After months of evaluating options to invest my seed money and build a passive income stream, I finally took the leap of faith and bought my first rental property in August of 2015. The property was a single family home in a good neighborhood and good school district – kind of property which is classified by realtors as Type A. I was elated with my recently acquired skills of picking out the winners and dreamt of being the owner of multiple rental properties. But alas . reality has a sobering effect. Read on and learn from my mistakes and you will know how not to lose money on rental homes.
Rental property offers many benefits including cash in your pocket each month, tax benefits and equity appreciation– if you have bought the right property in the right location. When I first started buying rental properties, I had no idea what factors are truly important in ensuring financial success. I thought I had a good understanding about the market dynamics, but I learnt the hard way that it is more easy to lose money on rental property than to consistently make money.
Two and half years after buying my first rental, I was still at negative cash flow.
So what does my monthly cash flow look like?
Mortgage – $1025
Property tax- $710
Insurance – $85
HOA – $30
Appliances insurance – $50
Maintenance – $50
Total expense – $1950
Rental Income – $1900
So I was losing $600 per year in cash flow for the past two and half years. So far I had received the rents on time and had no vacancy, else even a 10% vacancy per year would have put me back by few thousands at least.
So what are the actual factors that can hurt your rental property investment?
Top Ways to Lose Money with a Rental Property
Price-to-rent ratio.
This term refers to how much it costs to purchase a property versus how much rent it can bring in. If the price-to-rent ratio on your property is high, you will consistently lose money every month. For example: compare property A purchased for $100,000 that rents for $1100/month vs. property B purchased for $560,000 that rents for $2350/month. Property A will easily cover the mortgage and expenses and then even leave some extra in your pocket each month and has a price to rent ratio of 8.3% (Price/Annual rent).
Property B having a P/R ratio of 19.85, however, may not even cover the mortgage each month .
Cities that score a high P/R ratio (SFO – 45 or NY – 35 as per 2017 data) are too expensive to buy and show low ROI on rental property income. Long story short, these real estate markets do not favor owning investment properties because you may not get a good return on the rental income.
Keep in mind that P/R ratio is not the only criteria which real estate investors look for, however this is an important one.
Poor quality tenants.
Assuming your price-to-rent ratio is intact, the next fastest way to lose money on a rental property is with bad tenants. Worse than ending up with bad tenants one time is ending up with bad tenants multiple times. The scenario – tenants decide to stop paying rent either intentionally or falls into hard times due to loss of job . You, or your property manager, file for the eviction immediately but even in the states where the eviction process happens “quickly”, this will still take some time. All of that can easily be 4-5 months of no rent coming in, along with the added stress.
If you have a mortgage on the property, you have to continue to make those mortgage payments every month regardless of whether you are getting income or not. That can be rough! Thousands will be lost in rent, but you are also spending potentially thousands on the mortgage and other expenses. Eviction process may also have collateral damage in terms of damaged properties or stolen appliances. Surely a bad tenant is a sure shot way to lose thousands of dollars quickly.
Maintenance and hidden charges.
The running cost of a property is not only the mortgage payment but includes property taxes, utilities, Landlords Insurance, mortgage insurance, contents insurance, HOA where applicable, and repairs and maintenance. I am talking roofs, HVAC systems, wiring, siding, appliances, sump pump, flooring, others.
Anyone who has ever owned a house, whether for themselves or as an investment property, knows how much these things can cost thousands! Not to say a newer property won’t have any of these problems, but the older the property you buy, the more you should allocate towards potential repairs or improvements.
One popular rule of thumb says that one percent of the purchase price of your home should be set aside each year for ongoing maintenance. For example, if your home cost $300,000, you should budget $3,000 per year for maintenance alone. Consider all these additional heads while computing the real cost of ownership of your rental property.
Declining or flat market.
