What It Takes To Be A Landlord.

The ins and outs of buying and managing your rental property

When Linda Graves, a design engineer at Ameritech, purchased her two-family brick home in 1992, she was planning for her golden years. Just 43 at the time, she had already raised two sons and had begun thinking about retirement from the large Midwestern telecommunications company. She figured that she could use the rental income from the first-floor apartment to pay off her mortgage. So far, everything is going according to plan.

Graves (no relation to Earl Graves, publisher of BLACK ENTERPRISE), who lives in Shaker Heights, a prosperous suburb of Cleveland, has had good fortune in renting her apartment. For one thing, she's located near University Circle--the bustling district that is home to such cultural, medical and educational institutions as the Cleveland Clinic and Case Western Reserve. "I've gotten a lot of professional people," says Graves, who now rents to a couple who are fellows at a local hospital. To gain advice, contacts and tenant referrals, she regularly attends seminars conducted by the Shaker Heights Housing Department.

Her current status is vastly different from that during her days as a novice landlord just five years ago. In 1994, she bought and managed a four-unit investment property in nearby Cleveland with disastrous results. "I got all the rent from all four units once," she reflects. "After that, if I got rent from two tenants in one month, I considered myself lucky."

Her plan was to collect $1,000 in rent from her tenants, use $600 for mortgage payments and expenses, and pocket the rest. But Graves usually ended up footing the mortgage payments. "I said to myself, 'This is not going to work.'" Within a year, she sold the building.

Graves is not alone. A Census Bureau survey of the owners and managers of rental properties shows that roughly 28% of owners of multiple-family properties with fewer than five units lost money in 1994. And nearly 45% of the owners of single-family properties lost money or barely broke even.

Clearly, you don't become a landlord just because you enjoy early morning calls about leaky faucets and faulty heating systems. Asserts the battle-scarred Graves: "You should go into it expecting to get an income. That's why it's called rental income."

Experts agree. "Many people buy property because their gut tells them it's a good investment," says John Baiardi, a tax partner at Mitchell & Titus, a New York-based accounting firm. That's not enough. As with any other business, you have to have a plan. Owning rental properties can be a profitable investment, offering steady income and property appreciation. But don't underestimate the risks--if you aren't prepared, you might end up shoveling dollars down a money pit. Here's what you need to know about purchasing and managing residential rental property for prosperity--not pain.

FINDING THE RIGHT PROPERTY

It's an old cliche, but the top three considerations in buying rental property are the same as in spotting a place of your own--location, location, location. That doesn't mean your investment property has to be situated in a dream zip code. Save that for your primary residence.

Rather, the ideal neighborhood should have a built-in tenant base like, say, an area that needs housing for military personnel and their families.

Curtis White Jr., 43, maintains that location was a primary consideration when he bought his first house in 1993. He remembers asking himself one thing: "Will I be able to sell this house in 10 years?"

White learned from the mistake made by one of his clients at his tax preparation practice, e-Tax Pros, in Teaneck, New Jersey. "My client did well with rental property in Newark," he says, "but when he wanted to sell the building so he could retire and move to Arizona, he couldn't find a buyer because the area was depressed at the time."

With that lesson in mind, White bought a four-family building in Weehawken, New Jersey, a tiny commuter hamlet less than a mile square. Just 10 minutes outside New York City, the town offers breathtaking panoramic views of midtown Manhattan. White lived on one floor, rented out the other three apartments and met his future wife on the same block. Today, White and his wife, Chrystal Ingram-White, 34, own 16 rental units within a four-block radius in the community. Bearing out his assertion, White bought one property for $90,000 and made $56,000 in capital improvements. This year, he sold it for $239,000--a $93,000 profit.

When identifying a property, do your homework. Thorough analysis can determine whether a dwelling can generate enough income to pay for itself. "You should have a good handle as to today's and future expenses and how safe and secure the income stream is. Those principles don't change whether it's a two-unit or 100-unit apartment," says Dennis Cronk, president-elect of the National Association of Realtors (http://nar.realtor.com), a trade association based in Chicago. (See sidebar, "Is Real Estate a Viable Investment for You?")

With interest rates and unemployment low, conditions are favorable for acquiring rental property. But real estate is, by and large, a local investment. Research the market by asking area realtors about the history of rental rates and vacancies. Red flags to watch for: rents that haven't increased in five years or met the inflation rate.

