the landlord’s financial tool kit

As long as you research ahead of time, know your market,and pick specific properties carefully, your investment should grow over time.Most people start out with residential property inve

T h e L a n d l o r d ’ s

F i n a n c i a l To o l K i t

American Management Association

New York • Atlanta • Brussels • Chicago • Mexico City • San Francisco

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T h e L a n d l o r d ’ s

F i n a n c i a l To o l K i t

Michael C Thomsett

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Library of Congress Cataloging-in-Publication Data

L IST OF F IGURES AND T ABLES VII

F IGURES

L i s t o f F i g u r e s

a n d Ta b l e s

vii

Figure 10-1a Form 1040 (cont’d) 195

T ABLES

Table 8-1 Depreciation schedule, 5-year recovery period, 200 percent

Table 8-4 Depreciation schedule, 5-year recovery period, 150 percent

Table 10-2 Supplemental schedule, depreciation expense: straight-line

T h e L a n d l o r d ’ s

F i n a n c i a l To o l K i t

R e a l e s t a t e i n v e s t i n g i s a p r a c t i c a l a l t e r n a t i v e to the stock marketfor many reasons If you have lost money by investing in stocks, you alreadyknow how quickly paper profits can turn into actual losses, so solid, long-term, and safe investments are paramount in importance The more capital

you have to invest, the more critical it becomes to diversify away from risk exposure

high-Besides the historical profitability of real estate, there are other goodreasons to invest in income property Real estate is unique because it is theonly investment that allows you to shelter income and reduce your income

taxes It’s true that as a stockholder, you can control your taxes by planningwhen to sell or when to wait, but you cannot “shelter” income (that is tosay, stock investments do not reduce your tax liability) Real estate investorsare allowed to create legitimate tax losses by depreciating property Whiledepreciation does not require you to pay out cash, it does reduce rentalincome and may even create an actual loss Real estate is the only invest-ment that allows you to claim a loss above the limited $3,000 you can claimeach year when you lose money on stocks Another important difference isthat stock losses tend to be associated with actually losing cash, whereasreal estate losses often consist entirely of depreciation benefits

Before you can realize the many advantages of investing in real estate,though, there are complex reporting demands You have to keep books andrecords, not only of the money you spend on maintaining property, but also

of the calculations you use to divide expenses among several properties, tofigure depreciation expense, and to break down mortgage paymentsbetween principal and interest The tax-reporting rules are also complex,

I N T R O D U C T I O N

W h at T h i s B o o k W i l l D o

f o r Yo u

requiring you to fill out many schedules that most people never have to dealwith in their tax returns You have to report gain and loss on the sale ofproperty, income and expenses, and depreciation—all of which have theirown tax schedules.

This book is not aimed at the tax or accounting expert It is designedfor the individual who simply wants to invest capital outside of the tra-ditional but risky stock market and apart from the safe but low-yielding savings or money market accounts You do not have to learn a lot of ac-counting or tax rules to use this book It takes you through all of the record-keeping rules; shows you how to evaluate and plan ahead; helps you design

a simple but complete bookkeeping system for rental properties; andexplains, step-by-step, how to fill out tax forms You may need to use theservices of a tax or accounting expert to complete your tax return; howev-

er, by being aware of how taxes have to be reported, you will be fullyequipped to supply your tax preparer with everything required, so that youwill be able to claim all of the deductions to which you are entitled

In short, this book breaks down the complex matters you need to thinkabout: picking properties with financial concerns in mind, planning cashflow, setting up an effective but basic set of books, keeping track of themoney you spend, planning ahead for taxes, understanding reporting anddepreciation rules and limitations on losses you can deduct, and workingwith your accountant or tax preparer This book cannot replace the expertadvice you need; however, it will help you to become a more informed realestate investor And the more informed you are, the more likely that you willsucceed in this potentially profitable market

R e a l e s t a t e i s t h e m o s t c o n s i s t e n t l y p r o f i t a b l e i n v e s t m e n t choiceyou can make As long as you research ahead of time, know your market,and pick specific properties carefully, your investment should grow over time.Most people start out with residential property investments A single-family house or small multi-unit property (two to four units) is manageableand affordable, and you can always step up from there to buy additionalproperties or exchange your initial investment for larger ones To get start-

ed, you want to define what you hope to achieve by purchasing real estate.

Property is far more expensive than most other investments, so you will bemaking a commitment in most cases to a mortgage The majority of invest-ment value will consist of borrowed money, so you will be depending onrental income to make your investment affordable Given the potentialaffordability of real estate (with tenants essentially covering your mortgagepayment for you), the consistent historical growth of real estate values, andthe exceptionally good tax advantages, the benefits of real estate investingare significant

■ A n O v e r v i e w o f t h e M a r k e t

Since residential property is, by far, the most common real estate ment, we provide examples of housing as a primary emphasis in this book.Other choices (e.g., raw land speculation, commercial and industrial prop-erties) are much more advanced and beyond the interest of most investors.The residential housing market can be easily studied in any given area.You can readily find information about the local population, employment,

invest-C H A P T E R 1

T h e N at u r e o f

R e a l E s tat e I n v e s t i n g

rental occupancy and vacancy rates, and level of new construction underway These factors add up to the supply and demand for real estate in yourcity or town This, then, is the logical starting point if you are thinking ofinvesting in real estate.

Key Point: Information about local supply and demand for rental property can be

found through local real estate brokers, appraisers, and bankers Multiple ListingService (MLS) publications also provide detailed information about property pric-ing and trends

S u p p ly a n d D e m a n d

The supply and demand for residential property involves two separate kets One is the market price trends of housing, and the other is demand forrental units The first can be evaluated in terms of how prices are changingover time Are houses selling for more this year than last year? What is thepercentage of growth?

mar-Housing prices have consistently beaten inflation over many years, ting housing among the strongest growth investments Assuming, of course,that you’ve selected property on the basis of good research and sound mar-ket analysis, you can expect real estate to be less volatile than the stock mar-ket, consistent in its growth rate, and safer by far than other alternatives Insome areas, prices have remained flat or even declined, so using nationalaverages is not a safe way to pick a market You need to check the region-

put-al trend to ensure that reput-al estate in your town represents a viable ment In areas where employment is strong and the population is growing,real estate values tend to grow as well

invest-Market value of property is only the first of two important “markets” inreal estate The second market involves demand for rentals What is theaverage vacancy level? A very low vacancy rate is a positive sign, but a fluc-tuating or high vacancy indicates that there is more supply than demand Ifthat is the case, then the timing would not be good for investment, at leastnot right in your city

