Cows and Landlord Business Models
So there’s two main ways to make money from rentals, and one backup method that can be added to either one as flavor. They require slightly different business models to achieve, although they can always be combined. However, it’s important when getting involved in investment property that you design a long-term strategy and stick with it.
To get a good idea of what I mean here, I want you to take a minute and think about cows. There’s three reasons why you could keep a cow. One is as a milk source – keep the cow alive and keep milking it for as long as you can. It’s a long lifespan with a decent but not bountiful reward. Another is as a beef source – fatten it up and then eat it. This is a short lifespan but, if you’ll pardon the pun, a more meaty payoff at the end. Or you could keep cows because livestock owners get some pretty sweet government tax incentives for working in agriculture.
As a landlord starting out you’re faced with a similar choice. One goal is high cash flow – that is, consistent income that exceeds your expenses on a regular basis. This is your milk cow. Another focuses on rapidly building equity in the property and recouping the money when you sell it. This is like your beef cow. A third is using the property as a tax shelter and saving money by deducting losses & depreciation from your income tax returns.
The Cash Flow Route
So you want to go the milk cow route – keep milking your apartment building for cash all the way along. When most people think of becoming a landlord the first benefit that comes to mind is using the rent to pay the mortgage every month. This is basically a starter version of the cash flow goal. You want to retain the most income possible on a consistent basis. Here’s some strategies to keep in mind if this is your target.
Buy with long-term retention in mind. The whole point of a cash flow building is consistency. This is not a “flip” scenario. Plan to hold it for 10 years or more. Focus on properties that are already in good shape so you don’t have to sink too much up front into major renovations. You can upgrade slowly over time, but avoid properties where you’re going to have to layout more than 30% of the purchase price in renovations in the first 24 months of ownership just to get the building rent-ready.
Go with a short term loan with a high down payment. This will minimize your debt service (what you pay to the bank) and get it over with quickly. You’ll reach the point where you’re keeping all of that rent income a lot faster. Look at balloon loans or 5-7 year payoffs. It will also minimize what you pay to the bank in interest.
Turnover is bad. Set your rents and annual increases with the goal of keeping tenants for as long as possible. Apartment turnover is one of the highest costs you can have, both in terms of maintenance and commissions. Keep the turnover down by ensuring that your rents are affordable for your tenants. Small increases to keep pace with the local comps are good but don’t go crazy. You want it to be more affordable for your tenant to stay where they are then it is for them to move to something similar or better nearby.
Focus on preventive maintenance. Keep up with regular checks on major systems like the HVAC as well as the physical structure of the building. Pay attention to things like window frames, gutters and downspouts, porches and wiring. Think about fire safety too. Emergency repairs are far more expensive than regular preventive maintenance.
Go with larger apartments – 2 beds, 3 beds or larger. The chart below explains why quite succinctly.
Build a referral based business. The best source of good tenants is your current good tenants. Cut down on commissions by offering referral incentives to the tenants you have in house. If you keep your properties in good condition and court your tenants properly you may wind up with a wait list – a nice problem to have!
Nothing should be all-inclusive. Tenants should pay as many of the utilities as possible within the bounds of Illinois metering laws. Set up coin laundry and handle the coin collection & maintenance yourself. Rent the parking as an add on instead of all-inclusive so that if the tenant doesn’t need the space you can rent it to someone else.
The Equity Route
If a long term hold scenario isn’t for you, the quicker way to get money out of the property is to go with the quick and nasty beef cow route. Buy low, renovate nicely, sell high. You’ll get a nice payout at the end. If you’re buying a “beef cow” property, you’re going to want a different strategy.
Plan to turn the property quickly. Think about a 5-8 year hold at most. Your goal is to take a loss leader and improve it through good business practices and solid renovation work so that it becomes a major moneymaker quickly. With any luck it will get picked up by one of your Cash Flow focused counterparts when you’re done.
Faster turnover is to your advantage. Your goal here is to raise the rents from rock bottom to market level or higher as quickly as possible. This means you’re going to need the units empty in order to renovate them, and you’re going to need to always have one empty so that you can be testing the market for the best possible price. Most lenders and appraisers involved in the purchase of investment property will be looking for regular turnover to ensure that you’re maximizing your rents. Don’t go alienating the current tenants completely – you don’t want the property to get such a bad reputation that the next owner will have trouble finding occupants. However, you can be more aggressive in your rent increases than the cash flow landlord would be.