GAINING ACCESS TO FINANCING

Once you've landed the right property, how are you going to pay for it? Your options are dictated by the following:

* The type of property you want to purchase.

* Whether you will live in the property.

* The number of units.

* The size of the loan.

* The number of properties you currently own.

If you're living on the grounds--even though you're a landlord--your owner-occupied home is not considered an investment if it has four units or fewer. That means you can make a down payment of as little as 5% with a loan through a special program or 20% or more to avoid paying private mortgage insurance (PMI). The primary lenders for these types of mortgages are commercial banks, thrifts and mortgage bankers.

If you're an absentee landlord with a property of five or more units, however, the dwelling is considered investment property. Typically, these are highly leveraged purchases. Investors do not have the options regarding interest rates, terms or down payment that are available to occupying home buyers. Lenders usually require down payments of 20%-30%. The reason for demanding astronomical rates and down payments: rental property carries huge risks.

"Usually people will sacrifice everything before allowing their primary residence to be foreclosed. That's the last thing they sell," explains Frank Gooden, president of First Merchants, a Brooklyn, New York-based mortgage bank. "Investors, however, may walk away from a troubled property more easily."

Because of the risk factor, most banks will not give you financing if you own more than five investment properties with secondary market loans (those that are sold to other institutions). Once you own more than five properties, you have to arrange some other type of financing--or a commercial loan, where the typical down payment is at least 25%-30%. Larry Lick, owner of 24 rental buildings and founder of Rental Housing On Line (www.rental-housing.com), a resource for small real estate investors, suggests developing a relationship with a local banker who won't sell the mortgage on the secondary market and, therefore, isn't restricted by the five-dwelling limit. One caveat: these deals will probably be adjustable-rate mortgages (ARMs). Most investors clamor for fixed-rate mortgages so their costs won't vary in today's interest-rate-sensitive environment. "If you're paying 8% and the market changes, then you adjust to 10%--you can't just raise your rent to cover that," explains Gooden. "You'll only be able to raise rent a moderate amount on an annual basis."

Other options include government loans. Curtis White bought his first home with a conventional loan from a savings and loan, but he financed and rehabilitated his other homes through the Department of Housing and Urban Development's 203(k) program. Check out the HUD Website at www.hud.gov for more information on HUD programs.

HOW TO HANDLE TAXES AND INSURANCE

Financing isn't the only thing you'll pay more for when you own rental property. Insurance costs are higher, too. If you own a rental property worth $100,000, you'll pay about 15%-20% more than if you lived in the home. Insurers are wary of the increased liability of rentals because the owner doesn't have exclusive control over the property. "The [renter] makes the coverage go up," explains Madelyn Flannagan, director of research and information for Independent Insurance Agents of America (www.iiaa.iix.com), a trade group in Alexandria, Virginia. "As a result, insurance companies tend to be more careful in requiring the upkeep of the home--like requiring that broken sidewalks be fixed or pools drained."

Just like any business that obtains insurance coverage for potential hazards, consider policies that cover the loss of rental income. Then, if your property is destroyed by a fire and you can't rent it, the insurer will pay you a percentage of your rental income for the number of months the house can't be occupied. For example, if you collect $850 per month on a unit, this type of coverage would run about $60 a year.

Flannagan also suggests that landlords protect themselves in the event of a lawsuit by purchasing liability coverage of $500,000--with an additional $1 million umbrella for extra protection. Depending on the number of properties owned and the limits you choose, premiums will come to $250. If you have three or more buildings, you can save about 25% by scheduling all your properties in a commercial package policy.

The scales start to even out when it comes to taxes. Such costs as mortgage interest, insurance premiums and certain renovations are 100% tax-deductible. If you live in part of the property, deductions can be tricky. Let's say you make improvements or repairs to the whole house, you can only deduct the portion of expenses that pertain to the rental units.

With your primary residence, you can exclude up to $250,000 of the capital gain from a sale ($500,000 if you are married). If you live in the rental property, once every two years you can exclude the tax on the portion of the house you live in. If you are an absentee landlord, there is no capital gain exclusion. The tax rate on capital gain on rental real estate is generally 20% on the portion that has been depreciated and 25% on the remainder.

FINDING AND KEEPING GOOD TENANTS

If you've done your homework when purchasing the property, the biggest wrinkle you will face is your tenants. A tenant from hell can wreck even the most carefully laid plan. Curtis White recalls one such experience. "We had a deadbeat tenant who didn't pay the rent. It took months before we got her out. That is the worst thing that can happen."