Key Point: These supply and demand features of real estate are going to vary

from one location to the next, often drastically The next town over may have

vast-ly different real estate features, and even within one city, the suppvast-ly and demandcan (and does) vary from one area to the next It is essential to understand thepopulation, employment, market value, and vacancy trends—in advance of com-mitting your money

T h e B a s i c E q u at i o n

More details on these investigative ideas are covered in later chapters As anoverview, however, this is an important starting point The short-term mar-ket attributes of rental property are going to affect how well you can afford

to invest money now The whole market is likely to look different in a fewyears, but you want to make sure you have a reasonable expectation ofkeeping tenants in the property each month The equation worth keeping inmind is a balance between how much money you receive (in rent) and howmuch you have to pay out (in mortgage payments and expenses) For thatequation to work, you want to keep the property occupied as consistently aspossible Any time the property is vacant represents lost income, but yourmortgage payment continues from month to month

A L a n d l o r d ’ s P o i n t o f V i e w

The market for residential real estate is not difficult for most of us to stand Anyone who owns his or her own home knows all about mortgagepayments and the importance of being able to afford the house Anyone whohas not yet bought his or her own home knows that landlords expect rent

under-to be paid on time So the basic economics of real estate are familiar under-toeveryone and are not as mysterious as the market forces at work in othermarkets, such as the stock market

In evaluating investments, though, you need to look at properties from

a different perspective When you are shopping for your primary residence,you are interested in comfort features, condition, and size of the property

As a landlord, you might be willing to invest in a property that would notinterest you as a primary residence, but that is ideally suited for rental pur-poses

Example:You have a growing family and need a house with several bedroomsfor your own use However, you have discovered that relatively small housesmake excellent rentals A two-bedroom house in modest condition is relative-

ly inexpensive compared to other types of properties, and easy to keep pied A married couple or single person is drawn to such rentals and can affordwhat you will need to ask in rent, so such properties are easier to keep occu-pied than more expensive, larger homes would be

occu-In this example, your revaluation of the market would be made withrental income and payments in mind, rather than from the point of view of

a homeowner The investment attributes of your decision are going to be fardifferent from your personal requirements

Key Point: When you search for investment properties, your criteria are far

dif-ferent from what they are for your primary residence—an important distinction tokeep in mind

The real estate market has grown in value consistently over time This

is a national average, of course, and all real estate is local This means that

it is essential to understand the local features of supply and demand beforeinvesting You cannot depend on national averages or even on local trendsfor the long term If local property grows in value over fifteen or twentyyears in the future, that is a promising feature At the same time, you need

to ensure that rental demand is strong right now, in order to cover yourmortgage payments As you look for potential rental investments, youshould be interested in locating properties that are affordable, are most like-

ly to maintain value (and grow in value), and are appealing to likely tenants

■ R e a s o n s t o I n v e s t i n R e a l E s tat e

There are many good reasons to buy real estate Among the most importantreasons—assuming the local market conditions make it a viable choice—are the following:

❒ Diversification and Asset Allocation Sound investment requires

spread-ing capital over dissimilar investments You would not want to put all ofyour capital into a low-yielding savings account, or a single stock, or realestate You are better off diversifying your capital You may wonder: Ifreal estate is sure to grow over time, why not put all of your money intorentals? Diversification is important because different investments havedifferent attributes The stock market is volatile and you can make

or lose money quickly; however, your money can be invested or takenout quickly Savings accounts are very safe but yield very little Well-selected real estate is going to increase in value over time, but it is verydifficult to get your money out if you need it for an emergency You need

to diversify your capital so that you have some funds available as youneed them, some funds in very safe investments, and some in invest-ments likely to grow over time

A somewhat more sophisticated view of diversification is called assetallocation This is a strategic planning technique in which a portfolio isspread among many different markets or segments While diversificationusually refers to spreading risks within one market (e.g., buying manydifferent stocks), asset allocation is broader For example, you may want

to have some money in ready-cash accounts as an emergency reservefund; other capital invested in stocks, whether owned directly or pur-chased through a mutual fund; and yet more of your capital invested inreal estate These three markets represent completely different markets,and each is going to perform according to very different market forces Real estate is a superb market for asset allocation because of its stronghistoric attributes Your ability to allocate capital among dissimilar mar-kets protects your capital from cyclical changes In times when the stockmarket is weak or falling, real estate may be strong In fact, it is likely.

We have seen the offsetting effects of stocks and real estate time andagain When investors want to take money out of the market, they willnormally turn to either money markets or real estate Money markets orsavings accounts, for example, are not suitable alternatives if interestrates are low By contrast, real estate benefits from low interest rates, so

it is an excellent market for onetime stock investment capital

Diversification within a single market, and asset allocation among manydifferent markets, are sensible portfolio management techniques Realestate is a good fit for strategic asset allocation It is different from themoney market, however Investors wanting to get out of stocks for themoment, but who plan to go back in a few months later, may park cap-ital in an interest-bearing account and move it around without charge.Real estate is a longer-term investment, though So if you plan to employreal estate in your asset allocation plan, it should be treated as a longer-term decision You do not want to buy real estate in March and then look

to sell in June to put capital back in the stock market That would beexpensive and, given closing-cost levels, a difficult move to make prof-itably

❒ Long-Term Growth A second reason to buy real estate is for long-term

growth You can expect real estate to increase in value over ten, twenty,

or thirty years By holding property over that much time, you buildwealth for your own retirement, for college education expenses for yourchildren, or for more leisurely living later on Individual goals dictatehow important it will be to accumulate wealth through real estate Just

as different stock market investors will be drawn to short-term tion in some cases and long-term growth in others, your personal goalsand requirements will dictate how you use your investment capital Forlong-term growth, real estate has performed historically far above thegrowth rates of other investments

specula-❒ Safety of Capital Real estate is a safe place to invest your money because

it is well protected You carry insurance to protect against losses from

fire and other catastrophes, so if such a loss does occur, you are tected Maintaining condition also protects long-term value, so you mustkeep an eye on your property on a regular basis, ensuring that tenantsare caring for the yard and building and not trashing the house Landvalues continue to rise in areas with a healthy economy As long as yourlocal population continues to grow and jobs are available, you have everyreason to expect property values to climb steadily This growth furtherensures the safety of your capital If land values are not rising, your cap-ital loses buying power because it is eroded by inflation Well-selectedreal estate also offsets inflation.

