Rental property isn’t a guaranteed investment

Question: I saw your column on the subject of novice real estate investors. There is one issue I am interested in just as a public issue. This is the idea people seem to believe in that anyone who invests in real estate is somehow entitled to a rental income that is at least equal to their expenses.

I think anyone who advises potential investors should make it crystal clear that there is no “god-given” or natural law right to a positive cash flow in a real estate investment. Knowing that would help small and novice investors get along better with their prospective and actual tenants, and, as importantly, with themselves and their spouses or investment partners.

The idea that one can, by spending a tiny amount, end up owning a property worth hundreds of thousands without investing any further amount of one’s own money just isn’t very plausible.

I lived in Merced County in California at the height of the real estate bubble. Bay Area investors came in thinking they could put $5,000 down on a $400,000 property in an economically depressed area and get someone to pay $1,800 a month in rent.

Never worked, and I knew from day one it wouldn’t. People with that amount of money could afford to buy their own house and did.

Answer: You raise a good point, and I agree with you. Many years ago late night TV used to be filled with infomercials about how to “Get Rich Quick in Real Estate” by buying homes with “No Money Down!” What these gurus failed to explain was how much money it might cost to hold onto the properties after you buy them.

The no-money-down craze was popular when home prices were appreciating rapidly. The idea was that the rising home price would more than make up for any short-term negative cash flow you might have while holding the property.

But as we all know now, home prices don’t always go up. For the past six years home prices have dropped throughout the Puget Sound region. If you bought a home with no money down near the peak of the housing market, not only have you been losing money every month with negative rental income, but you have also lost the value of your home, so it’s a double whammy.

As you mentioned in your letter, it is virtually impossible to buy a home and rent it with a positive cash flow without making a down payment of at least 20 percent.

Buying a home with no money down is relatively easy in a weak housing market because many homeowners have very little or negative equity (owe more than their home is worth). All you are doing is taking over their financial problem.

It makes no sense in today’s real estate market to buy a rental house with a negative cash flow because we have no idea how long it will take before home prices start to appreciate at a reasonable rate.

It is possible to buy a fixer house and create “forced appreciation” by making repairs and improvements to increase its resale value. But that does not necessarily increase its rental value enough to generate a positive cash flow.

That’s why most fixer investors quickly flip the house to sell for a profit rather than trying to hold it as a long-term rental property investment.

Before you consider buying a rental property, make sure you do a rental survey of the area to find out the current rental rate for similar properties. This is easy to do by searching Craigslist and other online rental ad websites.

If you find that 3-bedroom, 2-bath homes in your neighborhood are renting for an average of $1,800 per month, don’t expect to be able to get $2,300 per month for your house just because that’s how much you need to pay your mortgage.

This is a fairly strong rental market for landlords, but you must be competitive. The best quality tenants are smart enough to search for the best deals. If you are able to rent your house for an above-market rate, you are likely end up with poor quality tenants who can’t qualify for the more affordable rentals and have no other choice.

That’s not the kind of tenants you want to attract.

Steve Tytler is a licensed real estate broker and owner of Best Mortgage. You can email him at features@heraldnet.com.

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