This article will cover all aspects of starting a rental property business from a surface, introductory, perspective. We will touch on many topics that are involved in this undertaking but due to the depth of the subject we won’t be able to cover every part in detail, for that we have more blog posts on each topic individually.
Before we can embark on specific ‘to dos’ or steps involved in starting a rental property business we must get our footing and understand that rental property business is, why people go into this business and what are potential advantages and drawbacks of this business.
What is the rental property business?
A rental property business involves owning and operating properties that are rented out to tenants in exchange for regular rental payments. It is a form of real estate investment where the property owner, also known as the landlord or property investor, generates income by leasing out their properties to individuals or businesses.
In a rental property business, the landlord's primary objective is to generate rental income while managing the property and providing a safe and comfortable living or working environment for tenants. The business typically involves acquiring properties, marketing them to prospective tenants, screening and selecting tenants, managing leases and rental agreements, collecting rent payments, and maintaining the property.
The types of properties involved in a rental property business can vary, including residential properties such as single-family homes, apartments, or condominiums, as well as commercial properties such as office spaces, retail units, or industrial buildings. The specific focus and strategies of the rental property business depend on the investor's preferences, investor’s access to capital, investor’s skill and background knowledge as well as, prevailing real estate and capital market conditions..
Successful rental property businesses require effective property management, including property maintenance, tenant communication, financial management, and adherence to local regulations and laws. It is crucial for landlords to understand their responsibilities, rights, and obligations as property owners and landlords. All of this knowledge culminates in three landlord activities, tenant selection, lease creation and property management. We will touch on each one of these activities in greater detail later in the article.
Just like any business, rental business comes with its own risks such as property vacancies, tenant turnover, maintenance costs, legal obligations, and market fluctuations. These risks do not deter millions of landlords that are profitably serving their tenants. In exchange for their services, landlords get a regular stream of rental income, potential appreciation of property value over time, tax advantages, and diversification of investment portfolios.
Now that we covered the basics, let’s dive deeper into the details of the business and the actual mechanics of how it all works. Next section will focus on the profitability aspect of rental businesses and how to defend and improve the margin or unit economics of rental properties.
Is the rental property business actually profitable?
There are millions of landlords in the USA, but not every single one of them is profitable. Profitability is paramount as lack of therefore can cause landlords to drop out of the business after investing their resources into the activity, leading to a loss. Avoiding loss is the number one rule for every investor and as legendary Warren Buffet likes to point out as his favorite rule number two, “never forget rule number one”.
The profitability of a rental property business can vary depending on various factors such as location, property type, market conditions, expenses, management efficiency, and individual investment goals. While rental properties have the potential to generate income and build wealth over time, it's essential to carefully evaluate and analyze the financial aspects before determining profitability. Here are some key considerations:
Rental Income: The primary source of revenue in a rental property business is the rental income received from tenants. The rental rates, occupancy levels, and rental demand in the market will directly impact the income potential. Conduct thorough market research to ensure the rental rates are competitive and sustainable. This includes leveraging online resources to understand the local market where your current or potential property is situated. Follow the process your potential tenant will follow to search for you target property to figure out what other rentals on the market you will be competing against for tenant’s attention. This will give you a clear idea where you stand in terms of pricing.
- Expenses: Operating expenses can significantly affect profitability. These include mortgage payments, property taxes, insurance premiums, property management fees, maintenance and repairs, utilities, vacancies, and other costs. It's crucial to accurately estimate and budget for these expenses to understand the net income and cash flow of the business. Having precise information regarding each one of the mentioned items is critical. Trust me when I tell you, that vast majority of investors that are able to scale to hundreds of properties don’t run their business using “back of the envelope” calculations. Have precise records in popular software spreadsheet applications to keep track of profit and loss is the key to running a profitable rental business.
