I've learned a few things recently as a result of becoming an unintentional landlord. After trying to sell my previous home for well over a year without success, I turned it into a rental property. Because I was never planning to hold on to this property, I made a judgment call that in retrospect, has turned out to be an error. I needed to pull most of the equity out of this smaller home (it was nearly paid off) to put 20% down on my fancy new attending home.
Since I was planning on getting rid of it within a few months, I opted for the least expensive option to get the equity out. That turned out to be a home equity loan (HEL). It was at a lower rate than the previous mortgage, and had minimal fees (~$200), so it seemed the best option for a bridge loan. (A bridge loan is a real estate loan to cover the time period between when you buy a house and when you sell your old one.) In retrospect, now that it is a rental property, I wish I'd done something else that is no longer available to me. I also wish I could have taken our No Hype Real Estate Investing course before I became a landlord. It would have saved me a lot of mistakes.
Here are the lessons I've learned in the process.
Your Cash Flow Is Better With A Longer Loan Term
This one is a bit of a no-brainer, but for me, has turned a property that would have had a positive cash flow into one with negative cash flow. Home equity loans are generally for a term of no longer than 20 years. 20 year mortgage payments are obviously higher than 30 year mortgage payments. That higher payment, combined with the other expenses, pushes me into a negative cash flow situation. Not nearly as negative as carrying an empty property for over a year, but still, it would be nice to not have to feed the beast each month. A good chunk of that payment is going into my pocket as equity, of course, but it is still money I can't spend or invest elsewhere.
You Can't Refinance A Home Without Taking It Off The Market
One of the reasons I chose the HEL as my bridge loan is that a true mortgage refinance would have required me to take the home off the market. Nobody would refinance a home that was for sale. Perhaps they were afraid I'd take the cash and then mail them the keys, I don't know.
HELs Are A Lot Easier To Get Than A Mortgage
The HEL didn't require much of an appraisal, which was an added benefit. They basically just asked me how much it was worth, then offered a maximum loan to value ratio of 80%, which was exactly what I wanted. It took one phone call, some mailed paperwork, and a fax. Less than 2 weeks total.
You Get A Lot Better Rate On A HEL If It Is The Only Loan On The Property
If your HEL is secondary to another mortgage, you're not going to get a good rate. If the HEL replaces the mortgage, your rate may be up to 2% lower.
Refinance Before You Move Out
If you think you're going to convert your residence into an investment property, refinance it before you move out. Rates are significantly higher for non-owner occupied properties than for your principal residence. How much higher? About 0.5% if you have a loan-to-value (LTV) ratio of 75%. That goes up to 1% for an LTV ratio of 80%. And above 80%? Forget it. You can't even get PMI these days for an investment property.
I’m interested in the majority of your blogs but find this one to be especially pertinent. I am in a similar situation in that my wife and I will also be unintentional landlords after I graduate from residency this coming June. We “own” our condo and plan to move out-of-state. However, we are heavily underwater and I don’t have the money to bring to closing in order to sell. In any case, I’m wondering what your feelings are about marketing (craigs list, classifieds, realtor, etc) and maintaining (do-it-yourself, property manager, etc.) the rental. Have you found any good texts for the amateur? Thanks.
I don’t know that I have any good text recommendations (perhaps other readers can sign in) for being a landlord. I do think it is worth hiring a property management firm (usually cost about 10% of collected rent) if you’re going to be out of state. They’re supposed to do the marketing with that money. We did discover it pays to shop around for these various property management firms (and I’d do it before you leave town) as the services offered, customer service, and price vary widely.
I think if you’re local, Craigslist works just fine. I’d also market heavily to incoming residents and medical students through the hospital/medical school.
Jeffrey, I was in a similar situation when I finished residency a few years ago. I was moving across the country and didn’t want to deal with being a long distance landlord. Plus both my wife and I are docs, so I felt we could make more money working instead of trying to manage a rental property. We ended up dropping the price significantly and taking out an unsecured loan from suntrust to make up the negative equity. Once we transitioned to attending saleries we rented and lived cheap for a while and payed off the loan in a few months. I don’t regret it for a second. Think long and hard about whether you want to be a landlord. It can make financial sense for some, but it can also be a major headache and probably isn’t worth your time if you can make more doing what you are trained to do. Also, maybe White Coat Investor can comment, but I’m not sure that real estate investments are the most tax efficient for those in our tax brackets.
As far as the tax-efficiency of real estate investing, yes REITs are pretty tax-inefficient. So they belong in an IRA or 401K. But in the beginning, most rentals don’t provide much income. My income from my rental from last year (granted, I only got it rented in December) was $7. Not much tax due there. But that was because I was able to write off all kinds of stuff against that income, plus you get depreciation. If I travel back to that area, I can write off the whole trip. So there are a lot of tax benefits to owning rental property. Now, if you don’t have very many deductable expenses, then yes, rental income is taxed at your regular marginal tax rate. But you get the capital gains rate (or if you do an exchange within 60 days you don’t pay at all) on gains when you sell the property.