To this day, White is more diligent in screening prospective tenants. To avoid experiences that make you pull out your hair, conduct a credit check and employment verification before allowing anyone to move in. He now calls the previous landlord for a reference and the bank to make sure funds for the security deposit are in place before handing over the keys.

You might consider using a tenant-screening service like Tenant Check of America (800-922-2214) or Rental Housing On Line. These organizations offer national databases and can often find out whether an applicant has a criminal record or has ever been evicted. Fees run under $25 per evaluation.

Once you have tenants in place, it's a good idea to set up an incentive for timely rent checks such as discounts for early payments or penalties for late payments--if your state allows it. You should also set up a system for handling complaints. Tenants who nitpick about problems they can fix--like Linda Graves' tenant who complained about ants following a trail of syrup spilled on the counter or the tenant who couldn't turn the doorknob because he had lotion on his hand--can cost you as much time and money as those who neglect to tell you there's a leak in the roof damaging the ceiling. Landlords should specify in the lease what repairs and improvements are permissible, grounds for lease termination and penalties if the lease is broken. "We ask that requests for maintenance be put in writing,"' says Lick. "It makes it less likely that they'd hound you every day."

If you hate being on call 24 hours a day to deal with complaints or fear taking a vacation lest there is trouble on the home front, consider hiring a management agency to screen prospective tenants, collect rent and arrange for maintenance of the property. Typical fees run between 5%-10% of the rent. Hiring a managing agent will probably be cost-effective for most small rental investors who own two or more units. And you should realize that the more maintenance and repair work you do for yourself, the more likely you are to have a positive cash flow. But it's still important to have skilled repairmen you can call on in an emergency or if you ever want to take a vacation.

Whether you manage the property on your own or with the assistance of an agent, you're responsible for complying with the myriad federal and local laws governing rental units. They include the Fair Housing Act banning discrimination; laws requiring you to inform tenants of lead-based paint hazards; rent controls typically found in New York, California, Maryland, New Jersey and Massachusetts; and local laws like the one in Shaker Heights that requires a biannual inspection of rental units before a permit is issued.

As an investment, rental property take a lot more work than owning securities. You can't just leave it alone for years and expect to come back to an investment worth more today than when you bought it. It needs constant maintenance. Remember, even though the property is an investment, it's still a home.

RELATED ARTICLE: Is Real Estate a Viable Investment for You?

It is up to you to analyze whether the property will meet your financial goals.

To make that determination, you have to first get your personal financial house in order. Take an objective look at your credit worthiness in the same manner as a lending institution. Correct mistakes on your credit report. Have your down payment and closing costs in place before you go into contract.

When you buy residential investment property, lenders factor in your income plus how much income the property will net. For example, if you have a mortgage on your primary residence, lenders want guarantees that you have enough income to carry, both mortgages. Typically, they'll add 75% of the investment income from the rental property to your income to qualify the property. Lets you earn $100,000 a year and are looking to buy a four-family home that brings in $40,000 per year. :The lender will add $30.000 of the building's revenues to your income to see if you can handle mortgage payments.

The next step is a financial analysis of the property. The property may net you $40,000 annually under current market conditions, but you must project how much rent you could get under various market conditions. An apartment in the building that goes for $1,200 today may only bring you $850 a month under less ideal market conditions. The best way to make these projections is to get the tenant history from the seller--the tenant turnover rate and payment history. Financial institutions use projected rents from a real estate broker or an appraiser who will quantify the rental rates for a given property in a specific neighborhood.

Also, consider the type of tenants you will attract and any additional expenses that will be incurred. "Is the property located in a stable area? If you have tenant turnover every six months, that means you're going to make such improvements as repairs, painting and cleaning, which will add to your expenses," explains mortgage broker Frank Gooden.

For example, if college students are the tenants in a neighborhood, you have to consider that they are only in school eight months that leaves you with four months of vacancy each year.

Lastly, define how much of a return you want on the investment. Gooden suggests that if you can put your money in the stock market and get a 15% return, then try to find a rental property with at least that level of potential income and appreciation.

Another factor: a positive growth trend in neighborhood prices. Ten years from now, you want the value of the property to rise to a level where you can sell or refinance it so you can pay for your retirement or send Junior to college.