There’s a type of small, mom-and-pop landlord that some derisively call the
accidental landlord, so-called because these landlords didn’t buy a property intending to become a landlord. Circumstances, or a discovered opportunity, led to them converting their previously owner-occupied primary residence into a rental property. I’m an accidental landlord, twice over! I have converted two of my former primary residences into rental homes.
I still own both of my rental properties and plan to own them for the foreseeable future. But when asked about my experience, I tend to generally try and dissuade people from attempting to do what I’ve done. Converting one’s primary residence into a rental is usually a bad idea and probably not for the reason you think. My main reason has nothing to do with having to deal with tenants or toilets or any of the other problems imagine when considering becoming a landlord. For me, it’s all about the Benji’s. And most homes people buy as a primary residence simply won’t cashflow. Or rather, they’ll be what’s called
cashflow negative. Negative as in a vacuum, sucking up money every month. If it don’t make dollars, it don’t make sense!
Most people, including many real estate professionals (I’ll be doing an upcoming post on this), severely discount the importance of positive cashflow in a long-term rental property.
First let’s define what cashflow is. It’s deceptively simple: income minus expenses equals the cashflow. People thinking of converting their home to a rental often do this back of the napkin computation: “I can rent out my house for enough to cover the mortgage. As long as I’m breaking even, I’m building equity and getting rich!” Whoa, there moneybags. That’s a good start but you’re not even close to having a cashflowing property. If you’re only considering your monthly mortgage payment as the extent of your expenses, you’re in for a huge surprise. Professional landlords know their monthly expenses also include, at a minimum: maintenance, vacancy, capital expenditures, and possibly property management.
Maintenance costs are pretty obvious: it’s money to pay for things like frozen pipes, your annual termite bond, semi-annual HVAC checkups, and the random breakage that happens with houses: leaking dishwashers, ice-makers that stop making ice, a wall-tile falling off the back-splash. These are things you might live with as a home-owner until you can get around to it (probably right before you sell the house). But tenants expect these things to be fixed. Now. And unless you know how to fix every damn thing, or if you’re using a property manager, that means paying someone to fix it. The amount you spend on maintenance is going to vary from month to month, but a good rule of thumb to budget is 10% of the rent. It works out because higher rents usually either mean larger houses with more things to break, and/or higher expectations from tenants. If it’s a newer house, you might get by for less…for now…but I wouldn’t count on it.
Vacancy is the time your house is going to sit vacant between tenants. If there’s no tenant paying rent, that means the money for all the other expenses have to come from somewhere. If you haven’t been setting aside money from previous rents, the carrying costs while the home is vacant is coming straight out of your pocket. Ideally, you’ll land a long-term tenant who’ll stick around for several years. But the longer the house is lived in, the longer it’s going to take to turn it over. To get the house ready for a new renter, you’ll need to fix all the little things the old tenant never mentioned, repaint, replace carpets or surface floors, etc… And you still need to market the property, screen applicants, and get a lease signed to get money coming in again. A good rule of thumb for budgeting for vacancy as an expense is to use 10% of the rent.
Capital expenditures are the large items that you actually get to depreciate on your taxes: things like a new roof, new appliances, new HVAC. These expenses occur infrequently enough that it’s easy to pretend they don’t exist and then when they do crop up, to chalk it up to bad luck. But it’s not bad luck. All of these items have a life expectancy. Landlords should be thinking ahead and putting some money away every month so when that 20-year old roof start springing leaks all over the place or the A/C gives up the ghost, there’s money sitting there -built up from previous years of rents- ready to cover the expense. Instead, most amateur landlords end up paying for these things out of their own pockets, or worse: taking out a loan or -God help you- putting it on a credit card. How much would one need to set aside to cover these costs? Ohhh, about 10% of the rent is a good number.
Last is property management. If you’re going to self-manage your property, you get to somewhat ignore this costs! But if you’ve become a landlord because of an out of state move, or if you just don’t want to deal with actually being a landlord, then you’re going to need to pay for professional property management and it ain’t cheap. I pay my property manager one full month’s rent (per house) every time they have to find a new tenant for one of my houses. On top of that, I pay an ongoing $100/mo fee. And there’s a whole fee table for other incidental fees that might come up from time to time. It’s yet another variable expense, but for a nice easy number to budget for…let’s call it…10% of the rent.
These expenses are why most houses that you, “can rent out for enough to cover the mortgage”, are terrible rentals. Covering the mortgage isn’t enough. Even if you’re “breaking even” on the mortgage, you’re going to be losing your shirt to your true expenses. And since most accidental landlords don’t run their rentals like a business and keep detailed records of their property’s inflows and outflows in a dedicated account, these real costs can fly under the radar enough that people don’t even know how much they’re sinking into a property. They just know they keep having to throw money at this house month after month until, finally, they throw in the towel, sell the house, and swear, “never again!”
In an upcoming post, I’ll run through the numbers with some concrete examples to compare the financial realities between owning house the cashflows modestly and one that just covers the mortgage. The total cost of ownership in the latter case is quite shocking.