Real Estate Investing For Dummies
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You can receive a return on your real estate investments basically in four ways — cash flow, equity buildup from loan paydown, tax benefits, and property appreciation. A great aspect of real estate is that you can buy properties according to your particular financial and personal needs. Different properties are geared more toward achieving one of these types of return than another. For example, an investor with significant earned income may focus on properties with tax benefits and not worry as much about cash flow. Investors nearing retirement prefer properties with cash flow. And all investors who have financed their rental property acquisition benefit from equity buildup while looking forward to appreciation.

Successful real estate investors continually ask themselves, “How can I improve the returns on my real estate investment in each category?” Her are more than ten of the best ways that you can enhance your return on investment with rental properties.

Raise rents

Although most rental properties have other sources of income, the largest source is almost always the rents. Real estate investors wisely begin with an understanding that rent increases lead to greater cash flow.

rentals as real estate investments ©Marc Bruxelle/

However, setting the proper rent and maintaining the optimum market level rents upon turnover of tenants is one of the most common challenges faced by property owners. Many rental property owners are reluctant to raise rents because they’re concerned that their good tenants may leave. This is a valid concern, but it shouldn’t prevent you from getting rents to market level — one of the fastest and simplest ways to improve your cash flow. Of course, you should always look for cost-effective ways to improve the property and make sure that your rents are competitive and a fair value.

We recommend raising the rental rate modestly each year rather than waiting for two or three years and then hitting your tenants with a major increase all at once. Tenants are less likely to move as a result of this consistent and predictable, but lower increase strategy; they understand that the costs of operation are rising slightly each year. Most commercial leases contain annual rent adjustments tied to a consumer price index or set rental rate increases. Use this effective strategy for all types of rental property.

If your rents are already at market levels, look to make upgrades to the property to justify higher rents. Maybe adding a combination microwave/exhaust vent unit above the stove, granite countertops, mirrored closet doors, reserved parking, storage lockers, or a deck or awning can provide an improvement that justifies higher rent. Use your market analysis or rent survey of competitive properties, especially ones that have the rents you would like to achieve, to see what they are offering and at what rent level. Any improvements that enhance the quality of living or bring the property to a level similar to higher-priced properties in the area can lead to increased market rents. (Market analysis and rent surveys are discussed in Robert’s bestseller Property Management Kit for Dummies.)

Reduce turnover

The single most important factor in determining the expenses of most rental properties is turnover. In both residential and commercial properties, tenant turnover is simply bad for the bottom line. A tenant moving out almost certainly means a loss in rental income, plus you’re hit with the increased expenses (marketing, leasing commissions, tenant screening, maintenance and repairs, and often capital improvements) to make the rental unit or suite available to show prospective tenants. Having qualified tenants sign long-term leases (with built-in rent increases), continually maintaining the property in top condition, and being responsive to the tenants can help reduce tenant turnover, which directly improves the Net Operating Income and cash flow. Doing so also increases the value of your building, which is your goal if you refinance, decide to sell, or use the 1031 tax-deferred exchange to upgrade your investment to a larger income property.

Another effective tool to reduce the loss of rent during tenant turnover is to prelease the rental unit or commercial tenant suite. If you can prelease the rental to a new tenant who takes possession only a few days or weeks after the current tenant vacates, you dramatically reduce your lost rent and increase your cash flow. After you receive a tenant’s notice to vacate, immediately seek permission to enter and determine what you need to do to make the property ready for the next tenant. Also begin advertising for a new tenant and gain the cooperation of the departing tenant to show the property. Preleasing is one of the simplest ways to increase your net income, but it requires some planning and a cooperative departing tenant, which you should have if you have been a diligent and conscientious landlord and have been responsive to your tenant’s needs.

Consider lease options

A lease option is an agreement that allows the tenant the right to purchase the leased property at a predetermined price for a certain period of time. Sellers typically use lease options in slow real estate markets to create additional interest in the property — even a potential buyer currently without a down payment has the opportunity to eventually become a homeowner.

There are many other benefits to the rental property owner willing to offer a lease with an option to purchase the property. You can often sell the property for a value above the current market, and the lease option usually requires a one-time option fee that you can keep if the buyer doesn’t exercise the option. Also, the renter/buyer typically pays a higher monthly rental payment with a lease option because a portion of the payment is applied to the ultimate purchase price. The higher monthly payments can be beneficial to you if the cash flows for the property are currently negative.

