I love the game of Monopoly. My sons enjoy playing it too. But we all have the same complaint about the game; it takes forever to accumulate all the wealth and ultimately win the game. Being a landlord means the same thing. It will take a long time to accumulate wealth. For those of you considering becoming a landlord, there are certain business dynamics and economics you should understand.
Patience is the primary business characteristic you must endure to accrue wealth. In addition, you must possess the business acumen needed to be shrewd in acquiring property and renovating the property to last long periods of time with little maintenance. In addition, understanding the tax implications is essential in turning real estate into real wealth. When you understand all these business dynamics and the economics of real estate; you can see how you can become wealthy as a landlord.
This article will explain these business principles and the associated real estate economics. The following sections cover real estate economics, the business acumen needed to buy and hold property, the tax implications related to renting property and finally how wealth is acquired in real estate.
Real Estate Economics
Since the beginning of human agrarian activity, owning and controlling land equated to wealth. The value was immense and to appreciate this; think about the men that signed the Declaration of Independence. All of them owned real estate and knew that if we lost the war, they would lose their land and their family’s wealth. Their economic status was tied to their land and their ability to attend Congress was solely related to their wealth. In effect, Land = Wealth.
That image is no different today. Except we don’t look at land in the agricultural sense; we look at it in the form of developed real estate. For younger or novice business owners, residential real estate is the symbol. When you go to a party, those that own rental property have no problem letting everyone know.
The primary goal of the landlord is to purchase real estate, operate the real estate via renting the home, and ultimately accumulate wealth via the increase in the overall value of the real estate in excess of the inflation rate.
The following graph is one of the more realistic presentations of inflation adjusted home prices over an extended period of time. I found this at http://observationsandnotes.blogspot.com/. This particular site provides information about economic issues using charts and graphs. It is a personal finance blog.
You can see via the graph the historical change during the early 2000’s and then of course the real estate market crash that occurred in 2008. What is interesting is that I reviewed about one dozen different growth charts and of course several painted unrealistic pictures of wealth accumulation. This relates to many variable changes that have taken place over the last 60 years. This includes the dramatic increase in the number of homes nationwide, the average increase in size, and even the rate of inflation (depends on your source of information). But this graph appears more reasonable to me; it is as close to reality as can exist.
Using the graph above as a guideline, if you purchase property today and hold that property for 30 years, you should see an inflation adjusted gain of around five to six percent. Doesn’t seem like a whole lot does it? Honestly, many investments have track records to match and actually exceed this value. How can someone actually generate wealth from holding land? The answer lies in the process.
In a typical scenario, the landlord invests about 25% of his own money in the purchase of the rental property. The balance is borrowed via a mortgage and over time the rental income is used to extinguish the mortgage. In effect the landlord leverages his money. Let’s walk through an example:
Kevin purchases a rental property for $100,000 and uses $25,000 of his own money. He proceeds to rent the property and pays the associated expenses of the property with the proceeds from the rent. After 30 years the mortgage is paid off and Kevin decides to sell the house. To keep this simple, there is no inflation during this period of time. The house increases in value by 5% during this 30 year stretch of time. Kevin sells the house for $105,000. Since there is no mortgage to pay off, Kevin keeps all $105,000. His overall return on his $25,000 is 4.8% per year. Remember, this is a zero inflation rate period. This would be considered a superior investment.
If you look at the graph, there is another interesting attribute. The real estate downturns do not extend over long periods of time. Therefore, this type of investment is safer and thus more desirable over extended periods of time. Remember, the primary characteristic needed for a landlord is patience. Go back to the game of Monopoly; it takes time to create wealth.
For those of you looking to become a landlord or are relatively new to the process, time is your best business partner. If you are looking at this in terms of a 10 year or 15 year window, you are looking at the wrong industry. To make this work, the investment must be purchased for a good price and you need to hold the investment. The following section elaborates on this business dynamic of being a landlord.
Buy Low and Hold
Over the years, I’ve had several clients as landlords. I myself was involved in it back in the 90’s. What I have learned is that for this to work, the rental property must be purchased for a relatively low price and carry positive physical characteristics. What do I mean? You need to purchase a piece of property with the following attributes:
- Good location for class of tenants, schools, access to amenities, access to major transportation routes;
- Solid foundation and structure, no sags in the roof line, no pest damage etc.;
- Excellent curb appeal with proper lot and landscape features;
- Simple floor plan and appropriate number of bedrooms and bathrooms; AND
- Modern kitchen features such as cabinets, countertops and appliances.
In many of these cases, you are purchasing a property that will require remodeling or some renovation work. It is OK to do this but make sure the purchase price matches the condition of the home. I explore some of this in my article House Flipping – Business Dynamics.
