Even smart landlords lose money with their rentals occasionally. You may be an experience landlord, or just beginning. Here are 7 ways landlords can lose money.
1. Government regulations and taxes
Ronald Reagan said, “The nine most terrifying words in the English language are “I’m from the government, and I’m here to help.” I think you would probably agree with me that whenever the government steps in, no matter how well intentioned, they will probably do a poor job of whatever it is they are doing and it will come at a cost.
Recently many cities and municipalities have started compiling lists of landlords and renters – requiring landlords to register with the city for the purported purpose of neighborhood preservation and for “health, safety violations, or in case of emergency”. The city of Sacramento regularly scans the tax records looking for non-compliant landlords. At first glance, this may all seem a reasonable request, but usually it doesn’t stop there. In several cities, including the city of Sacramento, there’s an annual inspection that is necessary that requires a city inspector to be have access to the interior of the rental.
The landlord must schedule a time with the tenant, the inspector – all at the landlord’s expense. In addition, to the inspection, these cities and others are requiring a business license and or a rental fee for every rental. The Cities of Rancho Cordova and Sacramento charge an annual fee for owning rentals in their cities. In addition, to health and safety violations, these inspectors are increasingly citing building code violations and unpermitted structures. In some cases, they can actually red tag a property forcing you to find and pay for housing for your tenant until the repairs are made to your rental.
Next, think about rent controls. Landlords have to pay for improvements, maintenance, and vacancies while at the same time keeping the rents below government thresholds. The result is that landlords aren’t able to keep up with all of the necessary repairs and the properties suffer. Given time, the quality of the rentals available begins to decline, and with it the prices landlords can collect for rents, adding further fuel to the problem. With the recent Oakland warehouse fire and the legislature getting concerned about affordable housing, is it possible Sacramento will be next?
2. Bad tenants
I know that you know that finding good tenants can be difficult. No matter how hard you try to find good tenants, there are unscrupulous people who know how to beat the system. The first thought that might come to your mind is clogged toilets, but that’s the easy stuff. More expensive are those tenants who call the local government agencies to report their landlords for issues.
Bad Tenants Next Door
You may be very good at screening your tenants. However, if the property manager for the rental next door isn’t, it will affect the type of tenants you keep. Years ago a friend had a three unit rental property next to several other rentals. He made a very profound statement that I’ve never forgotten.
This is common problem for many landlords. You have the best of intentions to only approve the best possible tenants. But what do you do when the tenants next door repeatedly drive your good tenants away? Try talking to the other property management company? Good luck with that. Unfortunately, many landlords buy rental properties that they think they can turn around by changing out the bad tenants for good tenants but forget the other rentals that they have no control over.
Not paying rent
I recently purchased a property from a reluctant landlord in Sacramento where her tenant with a lease-option had reported her to the city for a light that didn’t work and then stopped paying rent. When the city came out, they also cited the landlord for an un-permitted garage conversion that had existed for twenty years! The city then gave her 30 days to correct the problem. Her relationship with her tenant became so deteriorated, that she didn’t perform an eviction for six months for fear of what they would do to the property when they were evicted. Meanwhile, her tenants continued to live off of her for free costing her several months of rental income and added expenses.
There’s a lot of things that you can fix in a house. You can paint them and put new carpet in them, but there’s one thing that is impossible to fix – location. The old saying is that everything in real estate can be boiled down to “location, location, location” is still true.
Sometimes locations are deceptive. I recently went to look at a rental property that was in a great school district where everyone wants to send their kids to. As I drove through the neighborhood around this house though, I realized that the neighborhood didn’t match the school district. I had remodeled a house in the same area just three years earlier and things had looked great then, but since that time things had not gone well for the neighborhood. The area had become predominantly rentals with lots of deferred maintenance. It was only a matter of time before these tenants started looking for nicer neighborhoods.