pro-❒ Tax Benefits Real estate may be thought of as the last remaining legal

tax shelter You are allowed to deduct losses on your tax return (subject

to some limitations) whereas other investors are not If you invest inmarkets other than real estate, you usually are allowed to deduct lossesonly to the extent that they offset other gains; the loss cannot be deduct-

ed from other income If you have capital losses through stocks, yourannual losses are limited to only $3,000 per year under present rules, afairly small annual limit With real estate, though, you can claim up to

$25,000 per year in losses in most situations Because the computation

of profit and loss includes depreciation on your investment, it is often thecase that you can report a loss and, at the same time, be bringing in morecash than you are paying out So your paper loss is deductible, but yourcash flow is positive No other investment can match these benefits.Overall, the tax features of real estate make it attractive for many investors,and the comparison to other investment choices is convincing

❒ Cash Flow With most investments, you place cash in someone else’s

care, then you receive dividends, interest, or capital gains You are 100percent invested and there is little or no question of cash flow With realestate, you usually make a down payment and finance the lion’s share ofthe investment; so cash flow becomes critical Most real estate investorsdepend on rental income to cover their mortgage payment The badnews: If you do not keep the property rented every month, you have tomake the mortgage payment from your other funds The good news: Ifyou keep the property occupied, then tenants’ rental payments are used

to make those mortgage payments In this situation—and given nounexpected extra expenses—the property pays for itself

When you purchase properties at the right price for your local market,and when rents are high enough to cover your mortgage payment, youwill have a positive cash flow When you consider the tax benefits ofreporting losses (which are created because you are also allowed to

depreciate your rental property), it is possible to have positive cash flowand, at the same time, a net tax loss This seemingly contradictory situ-ation is quite common When the tax benefits from net losses withdepreciation create monthly tax savings, you can enjoy the best of bothworlds: having tax losses to deduct while you collect more cash than youpay out.

❒ Leverage Most individuals cannot afford to buy property outright and

pay cash, just as most homeowners cannot afford to pay for their ownhomes all at once One attribute of real estate investing is the need tofinance 70 percent or more of the purchase price in most cases As astrategic approach to investing, leverage is recognized as an importantand advantageous method to use Leverage means employing a limitedamount of capital to purchase and control a greater value in investment.You would not be likely to borrow money to buy stocks, because thestock market is an uncertain and risky place However, properly select-

ed and researched real estate is far less likely to lose market value Notonly does real estate tend to grow in value over time when other eco-nomic factors are positive; it is also insured through a fire insurance pol-icy, and investors have direct control over the investment Ownership instock is uncertain and less tangible; but given the features of locallyowned and managed real estate, leverage makes a lot of sense

W e i g h i n g t h e Pr o s a n d C o n s

The overall benefits to investing in real estate—combining growth, safety,and tax features—make it a choice worthy of serious consideration Youcannot expect this combination from any other investment While cashinvested in real estate is difficult to take out (because it can be removed onlythrough refinancing in most cases), the overall benefits of real estate make

it worthwhile, especially if you balance your capital between real estate andother areas

Even with all of the long-term benefits of real estate investing,

howev-er, there are some problems you should expect to face as a landlord Theneed to borrow money to buy property is a significant risk, so you must beprepared to live with debt There can be unanticipated expenses, such as forrepairs, property tax hikes, or utility rate increases Neighborhoods canchange for the worse, the local economy can fall apart, or a large employermay close down or move away

Another potential problem area involves dealing with tenants The lord-tenant relationship is usually amiable and fair It is occasionally emo-

land-tional or illogical As a landlord, you accept the risk that some tenants willnot be pleasant to work with This is one feature of real estate that discour-ages many people from proceeding If your temperament is inappropriatefor dealing with tenants, then you should not buy real estate At the sametime, if the risk of problems can be mitigated by checking references, and ifyou are willing to go through those steps, then you will increase yourchances for a positive, enjoyable, and profitable experience.

Key Point: You should be aware of these potential problems, large and small,

before you get into real estate investing, but many people find that the positivesfar outweigh the negatives

■ T h e I m p o r ta n c e o f Ta x P l a n n i n g

The benefits of real estate are difficult to ignore, and they make a strongcase in support of including real estate in your portfolio Equally important,tax planning requires serious thought and continually looking ahead.Anticipating potential tax-related problems in the future is always a neces-sary move, not only in managing your investments, but generally as well.Real estate investors need to plan The obvious reason—to reduce currentyear tax liabilities—is only one part of the larger picture Of course, youwant to time decisions as much as possible to minimize taxes The secondpart has to be kept in mind as well: the limitation on annual deductions.This comes in two forms: dollar amount and your income level

A n n u a l D o l l a r L i m i t

The dollar amount is set at $25,000 You can deduct that much per year aslong as your family income is at or below $100,000 If you are married butseparated, or if you are single, the dollar amount may be lower or it couldeven disappear completely So married couples living apart and contem-plating divorce need to plan carefully to minimize the tax consequences ofdivorce when real estate investments are involved

In situations where you believe your tax losses will exceed $25,000, youwill have to carry the excess over to future years or to the time you sell yourinvestment property You can do some planning For example, you can defercurrent-year expenses to next year to avoid spending money for deductionsyou do not need You can also extend the time you use to depreciate assets,

to reduce current-year expenses, and to move deductions to future years

I n c o m e L e v e l

The second consideration is your own income If your annual adjustedgross income, as calculated for real estate tax purposes, exceeds $100,000,you lose 50 cents in deduction for each dollar above For example, if yourincome this year will be $110,000 your ceiling will be reduced by one-half

of the income above $100,000 So half of $10,000, or $5,000, is appliedagainst the ceiling of $25,000, and your maximum loss will be reduced to

$20,000 for the year

Planning Point: Deferring payment of expenses or extending depreciation until

later years makes sense if you cannot take full advantage of those deductionsthis year Planning for tax purposes is an essential and important feature ofinvesting in real estate If you are not thoroughly versed in tax law (including thelaws in your state), you should consult with a qualified tax expert and get assis-tance in planning ahead for tax benefits or the consequences of decisions youmake throughout the year

