logic of landlording: how to make money?

February 14, 2006 6:49 PM

How can I possibly buy a house with the goal of renting it at a profit? I'm in LA and even duplexes are priced so high that the mortgage costs can not possibly be covered by rents...

I owned a three unit apartment in Orlando, Florida, about 15 years ago and made money from day one. (I wish I hadn't sold it when I moved away!). There are rental buildings for sale here, so I assume someone must be buying them. How are they making money? And what is the logic if they're not? Thanks!

posted by verylargecorp to work & money (32 comments total)

Put down a big enough down payment that the mortgage payments and operating expenses are less than the rent you'd be taking in. Yeah, that means a giant down payment.

How are they making money? And what is the logic if they're not? Thanks!

I know several people who have bought rental properties in SoCal recently who are losing money like crazy, and in big trouble. There's no sound logic that I've been able to discern in the current SoCal real estate market, aside from the ponzi scheme mentality (which, so far, has made money for lots of people, as any good ponzi scheme will do).
posted by JekPorkins at 6:59 PM on February 14, 2006

Some people might have enough money to buy them outright. I don't know that it's a good investment, but it's a lot better than a mortgage you can't afford.
posted by smackfu at 7:09 PM on February 14, 2006

The logic is try to get as much in rent as you can, lose as little month to month as you can, and hopefully make up the difference and then some when the property appreciates. That assumes that the market will continue to rise, which many in LA do assume. If the market continues rising at 20% a year you'll do just fine. If it doesn't...? But that's the logic.
posted by johngumbo at 7:15 PM on February 14, 2006

This is God's way of telling you it is dumb to buy right now. When rents are way below mortgage costs it is a sure sign that property prices are inflated and a correction is due. When rents are above mortgage costs it becomes economic and you can make money. There are lots of good reasons to own real estate but right now rental income is not one of them. Wait for the inevitable correction and then buy in. Meantime there are a zillion better places to invest your money.
posted by unSane at 7:19 PM on February 14, 2006

You're not "losing" money when someone is only paying 90% of your mortgage. Eventually, you own the house.
posted by knave at 7:19 PM on February 14, 2006

NB anyone who believes the US housing market will continue to rise at 20% p.a. needs to be put in a slapping machine and have the intensity control turned to 11.
posted by unSane at 7:21 PM on February 14, 2006

You're not "losing" money when someone is only paying 90% of your mortgage. Eventually, you own the house.

Only if the cost of maintenance, taxes, and interest are less than 10% of your mortgage.

unSane has it - now is a terrible time to buy in California. People are leaving the state because it is too expensive. Either wait for prices in LA to correct, or buy somewhere less expensive and wait for that area to go up (warning, might take years, might never happen).

Remember when everyone was talking about daytrading, buying YHOO, and making a killing? The noise peaked in '98 and '99, right before the market crashed. When a given market is in its early to middle growth phase, only the insiders know about it. By the time stories are being published in the popular presses, the market is getting close to the top, or has already passed the top.
posted by b1tr0t at 7:27 PM on February 14, 2006

I think that knave's point is that you are, in effect, getting someone to help you pay your mortgage. It is hard to see how this amounts to losing money. If I offer to pay 50% of your car payment does that mean you are losing money on the car? Of course not. You are losing less money than you normally would be. You are in fact keeping more money than normal.

You only lose money if you eventually sell the property for less than what you paid for it (adjusted for inflation). While you own the property you aren't actually losing money, you are investing it. You are getting something of value for the money that you spend. (That is, spending does not automatically equal losing.)

Whether or not now is a good time to invest in California real estate is a different issue. It seems clear that getting someone to help you invest in something is generally a good idea (especially when he will have no rights to the profit no matter how much the pay into the investment.)
posted by oddman at 7:44 PM on February 14, 2006

When a given market is in its early to middle growth phase, only the insiders know about it. By the time stories are being published in the popular presses, the market is getting close to the top, or has already passed the top.

This applies to many markets, but I'd disagree when it comes to property. The press has been ranting and raving about the ridiculous property price increases here in the UK for the last five years solid. The average house price at the moment is £185,788 Exactly four years ago it was £100,000 and while the increases have gone up and down, supposedly they're back on the up again now.
posted by wackybrit at 7:51 PM on February 14, 2006

I have a few friends who bought properties in the last few years and are also having trouble renting them out right now. And the rental buildings you see for sale? That should be evidence that the rents (or lack of rent money) isn't covering the mortgage.
posted by junesix at 7:54 PM on February 14, 2006

oddman writes "It is hard to see how this amounts to losing money. If I offer to pay 50% of your car payment does that mean you are losing money on the car? Of course not. You are losing less money than you normally would be. You are in fact keeping more money than normal."