Develop a market niche

Rental properties catering to seniors have always been popular, and the demographics clearly support continued attention to this dynamically growing market niche. Some senior properties are targeting those in need of special care and food services, and that is difficult for many landlords. But there is a growing need for properties with activities and social programs that appeal to active seniors and don’t require specialized skills or significant capital investments.

Robert has had success in Las Vegas (of all places!) with smoke-free apartments. After a long day at work in a smoke-filled environment, a health-conscious nonsmoking resident doesn’t need to have smoke wafting into her rental unit from her neighbor’s. Although there are additional costs upfront in thoroughly cleaning, completely repainting, and installing all new flooring and window coverings, the demand (and thus the occupancy) for these units is high. This trend is catching on, and several states are even implementing laws that require landlords to offer smoke-free housing, so you may as well be ahead of the trend. You may even qualify for lower casualty and fire insurance rates.

According to a study by the National Multi Housing Council (NMHC), student housing is also a potential opportunity. Some real estate investors find the market ripe for renovating rental units; college students nowadays would rather have a private rental unit with their own bathroom facilities and a high-speed internet connection than a traditional dorm. Figuring out how to handle the seasonality of student rentals can be a challenge, but this market will continue to offer more opportunities. Consider offering 12-month-minimum leases at a slightly lower average rent so that you can bridge those seasonal challenges. Better to get a slightly lower monthly rent for at least 12 months rather than a little more per month for only 8–9 months!

Maintain and renovate

The curb appeal or first impression that your property gives is critical to your overall success. Far and away the easiest way to increase cash flow and value is to simply clean up and address the deferred maintenance found in most properties. One of the fundamental rules of real estate is basic supply and demand. If your property really stands out and looks much better than comparable properties, you generate high demand; your rental will stay occupied at top market rents. That’s what cash flow is all about.

Besides curing the simple deferred maintenance, another great way to increase cash flow (and value) is to renovate the property. The key here is to spend money only on items that enhance the property and provide a quick payback. Examples include submetering utilities, upgrading appliances, or adding new features that tenants desire.

For residential rentals, the best return on investment inside the units is found in updating the baths and kitchens. Adding systems to limit access of nonresidents for parking and building entry can also be a positive enhancement in urban areas, because crime is a concern for many tenants. For commercial properties, upgrading dated interior common areas, including elevators and restrooms, with higher-quality materials and fixtures generally offers the greatest return.

One of the most cost-effective ways to increase the aesthetics and curb appeal of any type of property is through landscaping improvements. Often you can simply replace declining or dead plantings. If you want to do more, have your landscaping maintenance firm make suggestions or contact a landscape architect. Community gardens are also very popular these days and also build a sense of pride and community involvement. With water becoming more expensive every day, be sure to look into the installation of an automated, water-conserving, drip irrigation system, or even recycled water if it’s available in your area.

Cut back operating expenses

One of the first steps to take after you purchase a rental property is to evaluate current operating expenses. See whether there’s room for improvement, particularly without negatively impacting your tenants.

Asking the local utility companies to perform an energy audit can pinpoint ways for you to reduce expenses. New technology is making the use of LED lighting, solar energy, and hydronics heating systems attractive. Converting existing wasteful lighting to LEDs alone makes a real reduction in your energy usage, and it helps you offset the constant increased rates of your local electricity provider.

Tracking your natural gas usage can also alert you (if you see an unexplained spike) to possible minor leaks that can be expensive (and dangerous). Robert recently had a property where the monthly natural gas bill literally doubled during the off-season, and a simple call to the gas company, which tracked down and repaired the leak at no cost, solved the problem. They even offered him a credit for the excess usage as they were so glad to avoid the potential liability of a natural gas leak!

The rapidly increasing costs for water and sewer services in many areas of the country have made the installation of individual submeters cost effective for allocating and recouping the cost from each tenant based on her actual usage. Separate water meters for landscape areas only will eliminate your sewer charges if your local water utility offers them. The best way to achieve conservation of resources at your properties is to make your tenants directly responsible for their resource usage. This lets the tenants control their own costs and saves you money.