Lots of things go into location besides school districts. There are issues like flood zones where the flood insurance can cost as much as three thousand dollars per year. I’ve seen appraisers mark down the value of a house by ten thousand dollars because it backed up to the police station or for being on a moderately busy street.
Do you have a property in a less than ideal location? Are your tenants regularly move out after just a year? Do you have to deal with vacancies more often once every 2-3 years? You might have a location issue.
4. Renting to family
We love our families, and therein lies the rub. Johnny comes home from college and can’t find a job. To make ends meet, he starts working a minimum wage job while looking for better employment. He says it’s just a short term problem until his prospective employers start to call him back. He feels good about everything.
Does this sound familiar? The U.S. Census Bureau estimated that 19% of young men between the ages of 24 and 34 are now living at home with their parents. Many times a parent rents a home to them thinking, “I know the person. My property is vacant. Why not help them out?” Often times this starts at a discounted rent while their new tenant works things out.
Fast forward a few years, and often Johnny is still their tenant, and still hasn’t been able to find steady work leaving the landlord footing the bill for taxes, insurance and possibly even a mortgage. More costly yet, Johnny hasn’t been taking care of the property and is behind in his rents again.
What do you do? You can’t very well evict him. You’d never be able to go to another family get together again. So, you’re stuck, with a tenant you cannot evict, a mortgage to pay and maintenance costs mounting.
Does Johnny rent from you? Has Johnny paid his rent lately? How much longer can this go on? Pat rented a house to his nephew to help him out. That didn’t go well. He said.
5. Unexpected maintenance costs
When was the last time you had an unexpected repair come up at your personal residence? Appliances don’t last forever. Dishwashers, garbage disposals, ranges all have a limited life time. But when you live in your house, you see those items and probably take care of them quickly.
It’s the little costs
How many times does your tenant call you with little stuff; nothing big, just little things that still require sending a handyman or repair person out to look at? “The heater doesn’t seem to be blowing warm air.” “The AC doesn’t seem to be blowing out cold air.” “Part of the fence blew down in the last windstorm.” “A crack just showed up in the backyard window, after I ran the weed whacker.” These aren’t necessarily big expenses, but they slowly eat away at any profit you may have expected from your rental.
Your tenants’ little secrets
Then what about those needed repairs your tenants don’t tell you about? Do they tell you about the water leaks under the sink damaging your new cabinets, the showers and sinks that drip driving up your water bill, the hose bibs that spray water onto the wood siding causing dry rot, or the irrigation sprinkler head that is broken? No they just turn the irrigation timer off causing that nice green lawn to turn brown or the hose bib to continue to cause dry rot.
When you bought the property those were all in good condition, and yet just a few years later when your tenant moves out they finally tell you about it saying, “Yea, I put a bucket under there to try and catch it”. What about the clogged gutters that rust out, the hot water heater that leaks, and wash machines that aren’t hooked up properly and leak all over the floor?
How much more will these unexpected repairs cost you? How many more little expenses can you afford before you are losing money?
6. Bad property management companies
Not all property management companies are bad. There are definitely some great property management companies out there, but how would you know if they are more interested in your success than theirs? How do you know before you hire one whether you will be happy with them?
What’s their incentive?
Let’s be honest, property management companies don’t pay their bills by collecting a 10% commission off of your rent check. Could you run a business that was successful based on that kind of income? It would take so many rentals to pay your salary that you’d need extra help, which you’d then have to pay a salary for too. No, I sure you realize that the way management companies make their money is with extra customer services. Rent ups, vacancies, repair services, evictions, etc.
To be sure, all of these things are part of the nature of being a landlord, but is your property management company trying to reduce the amount of services they are providing to you or are they trying to provide you more? What’s the benefit to a property manager who truly makes everything go perfectly smooth, places the truly best tenants, and keeps your property in great shape while reducing your costs? But isn’t that what you expect of your property manager?
What’s it costing you?