But if it is an investment property, and therefore an extraneous expenditure, you would be putting more and more capital to work each month in the form of unrecovered mortgage payments. You have to compare your return on that capital to the alternative investment - and the returns on the investment property will get worse as you put more capital in. If the monthly outlay of capital gets too large, or lasts too long, and the apprecaite of equity is only modest the numbers will work out in favor of treasuries or some relatively low-risk investment.
posted by mullacc at 8:14 PM on February 14, 2006

How can I possibly buy a house with the goal of renting it at a profit? I'm in LA and even duplexes are priced so high that the mortgage costs can not possibly be covered by rents...

Allow me to re-formulate your question...

WHERE can I possibly buy a house with the goal of renting it at a profit?

There must be somewhere.

I'm in Australia, and a guy just published a book explaining how he came to own 150 rental properties.

Short answer, he researched which areas (often they're rural, not big cities) are "postively geared", i.e. a place where you can charge rent equal to or greater than the mortgage payment.
posted by AmbroseChapel at 8:20 PM on February 14, 2006

Short answer, he researched which areas (often they're rural, not big cities) are "postively geared", i.e. a place where you can charge rent equal to or greater than the mortgage payment.

This is precicely what I'm about to do (I'm in Australia), having had a house in a rural area that I'm about to try and rent out. Difference in rent between city and country? Small. Difference in mortgage / property value between city and country? Huge. My house was a rental property before I bought it, at $130 a week. I pay $137 a week mortgage on it - so I'll face a loss of $7 a week (not including council rates, insurance etc.) getting someone else to pay off my mortgage.

In terms of how people do it in the city, though? Well, I don't undestand either, aside from assuming they make big downpayments, and take advantage of negative-gearing tax breaks.
posted by Jimbob at 8:41 PM on February 14, 2006

Mullace writes "You have to compare your return on that capital to the alternative investment"

I don't think we are in disagreement on this. I agree that it seems fairly clear that there are better investment avenues than the current California real estate market. But this does not mean that a real estate invester in California is losing money. I don't think that failing to make as much money as you can equates to losing money.
posted by oddman at 8:44 PM on February 14, 2006

The housing market, especially in the US and the UK, is long overdue for a correction. Buying into a market just before it crashes is an excellent way to lose a lot of money.

If you are trading up from one property to another, there's no problem with buying real estate right now (although if you can cash out your real estate investment that might be even better). But you'd have to be some kind of idiot to transfer liquid assets into real estate when even the US government is predicting (rather hopefully) a 'soft landing'.

Every generation comes to believe that their experience is an exception and the bubble will never end. It always does, and all the economic indicators point to it doing so soon.

There are still good places to buy real estate. Canadian real estate, especially in Alberta and exurbian Toronto, is probably not a terrible prospect. And buying a place that you love and intend to inhabit for a long time is rarely a bad idea.

Taking out a 90% mortgage on an income property in a real-estate hotzone in the hope that its capital appreciateion will outweight the bath you are taking on the repayments is, however, a pretty sure route to financial ruin over the next 5 years IMNSHO.
posted by unSane at 8:58 PM on February 14, 2006

oddman: Why do you think this? And how far would you take it? I certainly wouldn't suggest that one direct all of one's action toward maximizing risk-adjust returns. But if one has already made the decision to invest a given amount of money, well, I just don't understand how making a subpar return given a similar risk can be seen as anything BUT losing money. I could come up with lots of exceptions to this (e.g. someone who really wants to learn real estate and takes on subpar returns now in order to learn and get in the game), but I don't want to put words in your mouth...
posted by mullacc at 9:26 PM on February 14, 2006

LargeCorp, if you have some bucks, email me for specifics, and maybe I can help. I live & work in Riverside, and in the last couple of years I bought many apartment buildings & rental properties. (I am a real estate agent). I buy & sell in the Inland Empire, and specialize in investments.
posted by growabrain at 11:02 PM on February 14, 2006

I don't think that failing to make as much money as you can equates to losing money.

