Are You Ready to Be a Landlord?

Are You Ready to Be a Landlord?

The pitch is compelling: Buy a vacant house or apartment building and rent it out to some of the throngs of Americans who have lost their homes to foreclosure. With interest rates near record lows and property values still slumping, getting into the landlord business is cheaper than it has been in years.

Investors turned off by paltry bond yields and the mercurial stock market are intrigued. Kimberly Foss , president of Empyrion Wealth Management in Roseville, Calif., says she has seen a surge of clients looking to purchase distressed homes and apartment buildings. Her clients have an average net worth of about $4 million, she says.




"Many of my clients are looking to use part of their portfolios to scoop up properties," she says. "They see it as an alternative retirement plan."

But aspiring property owners need to watch out for a slew of traps. Among them: prolonged vacancies, surprise costs, deadbeat tenants, difficulty refinancing and overestimating the rental potential.

It is easy to overlook those risks when the market conditions appear so ripe. Home prices have fallen to 2002 levels nationwide, according to the latest data from the S&P/Case-Shiller index, and financing remains cheap. For the week ending Nov. 10, the average rate on a 30-year fixed-rate loan was 3.99%, not far from the Oct. 6 record low of 3.94%, according to Freddie Mac data going back to 1971.

Rents are improving, too. The average monthly rent for all categories, including apartments and single-family homes, was $846 nationwide in the third quarter, up 2.5% from the same period a year earlier, according to Local Market Monitor, a Cary, N.C., firm that analyzes real-estate trends. That is lower than the long-term average gain of 3.5% a year, but better than the 3% decline in calendar year 2009.

Even the Obama administration is considering getting involved in the rental markets. Government officials have been soliciting ideas for how to convert some of the foreclosed homes owned by Fannie Mae and Freddie Mac into rentals, in order to cut the mortgage giants' losses on those homes.

All of this is attracting interest among investors. Brian Davis , who runs ezLandlordForms.com , a website for property investors, says traffic is up 20% this year.

"Most people think I'm crazy to buy now," says Jason Walker, a marketing director in Washington. But the numbers were too good to pass up, he says. Mr. Walker is closing this week on a town house in Baltimore, for which he paid $275,000. He says he put down 20% of the purchase price, locked in a 4.5% rate on a 30-year fixed mortgage and expects to net $1,000 a month in profit.

Here is what you need to know before taking the plunge.

Cheaper homes aren't always a good investment. Even if a property is selling for half the price it fetched during the boom, that doesn't mean it will generate enough income to make the deal pay off, says Wayne Copelin , a financial planner in Sugar Land, Texas.

The key is to figure out how much rental income the property will generate. A good rule of thumb: Make a deal only if you can collect at least 1.25% of the purchase price each year in rental income, says Jason Reed , a real-estate agent in St. Paul, Minn., who works exclusively with investors.

Determining the rental potential can be tricky. Some properties already have been rented out, and the owner can furnish records. Others have no rental history.

One way to examine the rental market is to use websites like FinestExpert.com , which tracks occupancy rates and rents across the country.

In certain sweet spots, rents are rising even as home prices fall. Take Nashville, Tenn., where rents have jumped 6% over the past 18 months, while home prices have dropped 3%, according to Local Market Monitor. Other markets where that is happening: El Paso, Texas; Houston; Omaha, Neb.; Raleigh, N.C.; Pittsburgh; and Washington.

Markets in areas that have been battered by foreclosures, such as Las Vegas and Phoenix, remain unstable. They might have low prices, but they also are suffering from high unemployment. That could leave aspiring landlords with empty homes, which then could fall even further in value, according to Local Market Monitor President Ingo Winzer .

Local Market Monitor cites Austin, Texas; Akron, Ohio; and Dallas as among the most attractive markets overall, and calls Detroit, Las Vegas and West Palm Beach, Fla., "dangerous."

When looking at properties, act like a renter, says Jeff Cronrod , president of the Boulder, Colo.-based American Apartment Owners Association. Tour the neighborhood to see if landlords seem desperate to lure tenants. Are there lots of vacancies? Are buildings offering deals like living rent free for a couple of months in order to drive up demand? If so, be wary, Mr. Cronrod says.

Carrying costs add up. Another pitfall for real-estate investors: not accounting for unexpected expenses.

Besides closing costs, which generally average between 3% and 6% of the purchase price, general maintenance expenses like taxes, insurance and repairs can be much higher than many investors expect, says Jason Post , president of Los Angeles based Post Investment Group, a boutique real-estate investment firm that buys and operates apartment buildings.

You should allot roughly $2,000 a year for insurance, taxes and any association fees for neighborhood pools and the like, Mr. Reed says. To ensure that a major repair doesn't break you, set aside at least six months' worth of expected rent, he says.

