Long term rental property is perhaps the first real estate investment vehicle that comes to most people's mind. I cannot tell you how many times I've heard, "I don't want to become a landlord. I don't want the headaches of being called with a broken air conditioner at two in the morning. Tenants are all low-lifes who can't afford to own a home." This usually comes from the same people who ask me how I've been so successful in real estate investing, and the answer is long term rentals.

The fact of the matter is that you can own rental properties and you don't have to be a landlord. There are many reliable property managers who, for a small fee (about 7-10% of the rent), handle the headaches for you. It might also surprise you that most tenants are very good people. Many people rent because they want to get to know a city before they plant roots. Others have jobs for only a year or so and don't want to buy a house. Others are in a flat market where the cost of renting is much less than the cost of owning so they choose to rent. Fortunately for the professional real estate investor, these misconceptions keep many people out of the market, leaving the good stuff for us.

Investing vs. Speculation
There are two main objectives when buying rentals. One is to buy a property where your rent exceeds your costs which results in a monthly passive income. This is the more traditional investment and is what most people think of when it comes to rentals. Another is to buy a house hoping that it will appreciate aggressively. While you still must consider the monthly pre-tax cash flow scenario, you may be willing to accept a neutral or even negative cash flow if the appreciation is exceptional. This type of investment is more accurately classified as speculation.

Many prominent investment advisors strongly recommend investors avoid any property that will not generate a positive monthly pre-tax cash flow. While I respect their opinions, it comes down to different strokes for different folks. Consider the investors that purchase vacant land. Their objective is to buy it at a low price today and hope that as the area develops, the value of the land will appreciate, and they will be able to one day cash in on this appreciation. In the mean time, unless they have a unique situation that they can make use of the land and get some kind of revenue to offset the monthly payments and taxes, they are certainly in a negative cash flow situation. (If they paid cash for it and don't have monthly payments, they should read the section on leverage below.)

If this is acceptable to most investment advisors, how is a slight negative pre-tax monthly cash flow unacceptable? In my opinion, if you purchase a property that is appreciating 1% a month and you're seeing a monthly pre-tax negative cash flow of 0.1%, aren't you at least deferring the majority of the financing liability to the rent? How is this not an advantage over owning vacant land?

Certainly there is less risk involved in owning property that has a positive pre-tax monthly cash flow, but as a rule of thumb, the more the risk, the more the reward should be. If you truly analyze the different markets, you'll realize that in some markets the rent for a standard house will exceed the cost of owning, while in other markets, the rent will fall short. In 2004, rent in Dallas is about 1% of the purchase price, while in Las Vegas it's about 0.5%. Not coincidentally, the annual appreciation in Dallas is lucky to be 3% while in Las Vegas, the houses appreciated an insane 52% (July 2003 to July 2004). So typically, unless you catch a market just before it booms, you will have more trouble making the pre-tax cash flow positive in aggressively appreciating markets.

One thing that most people forget to consider is the annual post-tax cash flow scenario. Frankly, this is more important to me than the monthly pre-tax cash flow. There are five criteria that drive how you can take passive losses, but I'd like to point out the two most significant. You can only deduct $25,000 of passive real estate losses against other income. Any further losses must be deferred to future returns. The second is if your adjusted gross income exceeds losses. You may be someone whose W-2 shows you receiving over $100,000, but it's your CPA (and everyone in any form of investing should be using a CPA) who will do their best to bring that amount down as low as possible so you can pay as little tax as legally possible. You'd be surprised how little you report (legally) to the government. If you still make more than $100,000 adjusted gross income, you can still write off your losses, but only 50 cents on the dollar, and once you exceed $150,000 you must defer all of your passive real estate losses to future years. (Real Estate Professionals, those who work more than 750 hours a year on real estate projects and who work more than any other income producing job they may have, can write off unlimited passive losses each year. If you feel you might fit this criteria, discuss this with your CPA.)