■ Yo u r C r e d i t a n d R e a l E s tat e I n v e s t i n g

One important consideration for every real estate investor is often looked or not mentioned at all That is the quality of your personal credit.Because you will be borrowing money to buy rental properties, lenders will

over-be keenly interested in your credit standing

Homeowners, even those with poor credit, can usually find a lenderwilling to carry a loan This is because owner-occupied property is very lowrisk and lenders recognize this fact In comparison, investment propertyloans are more likely to be foreclosed If the demand for rentals falls andinvestors cannot meet their mortgage obligations, it is possible that theinvestor will simply walk away from the investment So lenders are sensitive

to the possibility of default on investment property mortgage loans If aninvestor’s credit is not impeccable, it will be more difficult to find loans.With the higher-risk levels in mind, lenders require higher down paymentsfor investment property; and lenders may also require higher loan pointsand other fees, just to offset their higher risks The standards are higher,and for good reason

W h at t h e L e n d e r M i g h t R e q u i r e

If your credit rating is less than perfect, you may have to meet a series ofextra requirements These could include:

❑ Higher down payment requirements, so that you have more investedcapital at stake, which in turn reduces the likelihood that you will justwalk away from the loan obligation if the costs of keeping the propertyget too high

❑ Higher loan origination and other fees, charged to reduce the lender’srisk of default on your part

❑ Closer scrutiny of financial information and more reporting than usual,

so that loan underwriters will be confident that the information you vide is accurate and complete

pro-❑ More appraisal, inspection, and other outside fees, to ensure that theproperty being financed does not have hidden maintenance costs or isnot overvalued

❑ A higher interest rate on the loan itself, due to the higher level of risk tothe lender

I n c o m e v s O b l i g at i o n s

If your income is too low to qualify for the loan you seek, you will have toput more money down or simply wait until your income level rises You mayalso need to start out with a less expensive property so that your income willqualify you for the investment While different lenders employ many varia-tions of the basic strategy, they all look at the numbers in the same way.They calculate your net monthly income (your take-home pay) and thentake a percentage of that as the maximum obligation they will accept foryour mortgage payment (The “obligation” usually includes mortgage prin-cipal and interest, property taxes, and insurance.) If the payment goes overthat level, the loan will be rejected in its present form You may need toreduce the obligation by making a larger down payment, for example When you fill out a loan application, you are required to estimatemonthly obligations as well as monthly rental income A lender is probablygoing to reduce the estimated income you report to allow for possiblevacancies The degree of adjustment will depend on recent vacancy levels inthe area, a statistic that the lender will know or have access to So your totalnet income will include your take-home pay, any other income (e.g., fromdividends and interest), and rentals (adjusted downward for the vacancyfactor) The net total of this calculation is then multiplied by a specific per-centage that the lender uses to qualify investment property mortgage loans

If the total obligation exceeds the predetermined percentage of totalincome, the lender will not approve the loan

Key Point: The review of your loan application will be much easier if your credit

is excellent The better your credit, the easier it will be to find acceptable ing For anyone with poor credit, the flexibility to finance properties, without con-cern of being rejected, is going to be curtailed That does not mean it will beimpossible to find a loan, but the loan is going to be more expensive and reviewtime is likely to be greater as well

financ-G e t t i n g Pr e a p p r o va l f o r Yo u r L o a n

Prospective first-time homeowners can find a lender to prequalify them.Based on his or her income level and credit history, the borrower can findout what level of home the lender can approve The lender reveals the max-imum loan it will grant based on the borrower’s financial information Thepreapproval is conditional, because the lender also wants to ensure that theproperty being purchased is worth what the homeowner intends to pay andthat condition is acceptable for lending purposes Preapproval of a mortgageloan for investment purposes is not quite as easy Because the equationincludes rental income, it will be impossible for the lender to assess the bor-rower’s overall income and obligation without the specific property in mind.You may be able to find a very conditional preapproval from a lender.The qualifications will include the usual appraisal and condition standards,but will also go beyond that to place a condition on acceptable rental incomeafter deducting an estimated vacancy factor Assuming that the lenderwould qualify you on the basis of a comparison between total income andmortgage obligation, you may receive a type of preapproval when your cred-

it is not perfect At least a lender may be willing to stipulate that your cation will be given serious consideration Some lenders won’t go that far,making it clear that they will not approve loans if your credit is poor,regardless of property value and condition

appli-Poor credit is also the reason lenders are less likely to approve an

equi-ty line of credit Most lenders limit lines of credit to primary residences,although some allow borrowers to take Home Equity Line of Credit(HELOC) contracts on rental properties—but as a rule, this exception will

be allowed only if the borrower’s credit is exceptional

■ M a i n ta i n i n g I n v e s t m e n t Pe r s p e c t i v e

In every type of investment, you have to keep your perspective For ple, if you buy shares of stock because a stranger on an investment chat

exam-room tells you its price will go through the roof, you have no one but self to blame if you lose money If you invest because a stockbroker tells youit’s a “good” investment and that turns out not to be true, then it meansyour trust was misplaced.

your-The same cautionary warnings apply to real estate Success in investing

is the result of thorough research; identification of sound, sensible ments in strong markets; and proper ongoing maintenance (In the case ofstocks, you want to hold shares as long as value is rising and the funda-mental strength is high, and then sell when conditions change In the case

invest-of real estate, maintenance means finding the best tenants and then ing an eye on the property.)

keep-There are no easy ways to accumulate wealth Yes, some people havemade fortunes in real estate by buying in the right place at the right time;but it is also true that those people took risks and had to work to acquireand maintain their properties If you discover that you are simply not satis-fied with your investments, you should sell and get out For a stock investor,this means selling the shares if you spend your nights lying awake and wor-rying For a real estate investor, you should not have to dread your tele-phone ringing, fearing it is a tenant calling with a complaint If you have tofight every month to get your rent, or if you even worry about the possibil-ity of such problems, then real estate is not right for you

R i s k To l e r a n c e

Maintaining your perspective also has to include an ongoing evaluation oflong-term goals and your personal risk tolerance Keeping real estate forthe long term should be coordinated with a specific idea that you have aboutyour reasons for wealth accumulation, matched with your expectations forgrowth in real estate values (all on an after-tax basis, of course, because realestate tax benefits are significant) Risk tolerance has three major aspectswhen real estate is involved These are:

