Purchasing rental property is an excellent way to build your net worth, expand your retirement income and has proven to be a sound investment. Speak to any commercial or rental property owner that bought rental properties 20 to 30 years ago and find out if it was a bad investment? Their buildings would be close to paid off and they would be enjoying the fruits of their labor.
This article was written by Leon Zucker. Leon has been in the rental property business for many years and agreed to write this article for our site. Leon has very quietly built up a real estate portfolio that is worth approximately $3.2 million today after 25 years. Nothing fancy as he says, just hard work. He reminded us that when he purchased his rental property, his total investment was under $400,000. How times have changed!
We've purchased many rental properties over the past 25 years and managed a few buildings for large mutual funds. We've had mostly winners and a few where we've lost money. The attitude we had going into a rental property is that it is for the long haul. If you're new to the rental property world, don't forget that you are still dealing with one of the most difficult and inconsistent things in the world... people. Even when they sign the lease, life happens for everyone. Divorce, death, job loss, broken plumbing with water leaks, dishwasher hoses flooding the levels below all break one-year lease agreements. We've had people just disappear and enter the suite to find three-month-old food in the fridge. Light bulbs in hallways constantly need replacing, cutting grass, shoveling snow, plowing parking lots before everyone gets off to work are all part of rental property ownership.
If you are able to maintain the property with a good property manager or do it yourself, you should have an excellent asset in next 20-30 years. Here are the few items to be looking for when you're buying a rental property. This will get you started down the right path.
Location Location Location
The old rule of real estate always applies even when you are buying rental property. The number one thing to look for is location, location, and location. The location will dictate how fast you can get out of the property if you want to liquidate and the quality of tenant you will be dealing with for the next 20 years. (This is the most important decision)
Securing the right mortgage will be critical in managing your operational expense and satisfying the down payment requirement.
Here is where rental property location differs slightly from single family dwellings:
Transportation services are very important. Close to bus routes and/or high-speed transit services. Many people that rent either cannot afford a vehicle or do not want the expense of a vehicle. Parking is always an issue with a rental property so keep this on your checklist
Consider the Age Group of your Tenant
Are you renting to seniors, singles, families with children or adult living? This matters with location and the type of people that you want to deal with for the next 20 years.
Seniors - You want a location very close to groceries, liquor stores, doctors/hospitals, preferably walking distance to all. This becomes a priority when we get older. Simple is better.
Singles - Find a location on the edge of an up and coming area close to nightlife and trendy shops. If you are a few blocks off the highly expensive properties, this is a great starting location for anyone thinking of getting into the rental market. You can also look at large commercial areas like hospitals where they employ a lot of people with lower monthly income. Think of the kitchen staff, cleaners, porters in a hospital. There would be hundreds of them maintaining the operation.
Families - You will want a building with two-three bedrooms, best in the suburban area close to transit and schools. The more houses around the better with this type of purchase. You want a building that feels like it's in or near a prosperous suburb. The tenants will want this because it feels safe. The more apartment buildings, the less desirable. Areas like this can start to get run down very quickly. It only takes one building owner to let the building go downhill and it brings down the entire community.
Adult Living - These people are still active, do not have children at home and can range in age from 40-85. They are on the move usually with vehicles. They have money and they want to travel, a safe building is important. Security doors are a must. A gym and a pool in the building is ideal and they will pay for it. Close to the Young adult, on the edge of trendy works here as well.
Be willing to pay more for a building close to an upcoming area. Think long-term with this goal.
The building style is important depending on the age group. Balconies are important to all age groups but there is a large cost to maintain balconies including flooring, rails, and doors.
We recommend that you try to stay away from buildings that are bachelor suites. These can be difficult to rent and we have found attract a more transient tenant. The only place we would do this type of building is by a university but be aware that rents are difficult with 8 months of school terms.
Making Money on Rental Property
The financial goals when you purchase a rental property need to be slow and steady. It's like buying a mutual fund, but you in control.
The basics are always the same, current revenue to today's expenses in comparison to what needs repairing/replacing. Once you have found your first property to look at, you can start to get into financials. Here is a quick example of what you will be looking at.
This building has 17 units and the owner is asking $1.9 million
The unit is close to the university with 8 bachelor suites, 6 one bedroom and 3 two bedroom units. This is not ideal and we would not buy this building, it's only an example.
8-bachelor suite rents for $750.00 or $6,000.00
6-one bedroom rents for $1,100.00 or $6,600.00
3-two bedroom rents for $1,500.00 or $4,500.00
Total revenue is $17,100.00 / month.
25% down payment $475,000.00
Remaining balance to mortgage $1,425,000.00
Here is a great mortgage calculator to see if this building works for you.
We want to look at a 20-year mortgage at 4%. The interest is $659,000.00 over the term.
50% of the units have been completely renovated including kitchen and bathroom fixtures and most of the windows have been replaced.
We are estimating an additional cost of repairs at $200,000.00 and we will build this cost into the original mortgage. With these upgrades, we are considering a 10-15% rent increase on 50% of the units.
Check out this apartment building calculator to see if the building you're looking at works for you.