So overall, I wouldn’t necessarily shy away from rental real estate due to tax-inefficiency. The hassle factor is a far bigger issue in my opinion. For me, I wasn’t willing to give the property away for what I felt was way too low of a price, so I decided to rent it instead. I’m minimizing the hassle by using a property management company. I’m sure you’ll hear over the next few years whether I think in retrospect that it was a good decision.
Thanks for sharing your mistakes. We all learn so much through them.
I agree with the White Coat Investor….the headache of managing residential real estate is significant. I’ve taken a lot of lumps through the years. I believe all doctors should have some real estate in their portfolios, but not residential. We now invest in apartment buildings (commercial real estate) as fractional owners using an asset management company. No, headaches, just checks in the mail.
As for taxes, real estate can be the best tax advantaged investment available. Depreciation is nice, and accelerated depreciation (AKA cost-segregation) is even nicer. However, at our salaries, that paper loss may not be allowed (it becomes suspended until you sell). If you have a spouse that doesn’t work, you might want to look into him/her becoming a “real estate professional.” Definite rules that one must meet, but then the losses can be taken against your earned income no matter how much that may be.
Lastly, good syndicators will force appreciation by raising net operating income. Once they drive the Loan to Value of a property down to say around 60% then they can refinance the property back to 75% – 80% LTV. Depending on the syndicator, the deal, and the market, this generally takes about 5 years. Then they will refinance and return the profits to the investor…..Refinances are always tax-free events. So in my mind, real estate can be a fantastic investments when it comes to taxes, but I would echo other’s concerns about the headaches of self-managed residential investments.
A couple of questions for you.
I just became an intentional landlord. Wondering how you feel about your property manager (and if you would recommend yours). Also, did you transfer the property to an S Corp or LLC? Did you run into any issues with your lender? Obviously running it as business has many tax advantages if you are a W2 employee (I think you are not).
Interested in your thoughts on property managers and incorporating for real estate investors.
Thanks!
All of my properties are in LLC’s. I do it for asset protection purposes primarily. I have a property manager that takes 8% gross rents. For residential properties 8% – 10% is standard. Its lower for commercial. If you run it yourself (or if your spouse runs it and does not have another job) he or she might be elegible for Real Estate Professional Status with the IRS. This is significant, but the rules are defined, so consult a competent CPA or better yet a tax strategist that specializes in real estate.
As with lending, you run into the possibility of triggering the due-on-sale clause in the contract if you transfer the property from your name into your LLC name. You can speak with your lender and see if it is alright…..If they say yes, I’d get it in writing. I know others who have just done it and not told their lenders. Its a risk doing it that way.
JL-
I’m not thrilled with my manager. They were great at getting a renter in, but not as good at servicing the property.
Putting it in the LLC is the way to go. Sounds like Dennis has more experience along this line than I do. I’m still getting around to putting mine in an LLC. It’s on my list to do prior to the end of the year. I don’t see any reason to incorporate your property. The LLC provides asset protection for you and you get the favorable tax circumstances associated with real estate without having to incorporate.
Property Management is one of the big reasons that I’ve been selling off my residential and going into commercial with bigger properties. I’ve changed PM’s more than once with residential. Unfortunately with single family homes and four-plexes, you tend to be stuck with the local mom and pop manager. They can only make their money this way by volume. As such, my experience has been that they tend to ignore your properties and do the bare minimum. You can find good ones out there, but they are few and far between. With bigger properties, you can get the big managers who have systems in place to make you the most money. They utilize economies of scale and its so much better.
With real estate, there is really only four stages for the investor. Capital raising, acquisitions, operations and liquidation. If you mess up acquisitions or operations, you can really get screwed. I know, I’ve been there.
Knowing whether to keep your property as a rental or liquidate, depends a lot on the market. There is a lot of institutional buying of single family homes that are bringing areas back rather quickly. For example, Phoenix home prices are now back to late 2006 prices. Atlanta and Charlotte have bottomed out and just starting to move up and will follow the trend of Phoenix rapidly. Markets like these MAY be worth keeping your properties for awhile longer. However, you need to know whether there is population and job growth in those cities. Most people just buy in their local market not even knowing if its a good market or a place like Detroit where population and jobs are declining.
Even in good markets, most properties are not great investments. The submarket is crucial. Good schools and low crime make your properties desireable to buyers. Lots of marginal submarkets get over-run with rentals and nobody wants to buy that for retail price as their dream home.
Most property bought for cash are value 10-20% lower than the market value,But there are firms out there would only deducted 10% of the valuation.( It was published in The Daily Mail some 4 months ago).
But thanx for the great post
WCI,
Any update on the property? Was browsing old posts and found this series on RE investing. Have considered adding residential properties to my investment portfolio slowly over time if possible.
Poster above (Dennis) seems to have some pretty good insight into residential and commercial RE. Wonder if you would consider a guest post by him on this topic
Dennis has guest posted in the past. https://www.whitecoatinvestor.com/commercial-real-estate-investing-using-a-private-real-estate-investment-team/
I still own the property. Darn disposal and range went out this week. I definitely don’t recommend owning real estate directly in another state. Those syndicated deals Dennis advocates seem more and more attractive all the time.
Excellent commentary – I am thankful for the insight . Does someone know where my business might be able to get access to a sample SSA-7050-F4 copy to edit ?