That's the definition of an "opportunity cost". It isn't the same thing, but it isn't a good thing, either.
posted by dhartung at 12:09 AM on February 15, 2006

The Australian approach is based on negative gearing - you offset your investment loss (mortgage payments, agent fees, depreciation, in fact any loss) against your (salaried or other) income in an attempt to balance it all out - meanwhile taking advantage of capital gains (the property appreciating in value over the period of your investment). In effect the tax break helps pay off your investment (so you're not really losing money).

You can have an accountant work the figures for you so that you can plan what you need to outlay, how long you will need to invest, and the implication of selling and making a capital gain.

Is negative gearing as a tax break available in the US?

For Australians with the same ideas - I found this site to be incredibly helpful (like an AxeMefi for property investors)
posted by strawberryviagra at 12:48 AM on February 15, 2006

I really don't get how you would ever think the buy-to-let people are losing money. They're getting people to pay the mortgage on a house for them! Even if rents are only enough to pay, say, 80%, the owner is still putting in 20% of the money yet getting out 100% in the end -- effectively multiplying their money by five. How can you match that in any other market?
posted by reklaw at 3:03 AM on February 15, 2006

getting out 100% in the end

You're assuming that property prices can only go up, not down.

You're ignoring the effects of inflation.

You're ignoring the opportunity cost.
posted by meehawl at 5:08 AM on February 15, 2006

Over the long term, it is quite possible to make money by renting out below the mortgage cost, but over the short term it will kill you.

Let's say you buy a $500,000 property with 20% down and finance the rest with a 20-year fixed rate 7% mortgage.

Your mortgage repayments will be about $2600/mo.

Your total repayment over the 20 years will be $744,288.00.

Since we are using 7% as our figure, let's assume that the property increases in value by 7% p.a, which is about right for the last 20 years.

At the end of the 20 years it will be worth $1,934,842.23

If you had invested the $100,000 for 20 years and let the interest compound at 7%, it would be worth $386,968.45

Let's say you rent the property out for $2000/mo.

Every month you are down $600, a total of $144,000 over the twenty years. I'll ignore the interest on that for the moment.

At the end of the 20 years, it works out like this:

On the debit side

$386,968.45 your initial deposit of $100k would have been worth
$744,288.00 total repayments

Total: $1,131,256

On the credit side

$2000/mo * 240 mo = $480,000 rental income
$1,934,842.23 final value of property

Total: $2,414,842

So you have more than a million dollars profit over twenty years on an investment of $100,000. Not bad.

Even over a short term it can look okay. Every month you are down $600, or about $7,200 per year. But the property is appreciating at about $35,000 per year hopefully, so even over a short term you are clearing approx $28,000 per annum.

The problem is that if you buy at the top of the market, like now, you stand to lose your shirt in the short term. Property prices could easily fall 20% in a year, in which case you have effectively lost your original $100,000 investment. If interest rates rise to 10%, the spread between your payments and the rent rises from $600 to $1800 per month. If both of those hit together (the typical scenario) it is a recipe for bankruptcy.

(The above ignores all the cost and hassle of running a rental operation of course)

So if you have $100,000 which you can afford to to invest for 20 years it can make sense. But in the short term, in the current climate, it is high risk.

(NB I am not a real estate or financial professional so it is quite possible there are terrible, dumb mistakes in the above).
posted by unSane at 5:22 AM on February 15, 2006

I disagree with Knave. If the rental income and appreciation do not cover mortgage interest, taxes, and maintenance, you're losing money. That's not counting the ~5% of the house's value you lose at settlement. Maybe you'll make the money back as rents increase. Maybe not.
posted by malp at 5:46 AM on February 15, 2006

You also can't live in a house someone is renting from you. You either have to rent your own place (or buy a new place with a new mortage). That is an expense you also have to take into account.
posted by PenDevil at 6:24 AM on February 15, 2006

If I read the question correctly, vlc is asking how to achieve “the goal of renting it at a profit.” To me, that means *not* going negative every month. I just don’t see how it’s possible with the numbers we’re looking at.

Nobody seems to be bringing up vacancy, promotional costs, correcting damage that occupants cause or even the personal time-cost of a deal like this in the current climate. To break even, you literally have to have the perfect A+ occupant, secured to a long term lease, and virtually no repairs or costly maintenance to deal with.