This is what you will be plugging into the calculator:
Less vacancy and uncollectable rent:
- Management fees
- Maintenance and repairs
Break this down for each suit to see your real revenue per suite and be realistic with possible vacancies. Research the current market for vacancy rates and expect the same or worse for you.
Why is this Building Being Sold
A good quality well-maintained building typically does not come on the market. Why would it so why is this building on the market? Imagine yourself in a position where a building is up to date on all repairs, everything is paid off and rent in coming in, why are they selling it. Be very skeptical. We have found buildings for sale for a few reasons:
2. Maintenance costs are so high that the costs to repair will eat all of their future profit.
3. Death in the family and they are liquidating.
Find out why they are selling. Number two will be obvious. If you have the ability to do these repairs yourself, this may be your opportunity.
Let's get into the Buildings Condition
The first thing you need to look at is all of the repairs bills over the past 5-10 years from the previous owner. The cost of maintenance is your profit so be careful with this. Here are a few examples of the big ticket items.
When was the roof replaced? You need to get an inspector to look if it's over 10 years. This can cost you from $5,000 to $500,000.00 depending on your building size. If it's a flat roof, get it inspected before you buy it. Look for leaks internally. Go into the attic and check the material for web spots.
Items like carpet, light fixtures, toilets, sinks and anything else that is visible, look at the receipts for replacement. Did this equipment really get replaced or did this equipment go elsewhere? Many rental properties will have receipts against them and the work may have ended up in the current owner's house or cottage or even worse not at all. All items are a write-off with rental properties.
Bring a contractor or potential property manager with you to go over each rental unit and break down an estimate of repair for each suite. You may not do the work right away, but you can build a budget to when you will do the repairs. An easy example to follow:
Every time a suite becomes empty, you build a budget by suite on what you will repair. This could be a simple paint job of replacing the kitchen cabinets and bathroom fixtures.
One of the fastest ways to improve any building is to replace the carpeting or flooring in the hallways/common areas throughout the property. This gives the biggest bang with all tenants and a possible start to rental increases.
Curb appeal is very important. Landscape, exterior paint or brick needs to be clean and well kept. You want tenants that take pride in where they live. Make sure you budget enough to properly maintain the building.
Try to buy a building close to you. If you cannot afford your market, buy land and build something smaller. Proximity is important for saving money when you start. You can manage and advertise the suites, maintain the property, collect the rent and minor repairs if you live close by. If you have to pay for all of these services, that is your profit.
If you're in an expensive, hot market like the Silicon Valley, go to the edge of this market and buy raw land or a lot. Start with a smaller building like a four-plex. Many people work in the service industry or are just starting out in these markets. They will drive an hour to work. The Silicon Valley will probably keep expanding over the next 20 years people and your property will eventually be in the heart.
You can get quite creative with a four-plex building plans and it's a great way to start. You can live in one of the units until your equity builds up in the building, then rent it out and build another building using the first building to leverage the second.
If you're in a normal market where real estate is stable, you're dealing with the basics of location and return on investment.
The cost of rental property has made it prohibitive in many cities to buy income property alone. It is very difficult to have partners, especially family when buying properties that require consistent maintenance and upkeep by the owners. If you can raise enough capital within the partner group to hire maintenance services and rental management, it will help with working together.
Partners Working in The Business
The first thing that every partner needs to agree on and understand is that they are all in the partnership for profit. Profit is the goal. Profit is why we invest. To make a profit, you need to be a good steward of the business. That means managing your costs like any good business. Family members need to apply this good stewardship principal to themselves within the business. We would never pay three times the price for any service if you did not have too. Why would a family member pay another family member double or triple the cost for service that they could get elsewhere? Some family members may invest because they believe real estate is a good investment, but have no interest in working in the business while other family members are excited to work in the business and want property management to be their career. To satisfy all family requirements, everyone needs to feel like they are getting good value with their investment.
Rental Partners Working in the Business
A great way to manage owner services is by starting out by paying everyone for their time based on the standard compensation for this business sector. If one person is taking a full percentage of profit at the end of the year and did not contribute with their time, you will have a major problem and end up selling the property or buying out partners before the large profits can be realized. We recommend that you start out by negotiating a salary for every job position. A simple way to calculate compensation is to use the market to set pricing. Request quotes from outside contractors for the service that you are providing within the partnership. Job positions are outside property maintenance like cutting grass or painting, repairs and maintenance within the suites, collecting the rent or showing the property. Contact a landscape maintenance company, a carpenter, a property management company and request a quote for the service that the family members are now providing. You may even want to get multiple quotes to satisfy the family members. The contractor bids will help set the price for what the owners are charging the company for services and will satisfy the family members that are not interested in working within the business. If the property is not generating enough income to pay the owners for their services, book the amount owing against the business and these amounts are paid out before anything else. We would recommend going through this bid process every two-three years. You may find a contractor that will provide the service at a reduced cost and allow that family member to work elsewhere. The shareholders need to know they are getting value from the services you are providing. Owners usually do a better than a contractor, so paying a bit of a premium is worth it in the long run for all partners if their work is top quality.
Good luck as you start buying the commercial real estate. It is very exciting to hunt for property. It took us 18 months to find our first building so be patient, it is worth it in the end.
We will keep adding to this article over time as there are so many topics to discuss. Please add your comments below. We appreciate feedback