1 Tenant Issues The most important level of risk involves your relationship

with tenants This is far more important than investment value or cashflow Even if your investment works well on paper, tenants can affectyour quality of life—especially if they are giving you trouble If yourexperiences are negative, then you have exceeded your risk tolerance.The problem has to be fixed (which may be as easy as replacing a poortenant with a good one); otherwise, it makes no sense to keep the prop-erties In the end, the whole experience has to be enjoyable for you

Many investors have problem-free relations with tenants; others have nothad universally positive experiences The potential problems vary byarea, due to the relative strength of landlord-tenant laws In some states,tenants have very strong rights, which may lead to abuse of landlords Inthose states, you could have great difficulty if you end up with a tenantwho does not pay rent, and it could take many months to evict a prob-lem tenant In other states, the laws are less complex or even favorable

to landlords

2 Market Value The best-known form of risk involves market value Is

your property value growing? On a month-to-month basis, tenants areexpected to pay rent adequate to make your mortgage payment; so overthe long term, you should be able to accumulate equity through rents.However, the risk exposure is only worthwhile if property values are ris-ing as well If market value is not growing, you might consider sellingthe property and investing in one with more potential

3 Cash Flow Of course, you want rental income to cover your mortgage

payment and other expenses An after-tax positive cash flow is desirable,and a prolonged period of negative cash flow can destroy your family’sbudget This form of risk tolerance has to be well managed in order foryour investment to work

Offsetting each of these potential forms of risk requires planning onyour part

D e a l i n g w i t h T e n a n t s

You reduce the risk involved in having to deal with tenants through properselection and by checking credit and personal references The majority ofproblems faced by landlords can be traced to lax procedures in checking ref-erences or misplaced trust

Screening Tenants.If rental demand is high and stable, you will be able toselect from among many applicants When vacancies are low—5 percent orless—you may receive more than a hundred responses to a single newspa-per ad You need to get a written application from tenants This is the firststep in checking whether tenants can provide the basic information youneed—employment verification, current landlord’s name, a bank accountreference, and monthly salary verified with copies of recent pay stubs Use

a form such as the one shown in Figure 1-1 and require all applicants tocomplete it

Some applicants will fail to fill out the form, meaning that they knowthey cannot refer you to their landlord, that they do not have a bankaccount, or that they have no income Any of these problems disqualify theperson based on even a cursory review Therefore, requiring a written appli-cation is a necessary first step.

Key Point: Look for applicants who have jobs, a current bank account, a local

address, and a record of no evictions You will discover that people lacking theseimportant features will apply for your vacant rental, even though they have noreasonable expectation of making rent payments Verification (including callingthe person’s employer to confirm income) is essential

Checking References. The second step is checking all references Theimportance of checking references—even when your instincts tell you thatall is well—cannot be emphasized too much Confirm the bank account tomake sure it exists and is not currently overdrawn Call both current andpast landlords to determine whether they will provide positive recommen-dations If the applicant does not provide you with both landlord references,

or if they simply don’t have references to give you, that should disqualifythem For example, if an applicant claims to have been living with his par-ents, you have no reliable way to determine what kind of tenant he will be.Another potential problem is that the current landlord might be so motivat-

ed to get rid of the tenant that the reference will not be objective or rate This is why you also need to talk to a past landlord

accu-Also, talk to the employer Are the reported salary level and dates ofemployment accurate? You also want to make sure that the individual does

in fact have the job and is in good standing At this stage, you simply want

to verify information the applicant has provided to you There is no way toensure that employment will continue into the future, and this step isintended only as a fact-checking phase

If the applicant is self-employed, you cannot verify income in the samemanner You will need to get a copy of the person’s bank statement for thepast two or three months to ensure that deposits are going into the bank.There is no reason to reject an application just because the applicant is self-employed; but as with all forms of information, you need to be able to ver-ify what you’re told on the application

Reviewing Credit History. You may want to collect a small fee from theapplicant to run a credit check The cost is usually about $15, although youwill need to subscribe to a service and obtain written permission from the

Rental Application Name Date Property address _ Your current address Telephone number (home) (work)

Names and relationships of all people who will be living in the property with you:

_ _ Your current landlord’s name _ Address _ Telephone Dates of occupancy (from) _ (to ) _ Property address _ Reason for leaving Your past landlord’s name Address _Telephone Dates of occupancy (from) (to ) Property address Reason for leaving Your bank _Account number Bank address Your employer _ Employer’s address _ Supervisor or manager’s name Telephone Monthly income $ _ per Years employed _

Signature of applicant Signature of spouse

Figure 1-1 Sample rental application.

tenant applicant If the would-be tenant does not provide all the tion you need, or is unable to give you verifiable references, look elsewhere

informa-Checking Legal History.It is also easy in most states and counties to checklegal history, since it is part of a public record You can go to the clerk of amunicipal or superior court and provide a name to be searched From thissearch, you can discover—usually for no fee—whether a person has everbeen evicted in that county or convicted of any crimes

Being Alert to Warning Signs. Some tenants cannot afford the rent youare asking They may try to barter with you for part of the rent by “doingwork around the place,” or performing landscaping chores (which is theirresponsibility already in most cases), or offering to paint the house Theseare warning signals You are probably not going to have a positive experi-ence in hiring tenants in exchange for rent for any purpose If the tenantcannot afford to pay the full amount of rent, her application should berejected

Renting Month to Month.If you are unsure of how long you wish to rent

to a specific tenant, offer a month-to-month arrangement rather than alease The month-to-month option protects you; if the tenant does not payrent, it is easier to give notice under a month-to-month arrangement.Having a lease gives you a legal contract, but if the tenant is a deadbeat, it

is unlikely that you will be able to collect what the person owes you Themonth-to-month idea may make more sense

Using a Management Company.You could also hire a management pany to deal with tenants directly This service will cost you a percentage ofrents collected, and some management companies are better than others

com-So, even if you hire a company, you need to check it out beforehand as well.Join a local landlords’ association if there is one and ask other members forreferrals to local management companies

K e e p i n g a n E y e o n M a r k e t Va lu e

The best way to reduce the risk of stagnation in market value is withadvance research You should know your local market before you buy Thatmarket includes the recent historical price trends for housing, as well asoccupancy trends in rental housing While current trends are not going tocontinue forever, you can certainly determine whether current conditionsare strong or weak You want to buy in a market where properties are avail-

able for attractive prices, but rental demand is high This is the best of allconditions, especially if the cyclical supply and demand factors are timed inyour favor If real estate prices rise during the time you own the property,you benefit in several ways: from year-to-year tax benefits, tenant-paidmortgages, and good cash flow

