What to Consider Before You Become a Landlord

When those around you appear to be making good money from investing in homes, you might begin to think, “Hey, maybe I should become a landlord, too.” Perhaps you’re considering buying a second home as an investment. Or maybe you’d...

When those around you appear to be making good money from investing in homes, you might begin to think, “Hey, maybe I should become a landlord, too.” Perhaps you’re considering buying a second home as an investment. Or maybe you’d just like to upgrade to a larger home, but you want to keep your starter home as a rental property.

Before you become a landlord, think carefully about the larger real estate market, your investment, and your life to make sure that it’s the right move for you. Real estate isn’t without risk, and it isn’t for everyone.

The Big Picture of Real Estate Investing

Real estate investing can produce a great return. Average 20-year returns for commercial real estate run around a 9.5% return. Residential and diversified real estate investments come in a bit higher at an annual average return of 10.6%. And real estate investment trusts (REITs) perform even better with at an 11.8% return.

All three of these types of real estate investing come in slightly higher than the S&P 500 Index’s 20-year average annual return of 8.6%.

While these are impressive numbers, they are on a national level and over 20 years. Real estate is very local, and the average real estate newcomer doesn’t hold on to a property for 20 years. Real estate booms and busts make a big impact on individual returns.

Take the state of California. California has appreciated an average of 3.29% a year since 1990, -0.48% a year over the last 10 years, and 6.88% over the last year. And these are just appreciation levels. California sports some of the lowest rental cash flows in the United States due to the high purchase price as compared to the market rent. Investing in a state like California takes a special, long-term investor.

When you look to invest, consider your local market. Do they have good cash flows and good annual returns? Are homes poised to appreciate rapidly, or have they already reached historic highs? How do experienced real estate investors in your market invest?

Is It The Right House?

Your experience as a landlord, for good or bad, will depend in large part upon the house you decide to buy and rent. Real estate might be a good investment as a whole, but is your house a good investment?

When you run the numbers, does the house rent for more than all the expenses, including the mortgage and maintenance costs?

Make sure that you’ve also accounted for the value of your time. Life happens, and you might end up too busy later on down the road to take care of everything yourself. Even better, run the numbers to make sure you are still making a good return after using a management company. If you have to outsource, you’ll still make money. Having good cash flow is important to make sure you can continue to afford the property over the long haul.

You’ll also want to calculate the property’s capitalization rate or “cap rate.”  This is the annual return for the property, which is calculated by dividing the net income by the cost of the property. When you compare the cap rate to the long term performance of the stock market, how does your property perform? Holding a stock, bond, and REIT portfolio can be much easier than managing a rental property, so you’ll want your return to be higher than what you can obtain in the market.

In high dollar markets like California and New York, the high prices of homes make it difficult to have good cap rates. According to RealtyTrac, a leading home research source, the annual gross yield in the Southern California market ranges from less than 5% to 9% depending on the county.

Should You Become A Landlord?

In real estate, it’s not just the home that matters. Are you prepared to become a landlord? Is owning a rental property the right fit for your lifestyle?

Consider if you have the time, desire, or skills to manage a rental property, especially if you want to do it yourself. If a pipe breaks in the middle of the night, who’s going to go take care of the problem?  Even if you hire a management company to manage the rental, you’ll still be on the hook for making decisions and providing the cash for repairs if needed.

It’s more than figuring out how you’ll take care of the property. You also want to consider how such an investment will impact the rest of your life.

Are you young, single, and available to move for great career opportunities? You might not want to be tied down by a lingering obligation like a rental house in the future.

Do you have a young family that you’d rather spend time with instead of dealing with a rental property? These are important considerations when deciding whether or not to become a landlord.

Investing in real estate the right way can be a great way to build wealth. But before you become a landlord, make sure that it’s a good decision by taking a look at the market, the property, and your lifestyle.