What happens if the market you invested in starts declining? Maybe a major feeder industry goes out of business or the economy goes south or the quality of the neighbor hood deteriorates Either way, the value of your house will drop. The good news is the value of a house doesn’t matter if you aren’t trying to sell it, but if you suddenly need to sell or maybe you have a financing issue where you really need to refinance (like if you have an adjustable-rate mortgage that jumps, knocking out your cash flow each month), you might be in a spot.
Lets face it. Housing has never been a great investment option. For the majority of U.S. history – or at least as far back as reliable information goes – housing prices have increased only slightly more than the level of inflation in the economy. Only during the period between 1990 and 2006, known as the Great Moderation , did housing returns rival those of the stock market.
How to prevent the Losses?
All of the above certainly sounds horrifying. And the worst part is, those problems are so common in rental properties! That’s the bad news. The good news is that there are actually ways to mitigate many of those risk factors. Although even if you mitigate every single factor, you still aren’t guaranteed perfect success but you will have so dramatically lowered your risk that you are in a much better position for avoiding those issues.
What are the mitigations? These guidelines go for investment properties in general:
Buy in areas with good price-to-rent ratios. Make sure the market rents suggest that you will profit every month after all expenses, compared to how much you have to pay for the property. Spent adequate time doing a detailed study before you decide to jump in . Location is critical. You won’t find good price-to-rent ratios typically in places like Los Angeles, San Francisco and most Florida cities.
Do not buy in lower-quality areas. There is a tendency among investors to buy properties which are very low in cost and many times these properties are not in great condition and are in areas where typically the crime rate may be high or schools may be of poor quality. Not to say every house in a lower-quality area is bad, but the chances are much higher and this will increase your chances of the bad tenant scenario.
The nicer the area, the higher-quality tenant your property will attract. If you really want to shoot for the areas that are likely to attract the highest-quality tenant, look for areas that are more primarily owner-occupant residents than renters. This goes for general markets too. Some cities boast that they have a huge percentage of renters, which suggests you will always be able to find a renter, but that kind of statistic actually says that the general quality of the population may not be as high.
Try to buy newer properties that check out in an inspection. No matter how good of an old house you get, it is an old house and will cost you a good bit in maintenance much sooner than if you were to buy a newer property. Always get a full inspection before buying any property so you know all the potential issues, but regardless of the initial condition you will have to start putting money into maintenance eventually. The nicer a property you buy upfront, the longer you can go without forking over that money and maybe less total over time.
Be conservative.Many a times real estate brokers will paint a rosy picture on potential rental prospects and running costs. Do not believe what you hear – do your own research. I was hoping to put my house on rent for $2100 per month and this was in line with the rents in the neighborhood, but as we struggled to find a good quality tenant and had lost a month in tenant search, we had to compromise and settle for a lower rent. Even though my initial computations factored in the current rents, in reality I had to settle for a rent which was almost 10% less and this was the difference between being positive or negative on the cash flow. So things will not go according to your plan – build the contingency into your plan
There are so many mitigations to lower the risks of rental properties. People just don’t realize what factors realistically cost an investor more than they ever bargained for. I know I didn’t know when I started! And when I hear other people talk about wanting to buy rental properties, I realize they don’t realize the reality either. Buying a newer property in an owner-occupied neighborhood in a nice area will inevitably cost you more money than buying an old property in a not-as-nice area.
When people see higher returns on the lower-quality properties, they take those numbers as gold and buy without enough due diligence. While you may pay more, buying higher-quality properties in nicer areas will almost always put more money in your pocket over the long-run, assuming that you have a favorable price to rent ratio.
Rental properties do provide benefit of mortgage interest, property tax and insurance deductions and depreciation benefits. But in my books if the property in not returning a positive cash flow, then my money is smarter invested elsewhere.
For more stories on investment read Trade wars and falling markets. Should I move into bonds.
“This post was originally publishes in 2018”
If you are aiming to achieve financial independence and travel the world send us a note and we will send you a FREE booklet on “How much do you need to achieve Financial Independence.”