- Financing Costs: If you financed the property through a mortgage or loan, the associated interest payments should be factored into the expenses. Higher interest rates or financing costs can impact profitability, particularly if rental income does not adequately cover the expenses. The cost of capital, another way to call this expense, is important to keep in mind as you increase the leverage of your transactions. Different capital providers will have different criteria and qualifications that will adjust the cost of capital for your transaction. When evaluating any loan opportunity, make sure to contact several providers to find the best deal on your debt.
- Property Appreciation: Rental properties can appreciate in value over time, which can contribute to profitability if you choose to sell the property in the future. However, property appreciation is not guaranteed and can vary based on market conditions and location. This point can’t be overstated. Just like in any business, unit economic matters. Positive unit economics of each rental property means that each property is producing cash flow. This way you won’t be reliant on speculative appreciation, if it does happen, its a nice bonus.
- Tax Implications: Tax deductions, such as mortgage interest, property taxes, and depreciation, can help reduce taxable income and positively impact profitability. Consult with a tax professional to understand the specific tax implications for your rental property business. Beyond just consulting a tax professional, roll up the sleeves and learn more about treatment of real estate by the government. Just like when working with contractors on the property, you need to have some understanding of the activity you are asking them to complete. Learn the specific schedules such as Schedule E that is part of 1040. First part of Schedule E is “Income or Loss From Rental Real Estate and Royalties”. Look at the listed sections, just to name some of them:
- Auto and travel
- Cleaning and maintenance
- Legal and other professional fees
- Management fees
- Mortgage interest paid to banks, etc.
- Other interest
- Depreciation expense or depletion
These expenses have very strict definitions listed in the instructions to Schedule E. Learn what they are so you can recognize them when you incur them and make sure to save all of your receipts. Categorize and file all supporting information according the tax year. There were several times when IRS has followed up several years (3-5) after the year of the return to ask for more information or pay some tax that they think you owe them based on lack of information (they do lose records sometimes so having duplicates of everything you filed can save you hundreds if not thousands of dollars over the years).
- Market Conditions: Rental property profitability is influenced by local market dynamics, including supply and demand, job growth, population trends, and economic stability. Strong rental demand and limited supply can lead to higher rental rates and increased profitability. Once again, leveraging online resources to research these finer points of the local market is necessary to avoid hidden dangers that aren’t apparent from a mere visit to the property of a drive-by of the area.
- Management Efficiency: Effective property management, including tenant screening, timely repairs, and proactive maintenance, can minimize vacancies, reduce turnover costs, and enhance profitability. Before efficiency across this activity can be reached, its ok to invest time and money into this process. Tenant selection is the step with the highest degree of risk since once they sign your lease they are there to stay until they move out or you evict them. A common saying is “an ounce of prevention is worth a pound of cure”, rings very true here. If you find and lease to a high quality tenant, your operations will be smooth. Once you perfect your process to select for quality tenants, then you can start thinking of how to make them ‘efficient’ to maximize profitability, but when you starting out, it’s worth it to for example, try out several background checking services, but once you figure out which one provides the best service you can only use that one.
- Risk Factors: Rental property businesses carry certain risks, such as property damage, unexpected repairs, tenant defaults, or legal issues. Adequate risk management strategies, insurance coverage, and contingency plans should be in place to mitigate potential risks and safeguard profitability. Ultimately, some things are out of your control, but just being aware of the risk is already a step in the positive direction. Carrying adequate insurance for unavoidable risk is also a great move to give you a peace of mind.
It's important to conduct thorough financial analysis in excel or other spreadsheet tool, including cash flow projections, return on investment calculations, and sensitivity analysis, to assess the profitability potential of a rental property business. While it may sound daunting, we would emplore you to search each one of those terms and add “template” at the end to get started. Many providers give you free, ready to use templates that just need you to plug in the numbers to give you a good idea of the financial picture. For example, we have a very simple DSCR calculator that will show you if the property will have cash flow and how much cash to close you need. This analysis is simplistic and needs more research, but it's an easy first step in the right direction of getting comfortable with concrete calculations that will back your rental real estate business. Consider consulting with real estate professionals, accountants, or financial advisors who specialize in rental property investments to help evaluate the financial viability and profitability of your specific rental property business.