For larger residential and commercial properties, ask each of the current contractors and service providers to present a proposal or bid. Find other comparable firms and ultimately give your business to those firms that are insured and offer the most for your dollar. As your real estate empire grows, you’ll know who the best value providers are, and you may find that contractors and service providers offer discounts based on volume.

Another great way to reduce your operating costs without any reduction in types and extent of coverage and policy limits is to combine your various rental properties under one insurance policy. Contact your insurance broker for details.

Scrutinize property tax assessments

A review of the expenses for most rental properties indicates that the property tax expense is often one of the largest costs in owning real estate. In many parts of the country, property taxes are tied to the value of the real estate. If that’s true for your area and real estate values decline, contact your local assessor and inquire about getting a reassessment. A lower assessment leads to a direct reduction in your property tax bill and a corresponding increase in your cash flow.

You may feel helpless against the bureaucracy, but remember that tax assessors have been known to make clerical errors or to fail to take all factors into account when valuing rental property. Some assessors don’t carefully determine the proper value of your property but seek to assess the property at the highest possible level that won’t trigger a request for reassessment. If there are no limitations, they may even raise the assessed value each year until you react. After all, the higher your property’s assessed value, the higher your property taxes and the more money for local governmental spending. Remember no one is going to look out for your best interests but you.

If you feel that your assessment is too high, contact your assessor. She may be willing to make an adjustment if you back up your opinion with careful research and a good presentation. Or you may need to make a formal property tax protest. Protests are often first heard within the assessor’s office or a local board of appeal. If a dispute continues, appeals may be taken to court in many states and that is when you’re likely to want to retain a professional to present your case and support it with relevant data from the local market.

Refinance and build equity quicker

Although you may have little control over interest rates and are at the mercy of your lender unless you have a fixed-rate loan, don’t forget that refinancing to a lower rate can have a tremendous impact on your cash flow. Of course, going with an interest-only loan or a 40-year mortgage can also reduce your debt service payment and increase your cash flow, but these options are extremely risky and not advised.

You can enhance your equity buildup through refinancing to a shorter-term loan. When you first purchase a rental property, your rental income to make your mortgage payments is typically very tight, and you need to use financing with 25-year or even 30-year amortization terms. But after you’ve owned the property for several years, you may find that the cash flow has improved to the point that the property can handle a higher mortgage payment. That is when you can consider refinancing your long-term mortgage to a shorter-term mortgage, so that the amount of principal reduction paid with each payment dramatically increases.

Another way to achieve similar results is to arrange to make additional payments designated as principal reduction. This strategy can significantly reduce the total amount of interest paid over the remaining life of the loan and bring the loan payoff date much closer because the interest paid on the loan is a function of the outstanding principal balance. Robert routinely applies this strategy when refinancing properties that have improved fundamentals — increase in value and increased cash flow — so that he can go from a 20- or 30-year loan to a 15-year loan. If the interest rates have fallen, the monthly payment may not even have much of an increase.

Before refinancing or making additional principal payments, make sure that your loan doesn’t have a prepayment penalty. Lenders count on a certain investment or financial rate of return on their money, and the early payoff of a loan results in additional costs, so they may include a penalty in the first few years of the loan. Also, some lenders waive prepayment penalties if they handle your refinance.

Take advantage of tax benefits

The tax benefits received from real estate vary from investor to investor, but most rental property owners find tax benefits to be a boost to their return.

Even novice real estate investors can take advantage of the generous tax savings with the capital gains exclusion for their principal residences. This exclusion allows sellers to completely eliminate any income tax on their capital gain of up to $500,000 if they meet some simple requirements. For investors willing to live in the property during renovation, the serial home-selling investment strategy can be used every couple of years to produce tax-free profits.

Real estate investors in large residential and commercial properties routinely use a simultaneous or tax-deferred exchange, which allows them to keep their money working rather than paying taxes. The more money you have invested in real estate, the better your cash flow and your accumulation of wealth.

Depreciation or cost recovery allows the owner to take a noncash deduction that reduces the taxable income from the property. Land isn’t depreciable, so the amount of depreciation is determined by the value of the buildings. One way to maximize real estate’s potential tax shelter is to be aggressive in allocating the highest possible (yet acceptable to the IRS) percentage of the acquisition cost of the property to the buildings to generate a larger deduction for depreciation.