What should you do if and when the market softens? The propertyvalue itself may go through many cycles over the long term, so you mayneed to be patient and wait out the cycles If employment in your city ortown is strong and people are moving in instead of leaving the area, demandwill continue to grow for property If current building trends are exceedingdemand but economic trends support long-term holding of your real estate,you may need to wait out the market The situation is far different when themarket for rental units goes soft If there are more rentals in town than thereare people wanting them, you could face a more immediate problem: theloss of rental income If you believe your investment is not growing quick-

ly enough, or if you experience higher than expected vacancies, you shouldkeep open the possibility of selling There is no sense in remaining invested

in real estate or any other market if you are not experiencing strong cashflow and market value growth

M a n a g i n g C a s h F l o w

The real test of real estate investments is cash flow You need to break even

at the very least, when you take tax benefits into account If you have highvacancies, you have to pay mortgage, insurance, taxes, utilities, and main-tenance out of pocket, since these expenses are not being covered withrental income With the tax benefits in place with fully occupied properties,you don’t need the tax write-off you get when properties are vacant Thesolution to cash flow problems is based in careful research before you buy

Be sure you know the demand market for rentals, and pick properties whosemortgage payment, taxes, and interest can be covered through rentalreceipts Also make sure that vacancies for rental properties are consistent-

ly low before you put money into rental investments Negative cash flow isnever a good thing, so you need to take steps to avoid finding yourself pay-ing out more than you are bringing in

D o i n g R e s e a r c h a n d A d va n c e P l a n n i n g

The nature of real estate investing includes the many benefits as well as risk.Dealing with tenants, keeping an eye on market value, and managing cashflow are all easily handled when you select properties and tenants well In

each case, advance research and investigation do the most to reduce oreliminate risk Always begin by picking properties in strong, healthy mar-kets—that is the essence of sound investing of any type Stockholders want

to pick strong companies whose stock rises consistently through the years.Real estate investors desire strong market demand as well as strong rentaldemand

Doing your research ahead of time—before committing funds andbefore signing a rental agreement with a tenant—is really the most impor-tant step for anyone contemplating real estate investment By avoidingproblems before they arise, your overall experience will be both positive andprofitable

T h e r e i s n o s i n g l e w a y t o i n v e s t i n r e a l e s t a t e Just as the stock ket offers a rich variety of methods for the flexible investor, real estate canalso be approached in a number of different ways You can distinguishbetween types of property, for example, with each having its own supply anddemand features In some cases, one type of property will have very strongdemand whereas another may be soft Consider a situation in which a largeportion of the local population consists of college students (creating astrong demand for multi-unit housing), but at the same time, there is verylittle retail trade or manufacturing in the area (causing a soft market forcommercial and industrial property)

mar-Real estate, like the stock market, can be set up according to the type ofinvestment you want and the level of risk you’re willing to accept Everyinvestment has attributes; these attributes define income opportunity as well

as risk Before deciding whether to invest in real estate, you should ine the positive and negative attributes in order to evaluate opportunity andrisk—just as you would do with any form of investing

exam-■ L o c at i o n , L o g i s t i c s , a n d L i m i tat i o n s

According to an old adage, the three most important attributes of real estateare location, location, and location Actually, it might better be restated aslocation, logistics, and limitations These are the three attributes that makereal estate a sound investment

C H A P T E R 2

G e tt i n g S ta r t e d i n

R e n ta l R e a l E s tat e

1 Location, of course, is the central defining element of a “good” real

estate investment The vast difference in land values between 400 acres

of Texas scrubland and a quarter acre in downtown Dallas make thispoint Whereas the scrubland is virtually valueless, the location of theurban land creates a demand that drives up its value

2 Logistics is the second defining attribute It does not matter how

desir-able land is in terms of its size, topography, and vegetation if it is notlogistically viable as an investment This means that you need services—roads, utilities, and public services—to ensure that the land will grow invalue You cannot build a house in the middle of an area that does nothave access to needed services The logistics dictate that such a proper-

ty is not a practical investment

3 Limitations are the third attribute that defines investment value In areas

such as Manhattan, San Francisco, and Tampa Bay, the proximity of land

to water naturally limits how much development can occur There is alimitation on the amount of land As a result, land becomes increasinglyvaluable as more demand for improvements comes into play When theland has been fully developed, further construction has to move upward,

or prices simply rise in response to the situation: The limitation of landmeans the supply is not enough to meet the demand, so land values rise

Other Considerations: There are many additional aspects to real estate

invest-ing, of course You also need to consider tax advantages; limitations of capital toinvest; and the unavoidable aspect of dealing with tenants, lenders, and localeconomic changes that could lead to vacancies Real estate investment requirescareful planning In turn, planning demands that investors understand how tokeep accurate records, plan ahead for taxes, and make the right decisions today

to protect the value of their investments, possibly for many years to come

■ F i n a n c i a l P l a n n i n g

The decision to become a real estate investor is usually made as part of alarger personal financial plan Many considerations have to be involved:available capital, family income, comfort levels with owning real estate andcarrying a large dollar amount of debt, other assets (e.g., stocks, retirementaccounts, and savings), and long-term goals Once you decide that youwant to include investment real estate in your financial plan, you also acceptthe attributes that go along with your decision The financial planning con-siderations include:

❑ Capital Limitations If you have little or no money to invest, real estate

will not be a serious prospective market for you Because of the inherentrisks of cash flow and debt financing, you will be in better shape whenyou have savings and adequate other investments available Few peoplewould seriously consider beginning a real estate investment plan withoutfirst establishing more liquid investments

