Warren Buffett, with a net worth of $116 billion, is one of the most successful investors of all time. One strategy of his is to avoid investing in areas in which he has little expertise. Buffett doesn't consider the rental property business his wheelhouse.
Few people can -- or even try to -- reach Buffett heights. And that's OK because many real estate investors make a good living, and sometimes a fortune, investing in rental property. Here are some reasons why investors, including me, love it.
1. Most people know something about it
Investing in what you know is good advice to take from Warren Buffett. I know about single-family homes mainly because I grew up in one -- a 3-bedroom, 2-bathroom ranch home in Orange County, California, to be exact. Growing up in a single-family home doesn't make me an expert in real estate investing, but I am at least familiar with the product and the type of market likely to be interested in it.
I saw people all around me getting rich after investing in California real estate, but by the time I was ready to invest, California had become too expensive. My family and I happened to move to the right place at the right time, though: Atlanta. Single-family homes were cheap here compared to what I was used to, and the city was booming.
Practically everyone I met had recently relocated here, as we did. I was ready to buy my first property in the summer of 2014. Besides knowing about 3-bedroom, 2-bathroom homes, I knew the location.
I picked a semi-distressed neighborhood with a large trailer park development around the corner. This location had great infrastructure. It was within walking distance of a national park and a Publix grocery store strip mall. Two years later, Whole Foods announced it would anchor an outdoor shopping center around the corner. (Yes, that corner.) I knew then this was the business for me and was ready to make my second deal.
2. Rental property can bring in decent cash flow
You can earn about $10,000 to $15,000 a year on a 3-bedroom, 2-bathroom rental property, assuming you're charging the right amount for rent and your expenses aren't excessive. Excluding a mortgage payment, your expenses shouldn't be more than 50% of your rental income. Mine average 40%.
What you'll earn from one rental property probably won't be a fortune, but you're probably earning at least as much as you would with other types of investing. And if the area pops, you could have significant home price appreciation, too. If you buy property outright, you'll probably have good cash flow right off the bat.
3. Buying property lends itself to buying more property
Once you start adding more properties to your portfolio, you can do pretty well. You might even be able to quit your day job. Most investors get multiple rental properties using leverage, putting down about 20% each time. Once you get enough equity in a property, combined with the income you receive from rent, you can probably get either a home equity loan or qualify for another mortgage.
You need to know the business
Remember Buffett's motto of having expertise in the area in which you invest. There's more to know about rental property investing than familiarity with the product and the neighborhood. You also need to learn the following:
Landlord/tenant law, both local and federal
You can find out your local landlord-tenant law by searching the internet for your jurisdiction (state and sometimes city as well). There aren't too many federal laws, but you need to follow them, or you could be out of business.
- The warranty of habitability: Requires that you provide a livable rental unit.
- The Fair Housing Act: Makes it illegal for landlords to discriminate against people.
- The right to quiet enjoyment: Makes it illegal for you to disturb your tenants after you've rented to them.
How to determine cash flow
Figure cash flow, also called net operating income or NOI, to determine whether you'll make or lose money each month. Do this by determining how much rent you'll charge based on market-rate rents for your area, and then subtract all your expenses (mortgage, taxes, insurance, repairs, maintenance, HOA fees, property manager, etc.) from that figure.
How to determine cap rate
Cap rate tells your return on investment. You figure it by dividing your NOI by the property's purchase price. If your cap rate is too low, you might want to pick a different property. Note that if your cap rate is very high, the property might be too risky, which brings us to the next point.
How to pick a good location
You can invest outside your local area by researching properties and neighborhoods. Up-and-coming areas that are attracting new business and people and are still affordable are usually worth looking into. Avoid overly expensive cities, tenant-friendly cities with laws unfavorable to landlords, and cities people are leaving.
How to know what to charge for rent
Look at what other landlords in your area are charging for rent for a similar property to give you an idea of what you can charge.
How to screen tenants
It's important to screen tenants so you can trust them to pay the rent on time every month and follow the lease terms. Set criteria, such as a minimum credit score, a good credit history, proof of employment, ability to pay move-in costs (security deposit, first month's rent), and a clean background check.