Depreciation deductions are a noncash item, so they often result in a taxable loss even though the actual cash flow for the property is positive. Ask your CPA or tax advisor about cost segregation (determining separate and often accelerated depreciation schedules for various building components) to maximize your depreciation write-offs. Even if you can’t immediately use a taxable loss to offset other earned income, you can use it in years that you have passive income such as a profitable taxable sale of another rental investment property.

Be prepared to move on

When most people think about real estate, they correctly determine that appreciation is where the real money is made. Over time, real estate has proven to be an investment that retains and increases in value. Even an average annual rate of appreciation of 5 percent dramatically increases your net worth over time.

However, appreciation can be heavily influenced by outside forces, such as the condition of the neighborhood and the local economy. That is why real estate investors need to perform a thorough due diligence review. But even after you buy a property, you can’t simply sit back and let the investment ride. If the neighborhood you’re in starts to take a downward turn, be prepared to sell and reinvest in a more dynamic area that offers more upside potential.

During the major economic downturn of the late 2000s and early 2010s, Robert advised owners of stabilized and cash-flowing rental properties in slightly less desirable areas to look to find cash strapped and motivated sellers of properties with deferred maintenance and/or poor management in the best neighborhoods. Why? Because while all real estate values were down, if you had a well-managed, cash-flowing property in a “B” area, you could still get good value by selling and then using a 1031 deferred exchange to upgrade and buy a property that was not well-managed or maintained in an “A” area. You essentially are exchanging into a much better location. Then you apply your proven skill at improving the condition and cash flow. While always a great strategy, and more feasible in weak markets or economic downturns, this is one of the best ways to efficiently use your limited capital to gradually build up a portfolio of well-located properties without having to pay the often high prices you would encounter with simply purchasing in the best neighborhoods from the start.

Improve management

Management is the one aspect of owning real estate that offers owners an advantage over other types of investments. You can’t call the CEO of a large company and tell him to change his company’s product or pricing, but superior management of your own rental properties can and will have a direct impact on your results.

The ability to control and immediately implement different management strategies can lead to more satisfied tenants and longer-term tenancies. Some owners are very hands-on with their properties, and others prefer to let a professional handle the day-to-day challenges, but a savvy investor knows that the best returns on investment go to owners that have top management.

Robert has been a property manager managing all types of income properties for decades. He has seen and competed with some of the best and some of the worst management companies in the country. The idiom “You get what you pay for” means if you can find a service provider at a very low price, it is because they are not very good. That certainly holds true for property management companies that compete on offering the lowest possible management fees.

The reality is that to properly manage a property using the techniques we describe throughout this book to obtain the best financial results takes a lot of time and effort and requires frequent visits to your rental properties. The low bidders for property management simply cannot offer the services you need unless they charge a reasonable fee. Of course, equally of concern to you, is that some property managers have compensation agreements that benefit them through hidden profit centers, such as mark-ups on maintenance, labor, and materials or undisclosed affiliated companies. Management companies, like all businesses, need to cover their costs and make a reasonable profit, but it is our opinion that you only should use a management company that clearly and openly generates their income through the property management fee that is negotiated upfront and fully disclosed.

You need to determine if you are the best person to manage your income properties or if you are better off hiring a professional. The answer will depend on a variety of factors, but in the early days the right answer for many is to self-manage. And while your portfolio is small, there is no one who will be able to match your time commitment. However, for virtually all real estate investors, the day will come when you are best served using a professional property manager. The right property manager will take his broad and extensive hands-on experience of managing many properties combined with key industry education and credentials, and be able to quickly implement the management practices and policies and procedures that will lead to better management. Proper management really can make a major difference in your cash flow.

About This Article

This article is from the book:

About the book authors:

Eric Tyson, MBA, is a renowned finance counselor, syndicated columnist, and author of numerous bestselling financial titles.

Tony Martin, B.Comm, is a nationally-recognized personal finance, speaker, commentator, columnist, management trainer, and communications consultant. He is the co-author of Personal Finance For Canadians For Dummies.

Laurence C. Harmon, JD, is the CEO of HARMONLAW LLC, specializing in apartment-related legal and property management consulting.

Robert S. Griswold, MBA, MSBA, is a successful real estate investor and property manager with a large portfolio of residential and commercial rental properties.

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