How to start a rental property business with no money?
Starting a rental property business with no money can be challenging, but it's not impossible. While having some initial capital is typically advantageous, there are alternative strategies you can employ to get started. Here are some steps you can take to begin a rental property business with limited or no funds:
Save the money. This is the most obvious answer but yet is often overlooked. Ability to retain money is necessary to be able to invest it. Make lifestyle changes to start accumulating capital, the further you live below your means, the more capital you will be able to save to provide you with starting capital for your rental business. This is often the easiest and best way because it avoids many of the downsides of methods listed below.
- Partner with Investors: Seek out potential investors who are willing to provide the necessary capital in exchange for a share of the profits. Find individuals or groups interested in real estate investments and present a well-prepared business plan that highlights the potential returns on their investment. Issue with this approach is that finding partners is hard and will require a skill set that is different from a skill set necessary to run a profitable rental business. Additionally, once you find partners they might not be the right partners. The operational life of a partnership is highly dependent on the relationship of the partners within it.
- Joint Ventures: Another way to partner with an organization or individual to participate in real estate. Main difference here versus the previous method is the duration of the cooperation. While the previous method dictates indefinite cooperation, this agreement limits cooperation until the end of this particular deal. This is a flexible, non-committal approach to handling real estate operations.
- Seller Financing: Seek out property owners who are open to seller financing. This means they are willing to finance the purchase themselves, eliminating the need for a traditional bank loan. They will hold the title for the property (and hence ownership), while you pay off the note that you negotiate with the property owner. Once the note’s criteria are fulfilled, you will receive the title from the owner. This option is flexible in that you don’t need to secure outside financing, however the terms that the seller presents you with needs to be carefully examined since they might include none standard criteria for fulfillment. Additionally, you may be able to negotiate favorable terms, such as a low down payment and flexible repayment schedule.
- House Hacking: This approach is specifically effective because multifamily properties that are owner occupied are given special treatment by FHA and they extend extremely favorable (low cost of capital) loans to rental business owners that qualify. FHA also has low down payment requirements compared to many other loan providers, so this is an incredibly low barrier to entry approach to start your rental property business. To qualify for this loan and execute on this strategy you will have to be living in one unit of a multi-unit property and rent out the remaining units. This allows you to generate rental income to cover the mortgage or other expenses, while also having very low cost of capital.
Remember, starting a rental property business with no money requires resourcefulness, determination, and effective negotiation skills. Building relationships, demonstrating your value proposition, and presenting a compelling business plan are key to securing partnerships and alternative financing options. However, as we stated in the first method that we recommended, all of these approaches are ‘noise’ to your main business of providing rentals to the tenants. There is no other way to say it, but the simplest way to start in real estate with no money, is to way until you save enough money to get started which often means living below your means or finding ways to increase your current income so you can save more each month for seed capital.
How do rental property business do tax deductions?
This is an extremely deep topic that we will explore in deep detail in an upcoming series of articles. For now we will cover some of the basics to get our feet wet. Rental property businesses are eligible for various tax deductions that can help reduce taxable income and lower overall tax liability saving you money on taxes. Knowing the tax code can be your edge in structuring future deals and profitably running your rental business Here are some common tax deductions that rental property owners can consider:
Mortgage Interest: Deduct the interest paid on the mortgage or loans used to acquire or improve the rental property. This deduction can apply to both the main mortgage and any secondary loans.
- Property Taxes: Deduct the property taxes paid on the rental property. Property tax deductions can be claimed as an expense in the year they are paid
- Bonus depreciation: Rental property owners can depreciate the cost of the property over its useful life as a deduction. Depreciation allows you to allocate the cost of the property over 20-30 years, providing a significant tax benefit. However, important note is that if the property is ever sold, this ‘Bonus depreciation’, and its called bonus for a reason, is “recaptured”, meaning you will have to repay all the claimed depreciation expense back. The only way to avoid this is to conduct a 1031 exchange, thus is a very common strategy to always roll over your rental capital through 1031 exchanges.