I like to view negative cash flow as an installment of the down payment. For example, you might put 20% down on a $200,000 property and have a neutral cash flow. You might, however, put 5% down on the same property and have a negative cash flow of -$500. So instead of putting $40,000 down, you only put down $10,000. That $30,000 difference will mean you could pay for 60 months (5 years) before you caught up to your initial investment. This isn't even considering that once you have 20% equity in the property you can remove the PMI, which will cost you about $163 a month. Taking this into consideration, and assuming a 7% appreciation so that you'll have 20% equity in 2 years, you'd be able to make 77 payments, or just over 6 years, before you caught up to your 20% down payment.

You Don't Have to Be Mr. Roper
"I don't want to be a landlord!" is perhaps the biggest objection our advisors hear. The good news is that you can be an owner and not be a landlord. There is a sector of the real estate industry called Property Management, and these professionals handle the day-to-day management of property for owners who would rather own real estate passively. For 7-10% of the monthly rent, Property Mangers can provide a range of services. From the very basic of just making sure the property is maintained, handling emergency calls, and collecting rent to more advanced tasks such as accounting for the property, Property Managers can make property ownership virtually passive.

Property Managers also provide another very valuable service: tenant placement. For a fee, which ranges widely from around $350 to as high as 75% of the first month's rent, they will advertise your property, probably list it in the local MLS for rent, interview prospective tenants, verify credit, work, and renting history, and arrange for the transfer of possession. Realize that if your property is listed in the MLS or other listing service, you will likely have to pay a small fee (around $250) to the agent that brings the tenant that moves in. This is usually part of the Property Manager's tenant placement fee, but be sure to determine this before signing an agreement with them.

Show Me the Money
As previously stated, there are two main objectives when buying a rental property. You can invest and find properties that will generate a positive cash flow, or you can speculate and look for rapidly appreciating markets. Regardless of your objective, every thing else about this investment vehicle is the same.

Because rentals are a long term investment, this investment vehicle is most affected by the concept of leverage. Leverage is often referred to as the OPM principle, or Other People's Money. If you have $10,000 to invest and you purchase stock, for the most part you purchase $10,000 of stock. In real estate, however, you can leverage yourself by buying $200,000 of property. (You can frequently roll the closing costs into the mortgage. Additionally, there are loan programs out there that allow investors to put zero down meaning you can leverage 100% of the investment.) So if stocks go up 10%, you get a return of $1,000, but if real estate goes up 10%, you realize $20,000 in appreciated equity, which is 20 times greater than the stock market returned. Even if real estate goes up only 1%, you double the return of the stock market with $2,000 increased equity.

Of course, the less you put down the more you owe. This is significant when determining if a property will have "positive cash flow" or not. Most investment advisors that preach you must have positive cash flow are from an era that 20% down or more was required on investment properties. Putting less than 20% down on non-owner occupied properties has only been around for the last 5 years or so. This concept is very crucial, so you are encouraged to read the detailed section on Leverage.

It is very critical that you perform an analysis on each and every property you purchase. You need to understand how much you must put down. Know how much the closing costs are going to be. Will you be able to roll them into the loan? What kind of loan program are you qualified for, and which is the best for you? What is the rental market doing, how much will rent be, and how long will it take to place a tenant? What are the associated fees such as Home Owners Association (HOA) fees, PMI (Private Mortgage Insurance usually required when putting less than 20% down), assessments, Property Management fees, taxes, and insurance? What is the anticipated appreciation for the area and what is the market trend? What will be your pre-tax monthly cash flow, and can, will, and should you tolerate a slightly negative cash flow on this deal?

That may seem like a long list of financial concerns, and it is. This is why it's very important to work with a Realtor who is already familiar with these factors. Additionally, once you register for free, you can access the worksheet that will allow you to analyze a property in a matter of seconds. If you are already registered, you can see the very detailed explanation of how to utilize the worksheet.

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