As a practical matter, it is most difficult to begin a real estate investmentplan until you have adequate capital resources Whether those resourcesare acquired through inheritance, savings, sound investment strategies,

or other means, they are essential Some investors are unwilling to facethe reality and to acknowledge the potential problems of getting into realestate before they are ready The tendency is to limit the question to hav-ing enough cash for a down payment; but the problem of capital limita-tion is far more complex If you don’t have any cash reserves or incomeavailable to cover a month or two of expenses when no rent is coming

in, then the risks of rental real estate are too high If you cannot qualifyfor a mortgage loan because you lack assets as well as a high enoughlevel of income, then there is no point in pursuing creative alternatives

to overcome the financial limitations The risks are real The best choice

is to wait until you are better situated and put real estate aside for themoment

❑ Family Income You need to balance all investment programs with your

personal income level Of course, someone earning a very low monthlywage would not be able to qualify for the mortgage loans needed tobegin a real estate investment program Family income, if too low, wouldpreclude your being able to qualify for loans Of equal importance, whenyou live on a tight budget, you cannot afford to carry a large debt whosepayments depend on rent payments by tenants In that situation, two orthree months’ vacancies could destroy the family budget

The level of family income has to dictate the types of investments priate for you for all of these reasons In analyzing future income, youwant to consider likely salary raises or higher income derived fromchanging a career, getting an advanced education degree, or pursuingother opportunities You should also consider changes such as alimony(which may be received today but will cease at a known date in thefuture) and the potential for loss of half your family income in the event

appro-of divorce, disability, or the death appro-of a spouse In analyzing likelychanges to family income, the financial-planning process usuallyincludes insurance If your budget depends on a spouse’s income, thatspouse should be insured The primary earner should definitely be car-

rying life insurance and, possibly, disability insurance as well Healthinsurance should be carried on both spouses as well as children.

❑ Personal Risk Tolerance In any type of investment, the program has to

be a good fit for your risk tolerance level This is the amount and degree

of risk that you can afford to live with—and that you are comfortabletaking on There is an inescapable relationship between risk level andpotential profit The greater the risk, the greater the opportunity forprice movement So a very volatile stock may gain or lose many points

in market value on a daily basis, but can you afford to live with the ciated risk? Real estate, if well selected in a strong market, is likely torise slowly but steadily in value over many years, but the market risks arefairly low So, in trying to match investment decisions to personal risk,you need to know the risk attributes of the market first, and then matchthose attributes to your financial goals

asso-❑ Debt Tolerance Another tolerance level involves debt Real estate

in-vestors are usually in debt for the majority of the investment value of theirproperties Some people are completely comfortable carrying large debtsand depending on tenant receipts to make mortgage payments on time.Other people worry continually about what might happen if they couldnot afford to keep up payments If an individual worries about thesepotential problems, real estate is not a good choice Debt tolerancedescribes your ability to live with debt itself

Another way to look at debt tolerance involves overall credit and debtlevels For example, if you are carrying so much debt on your personalresidence and other investment properties, you may have difficulty qual-ifying for credit elsewhere Your ability to buy a new car, increase thelimit on your credit cards, get a home equity line of credit, or gainapproval for a retail credit line may be limited if you are already carryingthe maximum level of debt you can handle, given your income

❑ Asset Balance The concepts of diversification and allocation have to be

part of your financial plan The defining attributes of risk and debt erance result in mandating how and where to invest available capital, thelevel of capital in each market that seems appropriate, and whether youshould be using leverage If you determine in studying asset balance that

tol-it would be proper to leverage your captol-ital, you will also have to mine how much leverage is appropriate The higher the leverage, thehigher your profit potential—and the higher your risk

deter-❑ Long-Term Goals The central purpose in going through the

financial-planning process is to identify specific personal and family goals, then

identify ways to get there and structure the decision within a framework

of risk tolerance Your goals in thinking about buying real estate mayinclude hedging inflation, saving for retirement or financial indepen-dence, or simply being active in a market you believe will grow substan-tially in the future Goals are going to vary from one person to another,

so it is rarely safe to just assume that advice given to you by a strangerapplies to you, especially if that individual does not know a) your expe-rience, b) your risk tolerance levels, c) your annual income and financialresources, or d) your personal goals

Your personal goals are also going to change, sometimes drastically,when you experience a major life change: marriage, the birth of a child,

a career change, the loss of a job, divorce, illness, or death All of theseevents also change all of the aspects of your financial plan: allocation ofassets; need for cash; available capital; income level; risk tolerance anddebt tolerance levels; need for insurance (and levels of coverage); and,

in some cases, your entire point of view about the process of investingand planning

■ T h e C o m m e r c i a l Pr o p e r t y M a r k e t

The market for commercial property has to be reviewed on a different dard than the market for residential property Even when demand for hous-ing is high, that demand does not necessarily translate to an equally strongdemand for commercial rentals You may have experienced this discrepan-

stan-cy in your own town It often happens that a downtown area has manyvacant properties whereas nearby shopping malls are fully occupied anddoing a robust business In commercial real estate, locational trends oftenare more important than areawide demand If most people in your areashop at the mall, the downtown area could be a ghost town So, if youreview demand for commercial space on an areawide basis, it might notreflect these differences It is unlikely that you will be able to acquire anequity interest in a mall, which is probably financed through a partnership,

a corporate entity, or an investment trust Therefore, your choices of

direct-ly owned real estate will be limited to other areas

Clearly, if the downtown commercial area is suffering from locationalproblems, it would not make sense to buy investment property in thatarea—even though the prices could be quite attractive One possibility forcommercial space may be found in an industrial park, which may includecommercial and retail properties It is possible to locate commercial invest-ments that will be more affordable than a multi-acre shopping mall by look-

ing at buildings outside of the downtown area The trend toward mall ping is not universal, either Depending on where you live, it may be prac-tical to look for commercial properties in the center of town Areas too small

shop-to support a shopping mall often have a healthy retail economy becausehighways run through the downtown area or because malls exist nearby

E va lu at i n g C o m m e r c i a l Pr o p e r t y

Commercial property valuation may be more difficult than it would appear

at first In the most simplified form of evaluation, the comparison is madebetween supply of property and demand for space For example, merchantswant to locate on desirable streets with plenty of parking and foot traffic;that drives up rents in the area, so commercial property values are higher.Another example: A once-robust street benefited because a state highwaywent right by the stores But when a bypass was constructed, traffic dried

up and values of commercial properties have now fallen Even with theseobvious examples, the comparison between supply and demand is complex.Additional market forces might be at play as well For example, a com-munity located on either a state border or a border with Mexico or Canadamight be valued based on cross-border considerations Oregon has no salestax, so buyers from adjacent Washington add to the volume of Portland-areacommercial activity If Washington appealed its sales tax or Oregon addedone, there would be an immediate change in the mix of commercial supplyand buyer demand In the case of the international border, monetaryexchange has a significant impact on commercial activity and value As long

as the Canadian dollar is weaker than the U.S dollar, the cross-bordertrade trends have an impact on both sides of the border