Bad property management companies fall into two categories, those who don’t take care of that property that you spent a lot of money for and those that go beyond great service to providing completely unnecessary services. One company generates their income by pretending to keep your repair costs low, while creating unhappy tenants, not to mention how unhappy you are with having to fill a vacancy each year. The other company generates income by taking great care of your property, but at the cost of unnecessary repairs. Costs that ultimately you pay for out of any profits you may have been expecting.
How much are you spending in unnecessary property management fees?
Vacancies are the biggest reason smart landlords lose money in rentals. There are lots of reasons for vacancies, many of them attributable to items already mentioned – poor management companies, location, schools, but there’s more. California is a still losing jobs to out of state companies. Texas is in a hiring boom. People are moving out of state to find work, even if it means breaking their lease. Some people get job transfers, others are buying a home and are no longer going to be renting. It may not be long before people are moving out of state just to find water.
Every time this happens, it costs you money; whether you manage your property yourself or you have a property management company do it for you. It costs you lost income, it costs you the maintenance costs of paint and other repairs, and if you hire out your management, it costs you their service fee. You can try and do everything you can to reduce vacancies and to quickly fill them, but the truth is they happen. And unfortunately, a vacancy no matter how short, can quickly eat up any profits you may get from the rest of your tenants rental period.
What are your vacancies costing you?
Are vacancies eating all of your profits? How much are your vacancies costing you?
BONUS SECTION – more ways that landlords lose money
Well, that’s the first 7 ways landlords can lose money in Sacramento. However, I always like to leave you with more than you expect, so here’s some additional costs you may have already thought about.
8. Too much money tied up in a property that produces too little income
You’ve probably heard of the term, Return on Investment or ROI. It’s a simple formula that takes the total net income produced by an asset and divides it by the total dollars invested. It’s a way for investors to compare two different opportunities to determine which has a better return. This is also called “yield”. Here’s an example, suppose you paid $200,000 for a rental property that rents for $1,200 a month. Annually that’s $14,400, which seems like a pretty good yield at 14400/200000 = 7.2% (remember income divided by purchase costs). That looks pretty good.
What’s the real ROI?
But did you really receive that much income? What about those management fees above, or the unexpected repair costs, vacancies, and government fees that ate away at your rents? It’s not unheard of to see 25-30% of rents go toward these operating costs. If you subtract 30% off of your rental income for these expenses that leaves you with $10,080 net annual income. That’s a 5.04% yield. That’s actually costing you money. You could have invested that money in a decent stock or index fund during the past few years and had a better return without all of the headaches. And then what about the big expenses that come up along the way like new roofs, HVAC systems and other big ticket items. These can erode your yield even further.
Some people buy properties because they have the mistaken belief that property values always go up. I suspect that the recent Great Recession probably has dispelled that belief for many. Robert Shiller, winner of a Nobel prize in economics and author of what some consider to be the two most important economic charts of the last two decades, has shown that since the 1890s, home prices appreciated roughly 3%, just in keeping with inflation.
If you’re counting on your property value going up or not including all of your expenses in your mental accounting, you’re rental property may be costing you money, rather than making you money.
9. Paying for expenses with credit cards or other lines of credit
We all know better, but often when surprise bills start coming in on a property, we start paying more and more of our bills with our credit card. We have every intention of paying them off when we can, but somehow we just never seem to be able to get caught up because those repair bills just keep coming in.
If we’re not careful these debts can get quite large and start to weigh on us. The interest we pay on this debt can be quite large and we forget that in addition to all of our other expenses for a property, we may still be paying monthly interest on those previous expenses, costing us thousands of dollars a year.
We can completely forget after a time that the reason our credit lines are maxed out to begin with is because of paying too many bills from our credit line for that property. We may have even been dishonest with ourselves and not associated our extra debt as being related to non performing properties and expensive repairs. Still the interest has to be paid and we keep on making the monthly payments, long after those unexpected bills were paid with our credit card.