- Repairs and Maintenance: Deduct the expenses related to repairs, maintenance, and general upkeep of the rental property. This includes costs for plumbing, painting, electrical repairs, and similar expenses that are necessary to keep the property in good condition. Make sure to keep solid records and receipts. It’s not unheard of IRS to request information four to five years after the filing date under the threat of charging you whatever amount their system thinks you owe since they don’t know your expenses and think you run your rental without them by default.
- Insurance Premiums: Deduct the premiums paid for property insurance, including coverage for liability and property damage.
- Utilities and Operating Expenses: Deduct the expenses related to utilities, such as electricity, gas, water, and sewer fees, as well as other operating expenses like landscaping, pest control, and cleaning services. In our experience, most rental business owners don’t pay for tenant’s utilities since there is misalignment of incentives so this doesn’t often get listed as an expense.
- Professional Services: Deduct the fees paid to professionals who assist with the rental property business, such as property management fees, legal fees, accounting fees, and tax preparation services.
- Travel Expenses: Deduct travel expenses incurred for the purpose of managing or maintaining the rental property. This may include mileage, lodging, meals, and other related expenses. If these costs are significant make sure to keep proof that shows that you actually incurred them.
- Home Office Deduction: If you have a dedicated space in your home that is used exclusively for your rental property business, you may be eligible for a home office deduction. This deduction allows you to deduct a portion of your home expenses, such as rent, mortgage interest, utilities, and insurance, based on the percentage of space used for your business. Be very careful with this deduction, the space must exclusively be used for business, thus having a bed, couch, toys, sounds systems or any other items that might show secondary use will disqualify your space from these deductions. In recent years IRS has been paying closer attention to these types of deductions because of a spice in their claims catalyzed by disinformation on social media.
- Losses and Vacancies: If your rental property operates at a loss or experiences periods of vacancy, you may be able to deduct those losses against other sources of income, subject to certain limitations and rules which will vary between the federal and state governments.
Before you consult with qualified tax professional, do your own research into local and federal laws and the tax code. Once you have some footing, pay for a consultation session with a qualified tax professional or accountant who specializes in real estate to ensure you are taking advantage of all applicable tax deductions and following the tax laws and regulations specific to your jurisdiction. If 99% worth every cent because of the information you acquire and the knowledge that allows you to better navigate the tax system helping you maximize your profits.
What are the risks and potential challenges of a rental property business?
Like any business venture, a rental property business carries certain risks and challenges that should be considered. Here are some common risks and potential challenges associated with a rental property business:
- Vacancies and Rental Income: One of the primary risks is the potential for vacancies, which can lead to a loss of rental income. This is a such a common risk, that your landlord insurance protects you from it (subject to specific criteria listed in your insurance policy, most commonly some internal defect of your unit that prevents it from being leased out). Extended periods of vacancy can impact cash flow and profitability, especially if there are ongoing expenses to cover without rental income. Vacancies may be driven by local economic conditions, but ultimately it all comes down to the price you charge your tenant. Hypothetically speaking, at $0 per month, everyone would want to live in your unit. You can’t charge that because it would be unprofitable to you and you want to maximize the profit. So you raise the price to a point you want. If you can’t rent at that point, you need to lower your price until the tenant moves in and this way you will see what amount of profit the market can sustain. You as the manager must make sure that tenant revenue is above all of your expenses so you have a positive profit.
- Difficult Tenants: An ounce of prevention worth a pound of cure. Screen, screen, screen. Make sure your know everything you need to know about your tenant before they sign a lease. Once they do, they become your problem. What if they start to give late rent payments, make property damage, have other lease violations, or cause disputes with other tenants? You will have to deal with all these issues and no one to blame but your selection process. Resolving these issues can be so expensive that it may drive you out of business.