Valuation of commercial property has to be made on a basis entirelyseparate from the basis used for other types of property Demand for resi-dential housing depends on employment and population trends, whereascommercial property value is affected to some degree by local, state, feder-

al, and international tax policy and monetary exchange; therefore,

proximi-ty to dissimilar economic areas (states or other countries) is an important

factor in value Economic cyclical change also affects the whole picture Acommercial property is valued based on existing economic circumstances,but subtle changes outside of the immediate area can affect valuation

Outside Factors. As an example, a community whose revenue is derivedlargely from tourism may suffer big losses in retail trade due to nationaleconomic conditions, political turmoil, and other outside causes The effect

on commercial values, even if temporary, is very real It’s even possible that

commercial values could be more volatile than comparable values in munities that are more self-sustained For example, an antique store locat-

com-ed in Niagara Falls is likely to be more vulnerable to economic change thanone carrying the same items in Omaha, Nebraska, or Philadelphia

Basis for Valuation. Another important difference in valuation betweenresidential and commercial properties is the basis for valuation itself.Appraisal of residential property is usually done on the replacement or costbasis The appraiser finds comparably sized homes with similar features,located in similar neighborhoods, then makes needed adjustments to arrive

at an approximation of value However, commercial property valuation has

to take different factors into account A well-constructed building has littlecommercial value if a highway bypass keeps traffic away, whereas a poorlyconstructed, outdated building located right in the middle of vehicular andpedestrian traffic lanes will have a higher value than property located a fewblocks away

Key Point: Investors in commercial property cannot depend on residential

crite-ria for selection and valuation They need to have, or to hire, expertise that can

be used to set value based on income generation potential, local trends, and nomic or political or cyclical factors, if applicable, that will affect a property’svalue

eco-■ T h e R e s i d e n t i a l Pr o p e r t y M a r k e t

Residential property, in comparison to commercial property, is usually thepreferred starting point for investors Understanding the commercial mar-ket, valuation of property, and demand features may be too complex (andthe risk factors too high) for the beginning real estate investor Most peo-ple more easily understand residential property Buying a house or duplex

as a starting point is often a more comfortable choice

Important: Assessing the demand features of real estate in terms of the need

for rentals (versus the separate market controlling price trends in housing) is thekey to selecting properties in the right place

Demand may vary within a single community as well as from one area

to another Many tenants need to be close to public transportation andshopping Students prefer to be close to their college or university Elderly

or low-income families prefer housing close to public facilities and local

assistance offices Consequently, properties in more remote areas of townmay experience greater vacancies than those closer to the conveniences thatthe mix of tenants finds desirable.

T h e M a n y A s p e c t s o f L o c at i o n

Location is not limited to the city or town alone; it may also vary by imity within a city or even within a fairly small town Most experienced realestate investors have discovered that it is easier to pick properties wisely ifthey are intimately familiar with these subtle but important distinctions.Demand can be lower than average just because a specific property is a mileaway from the closest bus line, school, or shopping center A property that

prox-is well located in terms of conveniences prox-is likely to remain occupied at ahigher rate; when markets begin to soften, the better-situated propertiestend to stay occupied longer In addition, location will also affect marketrent levels, so that property will produce better cash flow as well The point

is, you may think of “location” as having several aspects

Regional.In the broadest sense, location refers to the region of the try—a specific city, town, or even a state In fact, national statistics breakdown trends in residential real estate values by regions in that manner:Northeast, Midwest, Northwest, etc The broadly defined location is of lit-tle value in picking properties Just as stock indexes reveal overall trends inthe stock market, national and regional real estate trends provide an aver- age view; but averages consist of strong and weak markets, collectively.

coun-City to coun-City.When we get down to more localized definitions of location,

we can study real estate from city to city If you have studied the market atall, you already know that values can and do vary significantly from town totown Two cities, one next to the other, may have vastly different markets.One city may have consistently strong growth and property value trends,whereas the other is stagnant Subtle differences in economic conditions orthe political environment can make a big difference even when geography isnot great One city may be governed by a council that encourages employ-ment and new housing, and its real estate market is likely to be robust.Another may not encourage new employment or building, so that peoplemove away and there is no reason to expect real estate prices to grow A lack

of demand—generated from employment growth and the related tion growth—means there is no real market for housing, so there is no rea-son to expect growth at any time in the near future, either

popula-Neighborhoods.Location can be even more finely defined Within one city

or town, certain areas are thought to be more desirable than others Older,more established neighborhoods, those with their own grocery stores andother outlets, on quiet streets, will bring higher prices, and their marketvalue will outpace the local averages Homes located near highways, inhigh-crime neighborhoods, or close to downtown congestion or noise aregoing to grow at a slower pace

Individual Houses. In addition, you can look at two houses in the sameneighborhood and see considerable differences in value Consider twohouses only one block apart: One house is on a very busy thoroughfare anddirectly across the street from a school Every morning and afternoon,dozens of buses and cars fill the street During the recess and lunch peri-ods, you can hear the sounds of children playing The older children walk

by the house, so lawns often are littered The second house is one blockaway from the school, noise, congestion, and littering problem While both

of these houses are identical, the second house—because it is one blockremoved from the problems—will grow in value faster than the one on thebusy street in the school zone

Other Houses in the Area The houses next to the house you’re thinking

of buying also affect value If they are well maintained and the hood has a consistently high level of cosmetic maintenance, then your housewill benefit By the same argument, if neighbors do not care for their prop-erties, that will hold down value in your investment property

neighbor-Owner-occupied housing tends to increase in value more than rentalproperties With this in mind, it is strategically wise to invest in single-family properties in largely owner-occupied areas That factor, a subtleinterpretation of “location,” will help maintain your property’s value in linewith the larger neighborhood trend As long as you keep your property ingood shape, it is likely to grow in conformity with other homes In com-parison, if you buy a property in an area characterized by other rentals,market growth is likely to be lower than it would be in neighborhoods with

a majority of owner-occupied houses

Key Point: The location factor cannot be overlooked in the property study It

determines the ultimate value of the investment Just as one stock will form other stocks in the same business sector for a variety of specific reasons,one house will perform better for you because of its location, condition, andneighborhood