"You can't even fathom some of these strange costs," says Jerry Garretty , who runs a property-management firm in San Jose, Calif. Six months ago, Mr. Garretty says, he found a nasty surprise after overseeing the eviction of tenants who were three months behind on rent in a Cupertino, Calif., home: They had poured quick-drying cement into the sewer pipes—a $1,000 repair—and defaced the walls with graffiti scrawls, he says.

Jumps in property insurance premiums also can dent your investment profits, says Jason Holtz , a real-estate lawyer with Kevin Jursinski & Associates in Fort Myers, Fla. This is particularly common in states like Florida that are prone to tropical storms.

Kathleen Farmakidis , owner of a three-unit apartment building in Winter Haven, Fla., says she has seen her property insurance jump 50% this year, to $110 a month.

Venturing far from home can be dicey. It is a good idea to buy rental properties only in your immediate geographical area, Mr. Cronrod says. Although it might be tempting to venture far from where you live for better deals, those properties can be difficult to manage.

As an owner, you need to be ready to repair leaky faucets, collapsed roofs and all other middle-of-the-night disasters—or pay someone to do it.

Hiring a local property manager can help. Such managers perform maintenance, collect rent and even screen tenants. But they typically charge 8% to 10% of the annual rent for their services.

And some are much better than others. Michael Epstein bought a single-family home in Pompano Beach, Fla., in 2009 even though he lived more than an hour's drive away in Jupiter and the house needed work.

Mr. Epstein, a small-business owner, hired a property manager to rehab the house, which he scooped up at a foreclosure sale, and maintain it. But because Mr. Epstein didn't visit often, it took him months to discover the manager hadn't been overseeing construction and that the work was botched. He had to spend an additional $40,000 to bring the property up to building codes.

"That was a risk I didn't even factor in," Mr. Epstein says.

It pays to plan conservatively. Don't assume you will be able to attract renters immediately. If a neighborhood is littered with foreclosures, those properties aren't going to be any more attractive to would-be renters than they are to buyers, says Jim Evans , president of real-estate investment firm Bruce G. Pollack & Associates and president of the nonprofit Institute of Real Estate Management.

The best tactic, say financial advisers, is to build in a cushion. Assume you need at least three months to find a tenant, and keep that much cash in reserve.

John Interdonato wishes he had foreseen the dry spell he would suffer after buying an investment property in Cape Coral, Fla., for $280,000 in 2005. The electrical engineer planned to rent it out for enough to cover the $2,200 mortgage payments. But after the property sat empty for more than a year, starting in 2009, Mr. Interdonato fell behind.

Last December, after having sunk 50% of his savings into the property, he was forced to sell.

"It felt like I was staring down the barrel of a shotgun," he says.

Refinancing can be difficult. With interest rates so low, many homeowners have been able to refinance their mortgages recently. But lenders are reluctant to take on refinances of investment properties, says Matt Englett , a real-estate lawyer in Orlando, Fla.

Banks view such owners as more of a risk, he says, because they can walk away from the property more easily than owners of primary residences can.

Mark Cheplowitz, the owner of an international event-planning firm in Aurora, Ohio, says he is losing roughly $24,000 a year on two properties in Collier County, Fla. Last week, a lender declined his applications to refinance the mortgages.

Mr. Cheplowitz says he despairs whenever he flies down to check on the properties.

"Here I am, staying in a crappy motel," he says, "as tenants live in these beautiful carriage houses I am losing money on."

Screen tenants with care. Renting out your property to unreliable people can be a costly mistake. Eviction proceedings can take months, and owners can't rent out the property until the eviction is final.

Chris Ourand, a chief marketing officer for a technology company, says he battled for nearly 10 months to evict a tenant who had stopped paying rent in February on a four-bedroom town house in Arnold, Md.

Mr. Ourand, who lives in nearby Severna Park, says he trekked to court three times to get the tenant to pay up. In October, he says, he was able to oust the delinquent tenant, whom he says trashed the place.

Mr. Ourand says the ordeal cost him roughly a third of his annual investment income on the property. "This is the worst experience with investment properties I have ever been through," he says. "It was a nightmare."

Even tenants with clean credit can turn out to be unsavory. Attorney Rachell Horbenko says she had to boot tenants from her Chicago building after waking up in the middle of the night to the smell of marijuana. The tenants were consuming so much, she says, that the smoke had seeped into her six-month-old daughter's room.

"The room was cloudy," she says. "I could barely see the crib." The eviction process took more than three months, she says.

Write to Jessica Silver-Greenberg at jessica.silver-greenberg@wsj.com