There’s always the “pot of gold” line of thought, cashing out a tidy sum at a point many years down the road.....but that’s to be expected when you own property smartly. It can’t be the only justification. Why not wait until the cycle becomes positive again? It would certainly make it more comfortable than now, when prices and rental rates are debatably going to stay flat or start sliding down.

To address the hype-factor: When you see the seasoned pros beginning to dump buildings, unsophisticated buyers getting into irrational deals, and then putting them back on the market (vacant) in 6 months or a year, dare I say that you ought to take that as a sign of things to come in the near future.

FWIW, I’ve been in the business for years, and just sold nearly my entire (sizable) portfolio of residential holdings. I wouldn’t, for a moment, consider buying anything else unless I stumbled on to a one-off deal that was priced way under value. Current numbers just don’t work and there are better investments to be a part of right now. Email me if you want to.
posted by peewee at 6:54 AM on February 15, 2006

Buying a residential investment property is one of the few ways the average person can make a highly leveraged investment. It can make the returns look pretty damn good if you're willing to stick it out over the long-haul.
posted by mullacc at 7:37 AM on February 15, 2006

One thing that people really need to know is that real estate is an ultra long-term business. The people who make big money in real estate have business plans measured in decades, and do most of their property buying when markets are depressed, and in areas that people believe will never (re)gain any value.

The people who are making money with condos are those who bought the lots when the areas were thought to be irretrievable ghettos or industrial wastelands. The people who are making money with McMansions optioned farmland when few people imagined the hunger of middle-class people to add 40 minutes to their commutes for the privilege of living in a 4,200 square foot house.
posted by MattD at 9:03 AM on February 15, 2006

As interest rates rise, people are most likely to rent rather than own, thus creating a demand in the rental market, and thus causing rents to rise. If you already own a property with a 2002 mortgage rate, you have the luxury of being able to charge a higher rent versus your lower mortgage payment. That's what I call GRAVY!. As long as you can cover your mortgage and maintenance costs on a consistent basis, you really can't lose.

But as others have mentioned, you do have to think about opportunity costs, which in this case has to do with the DOWN PAYMENT that you placed on your rental property. For instance, you could have taken that 50k down payment a year a half ago, bought options with a good strike price on GOOGLE and made upwards of 400-500k in a very short time frame. It's always good to have some real estate in your portfolio. If you want to play it a little safer buy a REIT, although I wouldn't recommend that until there is a correction. Look at property in Costa Rica, Alberta, or D.C.
posted by jasondigitized at 9:35 AM on February 15, 2006

Buying a residential investment property is one of the few ways the average person can make a highly leveraged investment. It can make the returns look pretty damn good if you're willing to stick it out over the long-haul.

Nonsense. Anyone with $2000 can open a brokerage account for trading stock options or spot foreign exchange. The leverage ratio of options depends on the contract in question, but with spot foreign exchange, brokers typically offer between 50:1 and 200:1 leverage. With that kind of leverage, you can make millions in days, but you can just as easily zero out your account in an hour.

Leverage is a very powerful tool. Like a chainsaw, if you know how to use it properly, it can very useful. If you don't, you can can very easily do much more harm to yourself than you expect.
posted by b1tr0t at 1:03 PM on February 15, 2006

The brokerages I've encountered require you to have some relevant investing expertise or track-record, or at least sign a waiver saying this is so, before letting you dabble in such investments. Besides, I certainly wasn't unaware of derivatives, FX or margin accounts, I just don't think they fall into the purview of the "average person."

And further, I said "one of the few" specifically with this in mind. Don't be an asshole with that "nonsense" stuff.
posted by mullacc at 1:48 PM on February 15, 2006

For instance, you could have taken that 50k down payment a year a half ago, bought options with a good strike price on GOOGLE and made upwards of 400-500k in a very short time frame.

Or you could have taken that 50k and bought winning lottery tickets. You'd be up millions. However, my opportunity cost is not millions of dollars every time I don't buy a lottery ticket.
posted by malp at 2:29 PM on February 15, 2006

Good points, everybody. I guess my good experience previously, owning three units and renting them at a profit made me want to do it again. I guess I was lucky last time, and need to wait it out to get "lucky" again.

I'm interested in month to month profit and less interested in super long-term (not that I'm against it!).

Thanks!
posted by verylargecorp at 3:33 PM on February 15, 2006