Investing in rental real estate looks like a great idea on paper. You just buy a place in a nice area, find tenants, and let the cash roll in – right? Well, there are some matters you have to consider before buying a property and putting a "for rent" ad on the lawn and in the newspaper (or online). Here we provide a rundown of the pros and cons of owning rental property and give you a few tips on how to turn a profit as a landlord.

Key Takeaways

  • Investing in rental real estate has several advantages, such as producing additional income and yielding certain tax advantages.
  • Another advantage of investing in rental properties is the potential of an appreciation in value.
  • A few disadvantages include unexpected expenses, such as appliance breakdowns and plumbing issues, and bad tenants.
  • To minimize risk, landlords can run credit checks on potential tenants, have a professional agency inspect the property, and create an emergency fund.
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Tips for the Prospective Landlord

Advantages of Rental Real Estate

Many people who feel uncomfortable investing in financial instruments have no qualms about investing in real estate as it is a tangible asset. This is a psychological distinction, as a bad stock and a bad rental property are equally capable of losing money. That said, the following are the advantages that show on paper.

Current Income. 

This refers to the rent money that is left over after the mortgage and related expenses have been paid. Current income is monthly cash that you did not have to work for – your property produces it for you.

Appreciation

This is the increase in value that properties generally experience as time passes. Appreciation is not guaranteed. However, if you own a property in a stable area, the property will likely increase in value over the years. Even properties in sparsely populated and less desirable areas may appreciate due to general inflation.

Leverage

Rental properties can be purchased with borrowed funds. This means that you can control the whole property and the equity it holds by putting down only a fraction of its total cost – a percentage of the total value. Also, the property you purchase secures the debt rather than your other assets. If you fail to keep up the monthly loan payments, you may lose the rental property, but you shouldn't lose your own home.

Tax Advantages

Your rental income may be tax-free if you do not receive net cash flow after deducting expenses. This means that your mortgage is being paid down and you own more of the total value of the property (rather than just controlling it), but you do not pay taxes on the money that is doing this for you. Also, you can pull out tax-free money by refinancing your loan if the property appreciates and interest rates have fallen. Lastly, you may be able to avoid paying taxes on the sale of a rental property if you sell it and promptly reinvest the money in another property (called switching or tax-free exchange).

Disadvantages of Rental Real Estate

Liability

What happens if a stair breaks under your tenant's feet? With the increase in frivolous lawsuits and the impossible to quantify nature of "emotional distress," liability can be a scary thing. Sheltering someone in return for money puts you and the tenant in a relationship where both parties bear responsibility. You have to be certain that the property you are renting out meets all building codes and regulations.

Unexpected Expenses

What do you do when you pull up the basement carpet and find a crack that opens into the abyss? It is impossible to prepare for every expense related to owning rental property. Boilers, plumbing, and fixtures often need to be replaced and are not prohibitively expensive. However, faulty wiring, bad foundations, and compromised roofing can be very expensive to repair. If you can't pay for repairs, you'll be left without a tenant and with the grim prospect of selling the property at a significant discount. Also, as building codes evolve, lead paint, asbestos, cedar roofing tiles, and other materials that passed inspection in the past may be reevaluated to your disadvantage.

Bad Tenants

No one wants to have to use a collection agency to collect overdue rent. Unfortunately, almost every landlord has a story that involves police officers or sheriffs escorting his or her tenant out of the property – erasing all hopes of getting the five months' worth of overdue rent. Bad tenants can also increase your unexpected expenses and even hit you with a lawsuit.

Vacancy

No money coming in means that you have to make monthly payments out of your pocket. If you have an emergency fund, you will be able to survive vacancies with little trouble. If you don't have one, you may find yourself scrambling to pay the rent to the harshest landlord of all – the bank.

Tips for Landlords

Minimizing the disadvantages of owning real estate is simple. Here are some guidelines that will help.

Keep Your Expectations Reasonable

Have the goal of positive cash flow, but don't expect to purchase a new yacht at year's end. If you keep your expectations in check, you won't be tempted to jack up the rent and push out good tenants.

Find a Balance between Earnings and Effort

Are you planning to be a "hands-on" landlord, or should you work with a firm? Current income doesn't seem so great if you are putting in another full-time shift working on your rental property. Happily, there are property management firms that will run your property for a percentage of the rental income; you might consider engaging one.

Know the Rules

Federal and state laws outline your responsibilities and liabilities; so, you can't claim ignorance when something happens. You will have to do some reading; nevertheless, it is better to spend 20 hours in the library than in the courtroom.

Have the Property Inspected

One of the best ways to avoid unexpected expenses is to have the property inspected by a professional before you buy it.

Make Sure Your Leases Are Legal

If you make a mistake on the lease, you will find it more difficult to litigate if a tenant violates the terms.

Call References and Run Credit Checks

Too many landlords rush to fill a vacancy rather than taking the time to make sure the prospective tenant is a better option than an empty property. If you have time, you may want to drive by a prospective tenant's current living space – that is what your property will probably look like when that tenant lives there.

Join the Landlords' Association in Your Area

Joining an association will provide you with a wealth of experience, as well as sample leases, copies of laws and regulations, and lists of decent lawyers, contractors, and inspectors. Some associations may even allow you to join before you buy a rental property.

Make Friends with a Lawyer, a Tax Professional, and a Banker

If you find that you like owning rental properties, a network including these three professionals will be essential if you want to increase your holdings.

Make Sure You Have the Right Kind of Insurance

After learning the rules, you will need to buy insurance to cover your liability. You will need the help of an insurance professional to select the proper package for your type of rental property; a plain vanilla homeowners policy may not be adequate.

Create an Emergency Fund

This is essentially money earmarked for unexpected expenses that are not covered by insurance. There is no set amount for an emergency fund, but 20% of the value of the property is a good guideline. Nonetheless, anything is better than nothing. If you are getting current income from a property, you can pool that money into the emergency fund.