Investors are often advised to diversify their portfolios to minimize risk. Since investors are entrepreneurial to begin with, it’s not surprising that many have considered operating a second home as a rental property to create additional income. For those who’ve had great experiences with vacation homes, plenty have wondered, what if instead of spending thousands of dollars each year renting a house, we bought one, and rented it out when we’re not there? Other common scenarios are inherited properties, and families who are about to move who consider keeping their current residence and renting it out to generate passive income.
Sounds good, but if you’re seriously considering buying a rental property and operating it as property manager, there are five things you need to know.
1. You have to know the market
Like any investment, a comprehensive understanding of the landscape in which you’re investing is required. For a house, the investment includes both a down payment and ongoing expenses, as well as a time commitment determined by the mortgage, unless you buy it with cash. Either way, it’s vitally important to know about not just the property, but the neighborhood and the market it’s in. Which neighboring homes are competing rentals? How does yours compare in terms of amenities, curb appeal and price? Do the residents work to beautify and upgrade their homes, or is the neighborhood mostly transient renters, with no stake in the community? Does the HOA allow weekly rentals? Can you rent year-round, or are there limitations? If there is an HOA, it’s up to them, not you. Have you researched comps to see if you’re getting a good price and how prices are trending? Is the market heavily seasonal or is occupancy high year-round? Are rentals hard to come by or does availability fluctuate throughout the year? If you’re looking at a beach house, for example, you should factor in how many mortgage payments you’ll be making each year when nothing’s coming in when you evaluate the price.
2. Welcome to landlord hell
Property management is not passive income. When you rent out a property, you’re responsible for all the amenities and appliances, and some of the service agreements too. If there’s a leak or the air conditioning fails, you’re getting the call and the bill. And rental homes are often treated like rental cars. Not well. But, if you’re charging a premium, you have to provide premium service, too. Be prepared to field a 3 AM call about a broken toilet with alacrity. Of course, you can sub out maintenance and service issues, but you’ll need to vet all of your providers well in advance, because if you’re googling “plumber” in the middle of the night, you’re going to hire the first person who answers the phone. And if you can’t find a qualified provider, you may be inviting nonpayment or litigation.
3. Administrative talent is a must
For this venture to work, you need high occupancy rates; 90% or better should be your target. This requires marketing, staging and the bandwidth to show your property as needed. You’ll need to build relationships with trusted professionals to provide cleaning, plumbing, painting, landscaping, paving and electrical services so your property is always showroom ready. If tenants are primarily vacation renters, effective marketing will be critical to keep your property in front of the right audiences, and you’ll need top-notch housekeepers too, to turn it around each week. And in either case, you’ll need to vet your tenants. That means running rental history and credit checks, plus employment history and background checks for long-term tenants. And unfortunately, even people who pass the screening may fail to pay or cause property damage, in which case you’ll need a collections plan and perhaps, a trusted attorney. On top of all of that, you’ll need the bandwidth to field property inquiries and handle billing, bill payment, record keeping, taxes and tenant correspondence.
4. Make sure you have a good lease agreement
Your lease sets out the terms of the rental agreement, which boils down to, who is responsible for what? Rest assured, both parties will look closely at the rent and deposit amounts, but equally important is understanding who is responsible for the water bill, sewage and the HOA. If the garbage bill isn’t paid, will collections call the tenant or the home owner? What are the contingencies if the lease is broken? Is renter’s insurance included? If someone is injured on the premises, who’s liable? Make sure that you know every inch of your lease agreement, because surprises are liabilities.
5. Run it like a business
If you want to make money as a property manager, you have to run it like a business. That means understanding your expenses, setting revenue targets for what you need to make each year, and creating an amortization schedule to manage repayment. You’ll need to create a balance sheet detailing your equity, liabilities, and the current value of your property, along with an income statement tracking insurance, taxes, upkeep, administration and marketing costs to understand clearly what you’re spending each month. And you need to determine and meet your target occupancy rate to cover these expenses and turn a profit. Typically, you’ll want a 10-15% profit for a rental property to be worth your time. You’ll also want to create a monthly investment statement to track the return on your investment. If you plan to hire a property management team to handle the marketing and administrative tasks, know that they’ll charge 8-10%, and you’ll still have to pay for any work that needs to be done.
To help clarify if a rental property is an investment you want to make, ask yourself three questions:
- Am I good at home repairs, painting, landscaping, administration and marketing?
- Do I have the time to vet tenants and actively market the property year-round?
- Will I enjoy executing these responsibilities?
If you would enjoy playing all these roles, you could be a great property manager, and this could be a revenue stream that contributes meaningfully to your financial strategy. Conversely, if the time, expertise and diligence required exceeds your bandwidth or skillset, and you decide you just really want to own a beach house, that’s perfectly fine too. The important thing is to know what you’re signing up for, and what you want to get out of it.
If you’d like to discuss how a rental property could fit into your financial strategy, one of our fiduciary advisers would be happy to talk through your plan, at no cost or obligation.
