as well as market status (vacancies, prices, incentives, etc).
Another good source of data for landlords of smaller units is the 5-19 Unit Market Report published regularly by Dupre + Scott Apartment Advisors.
The art behind establishing the cap rate should, in my opinion, take all these factors and more into account.
I put 20% down (half of that borrowed as a 2nd) and have subsequently increased the size of the second to handle a new roof. I have reinvested all profits since purchasing and invested some of my own money. I am just now at a point where maintenance is minimal, vacancies low, rents at market. I expect to pay down my 2nd mortgage within the next 4 years and then will have a monthly cash flow of ~$1K after all expenses and tax effects on gross rents of ~$4k/month.
There is more that could be said about many of these points, but… then it would be a book! Hope this is a helpful starting point for someone.