Once you have found the optimum piece of property, it is now time to properly finance the purchase. You should make arrangements well in advance and in most situations, you’ll need a bank to make this happen. Many mortgage companies require you to live in the property as your personal residence and they don’t finance rental properties. Negotiate with a bank related to the purchase. Agree to certain terms such as financing of 50% of the fair market value after renovations. Agree to the dollar ratios between you and the bank such as for every one dollar you invest, the bank provides two thus their position is 67% of the total actual cost of the rental property including the renovation costs.
The key is to have financing arranged in advance as this allows you to negotiate with the seller with a firm hand. Once financing is set up, now spend some time and find the best piece of property to buy and buy it low. Make a low offer and allow time to benefit you. Make offers that have contingencies involved such as: ‘Offer is good for 15 days unless rescinded’. If you make several offers on different properties, as soon as someone accepts your offer, rescind the other offers immediately. You will be surprised at how impatient sellers are in holding out for more money.
There are multitude of sources to purchase property and excellent opportunities. For example:
- Homes of the deceased are often disposed of by family members at high discount rates;
- Banks provide repossessed properties on their websites;
- Short Sales;
- Es Cheat Sales.
The best source is a real estate agent. They’ll find you something that fits your budget quickly as they have access to all these different sources including the Multiple Listing Service. Use the internet to find properties. Get to know house flippers as sometimes they are willing to sell off one of theirs when cash becomes an issue.
The second step in all of this and the most important – HOLD the property for the long term. To do this successfully, you must have a well managed landlord process. This is a different article for a different day. Suffice it to say, you keep the house occupied with a tenant during the entire holding period. This has a double benefit. First it generates cash to pay the respective bills and secondly, it reduces damage to your property during periods of vacancy.
But the most important and lucrative value with the HOLD concept is the time value of money. The longer you hold the property, the more wealth you will accumulate.
Naturally, there are the dreaded tax issues related to owning real estate. The next section will explain the basic principles involved and how they impact you as an owner of real estate.
In general, most real estate investments are passive in nature and therefore treated slightly differently than other forms of income. However, in the above scenario where you are the primary engaged individual in this business, your real estate operation is ‘ACTIVE’ and therefore you are liable for self-employment tax too.
The tax implications are difficult for most folks to understand due to the complexity and nature of the Internal Revenue Code. This is information for another article for another day. But I want the reader to understand that in general, renting property out to tenants generates little to no taxable income to the landlord.
Now in general, most landlords have very little taxable income associated with their respective properties due to depreciation used as an expense. In effect, when you buy the property, you are allowed to depreciate (take equal shares as an expense over time) your purchase. For residential real estate, the time period is 27.5 years. Land cannot be depreciated. Only the structures are depreciated. Sticking to our example above, let’s assume that the land is worth 20% of the total purchase price. Therefore, $80,000 of the $100,000 investment is depreciated over 27.5 years.
That is $2,909 per year. In addition, the landlord is allowed to take all expenses and the interest from the mortgage note as a deduction. For the sake of simplicity, the total cash out to operate this property per year is $7,571. Therefore the total tax deductible amount is $10,480 (the cash out expenses of $7,571 plus depreciation of $2,909). Any rental income in excess of this value is taxable income and taxable for regular income tax and self-employment tax. Even if you were to get $1,200 per month in rent, that would equate to $14,400 a year in rental income. Reduce this amount by the tax deduction of $10,480 and your total taxable income is $3,920.
Your approximate tax is $1,372 (income and self-employment taxes). You net $2,548.
However, don’t forget, you still have to make principle payments on your loan. In the earlier years, the principle payment is relatively small but increases based on the typical amortization schedule. In effect, most rental businesses are in a complete cash neutral position and this is where the HOLD concept generates the real accumulation of wealth. The following section explores this in more detail.
The single most valuable attribute in this business model is the HOLD principle. As time goes on, the real estate will begin to increase in value and as a landlord; this will begin to accumulate in your equity position. You will have unrealized gains associated with the difference in the current fair market value and your basis.
If your property is located in a good area, carries the attributes I describe above, then the value will increase at a faster rate than the national average.
In addition, the amortization of the loan will require greater principle payments in the later years of the loan. Again, time is your best business partner because rents will increase over the same time period covering the marginal increase in cash needed to make these principle payments.
This is how the business dynamics for a landlord work. The general economics of real estate allow for a return on your investment. In addition, there is a reduced risk associated with real estate due to the nature of the industry, i.e. housing is a need and not a want. Just like in the game of Monopoly, at some point your opponent will land on your property and be forced to pay the rent. In principle housing is inelastic. Act on Knowledge.