- Property Damage and Maintenance: Rental properties are subject to wear and tear, as well as the risk of unexpected property damage.Carry adequate insurance to avoid catastrophic issues such as fires and be timely about servicing minor things along the way. While staying lean is important, underspending on maintenance always leads to costly repairs down the road and bad life quality for the tenants which usually results in higher turnover. It’s a good practice to specify in the lease and communicate to the client that they should inform you about any issues they detect in the property as promptly as possible.
- Financial Risks: Owning rental properties involves financial risks, such as fluctuations in property values and potential market downturns. Unforeseen expenses, property taxes, insurance premiums, and mortgage obligations can impact profitability and cash flow. This is one of the easiest risks to mitigate. Use spreadsheets to make projections with healthy margins of errors to be able to shoulder any fluctuations listed above.
- Legal and Regulatory Compliance: Legal expenditures, in the end, are what kills every single real estate business, so it’s vital that you are aware of your legal standing and always ready to get professional help when the situation requires it. Non-compliance with local, state, and federal laws and regulations can lead to legal issues and financial penalties. It's important to understand and adhere to fair housing laws, rental regulations, safety codes, and other legal requirements.
- Liability Risks: Rental property owners face liability risks for accidents, injuries, or property damage that occur on their premises. Inadequate insurance coverage or failure to address potential hazards can expose landlords to legal liabilities and financial losses. Another reason to carry solid insurance and actually read your policy. The worst time to read you insurance policy is after some issue has happened.
- Market Conditions: Rental property business profitability can be influenced by market conditions, such as changes in rental demand, competition, or economic factors.This risk factor can also be mitigated to a highest degree through financial modeling in a spreadsheet software. Projections with solid margin of error, or ‘margin of safety’ will help you stay in business through most cycle since real estate is one of the least volatile asset classes.
- Financing and Interest Rates: Securing financing for rental property investments can be challenging, particularly for first-time investors. However, despite the challenges here, having access to capital can be an edge and will help you grow your rental real estate business
- Unexpected Events: Natural disasters, accidents, or unforeseen events can cause property damage, disrupt operations, and impact rental income. Adequate insurance coverage, emergency preparedness, and contingency plans are essential to mitigate these risks.
To mitigate these risks, it is important to conduct thorough due diligence, develop a solid business plan, maintain adequate insurance coverage, establish financial reserves, implement effective property management practices, and stay informed about market trends and regulations. Seeking professional advice from real estate experts, accountants, and legal professionals can provide valuable guidance in managing these risks and challenges effectively.
Can I use a rental property business as a retirement investment or income stream?
Yes, a rental property business can be a viable option for retirement investment or as an income stream. Many individuals use rental properties as a means to generate passive income during their retirement years. Here are some reasons why rental properties can be a beneficial investment for retirement:
- Income Generation: Rental properties provide a steady stream of rental income and can be put on ‘auto-pilot’ if there is enough margin to secure a dedicated property manager. Once a property manager takes over, they typically charge 8-10% of rental revenue to service your rental while you can use the remainder to cover remaining expenses. Its vital for the property to have a positive cash flow so it can sustain a retirement lifestyle
- Potential Appreciation: If you bought in a great location or in a path of development then you definitely stand a chance to get some property appreciation. Tax Benefits: The largest differentiator of owning real property is its tax treatment. Rentals enjoy a tax shield that can be used to lower your overall tax bill.
- Diversification of Investments: Owning rental properties adds diversification to your investment portfolio. Real estate investments have historically shown low correlation with other asset classes like stocks or bonds, providing a way to spread risk and potentially enhance overall portfolio performance.
It's important to carefully evaluate the financial aspects, market conditions, and potential risks associated with rental property investments. Consider conducting thorough market research, cash flow analysis, and consulting with financial advisors or real estate professionals to assess the suitability of rental properties as part of your retirement investment strategy.
Real estate rental business is a great way to supplement retirement income, but the best way to start is decades before you need to depend on this income. This will give you time to accumulate wealth of experience necessary to run a rental real estate business and subsequently put it on autopilot when you enter retirement by hiring a property manager that will eat into your profit margin but allow you to step away from day to day operations.