Rental Property Investing—Practices and Pitfalls

Are you thinking of investing in real estate rental properties? You aren't alone. It's a hot topic among people looking for passive income streams. But before you jump in, as someone who has owned two rental properties in the last 15 years, I can say from experience that it's important to look before you leap.

I never meant to get into real estate investing. I went into my first real estate venture out of necessity. And I learned a lot—the hard way. I bought a condo in 2007, basically at the top of the market. I lived there a few years, but then my life changed. I started working about an hour's drive away and going to grad school at night. I wanted to live closer to work and school. I thought about selling, but the real estate market had dropped, so it made more business sense to rent my condo.

But what did I know about the practical things like vetting a renter, handling complaints, and doing maintenance? I didn't think any of that through; didn't check credit scores, didn't even think about the fact that I'm not particularly handy. Long story short, my first tenant was awful, didn't pay the rent, had major complaints that took a lot of time, and I ended up having to get an attorney involved. The most important lesson I learned was the value of hiring a professional property manager, which  is what I did with my second tenant on this property.

My second rental property was also a personal situation. I was getting married, and my wife and I each owned a home. We decided to move into hers and rent mine out. I hired a professional, and the whole experience was a lot more positive.

But owning and renting real estate isn't just about the practical, day-to-day considerations. It's also important to consider the role that real estate can play in your broader financial plan.  For example, it could help diversify your portfolio,  be a hedge against inflation, increase cash flow, and help build wealth over the long-term.

However, to get the financial benefits, you have to know what you're doing. Here are some best practices and common pitfalls that I learned from experience.

• Look for positive cash flow. This means you're taking in more money than you're putting out. That's the ideal, but it's not always possible. With my first property, I had an even cash flow, so at least I wasn't losing money. With my second property, I had a positive cash flow. And luckily, I eventually sold each one at a profit.
• Location, location, location. This is the number one rule in real estate and makes equal sense whether you're buying a property to live in or to rent. You can increase the chance for a positive cash flow by choosing a property close to desirable amenities like schools, shopping, parks, and transportation. It can be worth it to work with a realtor who knows both the real estate and the rental markets and understands your situation. They can help you find a property—and tenants.
• Screen tenants carefully. This is another situation where a professional can really help. And as I said, I wish I'd done it the first time. Someone who works in rental real estate full time can do the research on a tenant and check credit scores and rental history. They can also potentially increase your pool of renters. It may cost you a month's rent, but to me it's worth it. I used a professional to find the second tenant for my first rental, and they stayed 10 years until I sold the property.
• Explore lending options.  There's certainly a lot of value in a traditional 30-year fixed. But if you know you aren't going to hold onto a property for more than five years, you might want to consider an adjustable-rate mortgage. That could give you a better rate and a lower payment, which could help with your cash flow.

• Failing to conduct initial—and ongoing—property inspections. This is a big one. Give a property inspection checklist to the tenant. Have them go through the property and mark down anything they see that could be wrong. And be sure to collect the checklist. If you don't, it's their word against yours. But don't stop there. Set the expectation that you'll be making periodic inspections. Ideally, write it into the lease so the tenant won't feel uncomfortable. It's eye-opening what you might discover.
• Underestimating operating costs. Property taxes and maintenance are a given. But you might also want to consider management fees. Hiring a property manager can save you both time and money. Especially if you live a distance from the property and can't make repairs on your own. If there's a maintenance issue, they get the call, not you. And they have a pool of people to do the work. A property manager will also help you collect the rent and do inspections. It may cost you 6-10% of your monthly rent, but I found it well worth it.
• Not budgeting for vacancies. Renters come and go. It might take you three to six months to find a qualified renter, depending on the market. Build that into your budget.
• Not changing your homeowners insurance policy. If you are turning your primary home into a rental, notify your insurance company that the home is no longer owner-occupied. For example, there could be a potential risk if there is a vacancy, and damage occurs to the home during that time.
• Not putting special clauses in the lease. Consider things like climate and pets or even rental insurance. For example, in a hot climate, is it necessary for the tenant to regularly water the lawn? In a cold climate, does the heat need to be kept at a certain temperature? I've made this mistake in both situations, dealing with burnt grass and bushes on one property, and a burst water pipe in a wall in another. And that's expensive. And what about pets? Do you want to limit the type and size? Will there be a cleaning surcharge? Last but not least, some landlords require renters insurance as part of the lease, which could protect the property owner from potential liability from the renter. Put it all in writing upfront to protect yourself.

Owning rental property can seem like a great tax move. For example, you may have heard terms like "depreciation," "bonus depreciation," and "cost segregation" that can help create a net loss (on paper) for your rental property. And you may think you could use the loss against other types of income like your salary. If only it were that simple.

There are lots of tax rules that apply, and they're not intuitive or easy to understand. To be able to currently recognize a net loss depends on your level of involvement, the type of property you have, average rental periods, your income level—and more. Adding in specific rules for short-term rentals and whether you own a property directly or through an entity like an LLC can make things even more complicated. Plus, you have to keep really good records.

Consider working with a qualified CPA who understands current real estate rental tax rules and stays on top of changing tax laws and regulations. Someone who can walk you through your options, both while you're renting and when it comes time to sell. There can be tax advantages, but it's complicated. Learn the rules and understand the requirements before you dive in, so you're not surprised later.

What does it take to be a good landlord? Start with a rentable property and some cash on hand to handle upkeep. If you have some maintenance expertise, that's helpful. But if you don't, you can still be an effective landlord. Just be sure to surround yourself with a team of people you trust that can educate you and help you manage the property.

Be sure to consider the pros and cons before you get started. Do your research, and talk to people with experience. Consider the risks, and while there's a lot to learn, there's a lot that could be gained if you can leverage your real estate investment to help you reach your other financial goals—like college for the kids or your retirement. It takes some work, but to me it's worth it. In fact, I'm now in the market for a duplex: one unit for me, one unit to rent. Far from being dissuaded by my experience, I'm doing it again.

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