Pad out your rents with included items. Include the parking, include the heat, pay for it yourself. It will make your rent rates look higher to the next prospective buyer, making the property look like a bigger moneymaker.
Keep a maintenance team on hand. If you’re doing this kind of thing repeatedly you’re going to need a reliable crew of workers who can upgrade apartments on a regular basis. Find some laborers that you trust and don’t be afraid to roll up your sleeves and jump in yourself to get the properties turned quickly.
Be selective about your preventive maintenance. As a Realtor and Property Manager it pains me to say that. But if you really want to maximize your resale value you’re probably going to have to replace many of the major elements of the property – boiler, roof, gutters, fascia – shortly before you sell. Not much point in wasting cash on gold-star preventive maintenance on something you’ll have to replace in 5 years anyhow. Focus your preventive maintenance dollars on things like tuckpointing, porches and foundation structure.
The Tax Shelter Route
Note: I’m not an accountant, nor a tax expert. I’m a blogger who tries to make this stuff easy to understand. If you read the next bit and get excited, your next call needs to be to a professional who does taxes for a living.
So you want to use your cow/investment property to get government handouts. Who wouldn’t? I really don’t recommend getting into apartment rentals only as a tax shelter, although some people do consider this their primary reason for investing. Personally I prefer to fold elements of this route into either of the two concepts above. There’s really two ways you can use investment property to save money on your income taxes: depreciation and the 1031 tax-deferred exchange.
Depreciation: Buildings and assorted moving parts wear out over time, although land doesn’t. As an owner of investment property you’re able to deduct not only your expenses for the property, but for depreciation as well. This is basically an offset for the loss in value that you sustain due to the property aging. (Wouldn’t it be cool if we could claim depreciation for our own bodies too? Oh well.) If depreciation is one of the reasons why you’re buying investment property, keep this little tidbit in mind: residential buildings allow you to claim depreciation for 27.5 years, but commercial property lets you claim it for 39 years.
Let’s say that $200,000 of your building is considered eligible for depreciation.
If it’s an apartment building, that means you could theoretically deduct $7200 per year from your taxes for the next 27.5 years.
If it’s a commercial building (or an apartment building with at least 21% commercial units), you could only deduct $5100 per year, but you could do so for the next 39 years.
Depreciation serves all investors well, but if you’re looking to maximize cash flow you may want to give some thought to the higher deduction and go for the residential building. However, the folks who are in it to build equity will probably be able to deduct more due to the expenses they’ll incur in upgrading the building than they’ll get out of depreciation. But for you Equity-building people I’ve got another option…
1031 Exchange: Oh, capital gains tax. So disliked. So complicated. Basically if you sell big stuff like real estate you’ve got to pay a pretty nasty tax penalty on your profit. And it makes for a big problem when you’re taking depreciation deductions like I explained above. You see, the government counts those deductions as profit when you sell the property and taxes you for them then. Yuck.
Fortunately landlords have a way to put off paying a large amount of capital gains tax. It’s called a 1031 Exchange. Basically, if you sell one approved investment property and buy another one within a short timespan, the IRS will count it as “exchanging” properties instead of buying and selling them. Equity builders will be seeing the benefit of this right off the bat. Buy a low-priced property, upgrade it, exchange it at a higher price. It’s a decent way to parlay a $50k investment into a $5million portfolio through the Equity-building route and not pay a dime on it while you’re working on it. Note the italics there.
1031’s are great for while you’re in the midst of your property-flipping career but they are deferrals – postponements, IOUs, what have you – you do have to pay the capital gains tax eventually. And capital gains on the sale of a $5 million property is a lot worse than you’d incur on that old $50k property you started with. However, if you’re going to 1031 your way up the investment food chain it’s probably better to pay taxes on one $5 million sale than on that and every intermediary sale you’re involved in on the way up.
Hopefully this has given you some insight into different ways you can structure your rental business and what your next steps should be in accumulating rental inventory. If you have questions, leave them for me in the comments, and I’ll see you on Friday!