I’ve said it before and I’ll say it again: landlording is a job.
If you manage your own properties, then you are a self-employed property manager. You get the tax benefits associated with owning property but you’re still working. Anyone who says that landlording is “passive income” is kidding themselves. Or trying to sell you something.
Are You Cut Out for It?
Finding and managing properties can be a lot of work. When you are starting out, and your investment capital is small, you have to find properties which meet a lot of criteria in order for you to minimize your out of pocket. If you hire out the work, you have to know the right people or you will end up paying more for the same work. During construction, you have to keep tabs on your contractors to make sure that the work is getting done to your standards. If you’re financing the purchase, and I highly recommend you do (assuming that it makes sense), then you have to have good credit and cash reserves.
When dealing with tenants, you have to be tough, or people will walk all over you. You have to be able to say “No”, often. No, you can’t replace the countertops. No, you can’t install that basketball hoop. No, you can’t keep that pitbull on the property. Seriously, get rid of that dog or I’ll get rid of it for you. You have to be able to enforce the rules, consistently. If you are late, you will pay the late fee. If you don’t pay, we will take you to court. We’ve done it before and we know how it works. If you damage stuff, we will take it out of your deposit.
You have to be flexible and handle stressful situations with grace, otherwise you might make a costly decision. If a contract falls through when you’re buying a property, you have to pick up and move on, regardless of how badly you wanted the property or how much time you spent on feasibility. If something breaks, you have to be ready to fix it. If you get into conflict with a tenant, you have to keep your cool and treat them like the customer they are.
It takes a certain kind of person, that’s for sure. But if you want to earn superior returns, and you are willing to sacrifice some of them to offload some of the risk or minimize your involvement, there are ways to invest in real estate without quite so much effort.
Alternative Real Estate Investing
Hard Money Loans.
I’ve explain this concept in other posts but mostly from the borrower’s perspective.
As a lender, you can lend your money to an investor for a short time period and earn a great rate of return. We pay 14% interest-only and 3 points at origination for a maximum of 6 months. The lender loans us the purchase funds and then reimburses us for the repairs as we complete them with a total loan amount of 70% loan to value.
You can protect your investment by properly qualifying your borrower in the same way that a bank does: verifying employment, running credit, verifying cash reserves, running an appraisal and inspection on the property, and any other feasibility checks you need to run to feel secure.
If you do it right, there’s really only two risks: that your borrower defaults and that your borrower cannot qualify for a permanent loan. But really, if you did your homework on the borrower, then you should have a high degree of confidence in their ability to repay and to get out of the loan.
Worst case: you have to foreclose on the borrower and take the property back. If no repairs were completed, then you could either 1) sell it for what they bought it for and take a small loss or 2) spend what they were going to spend to fix it up and try and sell it for retail value (i.e. flip it).
Best case: your borrower refinances within 3 months and you take the money and immediately loan it to someone else, making 4 loans a year. So, you earn 14% interest for the whole year plus 3 points every 3 months for a total of 12 points a year. 12% + 14% is a 26% annualized return if you managed to have your money constantly loaned out. This is something I’d love to do eventually but for now, we need more houses
Private Equity Funds
Some hard money lenders will take outside money and pool it together to make hard money loans. This takes a lot of the work out of the picture since the lender acts as the broker and does all of the due diligence on the buyers. But they also keep some of the returns in this case too: typically they keep the 3 points and some small percentage of the interest. So the lender will loan out of the money at 14% and pay their investors 12%. That’s still nothing to sneeze at since you don’t really have to work for it.
Single Family Partnerships
If you’ve got money and credit, you can partner with someone who has time and expertise. We’re working on one such partnership now and the next house we buy will be with someone else’s money. We’ll keep you posted.
We had an opportunity to get involved in one of these but we declined to focus on buying more houses. This couple was already in 2 apartment complex partnerships and was looking to raise about 600k through multiple partners who would act as passive investors. This would allow the partnership to buy an established, cashflowing apartment complex for $1M to $2M which would return 14% to the partners from day 1. The couple would act as the lead investors and would do all the work, taking a small percentage off the top of the profits (called an override).
I have to say, it was really tempting because this is the direction we want to go eventually. But at the stage we are now, growing our networth is more important and so we decided to stick with single family.
If stocks are your thing, you can get some exposure to real estate by investing in Real Estate Investment Trusts, or REITs. REITs get a pretty nifty tax treatment since they pay out at least 90% of their income as a dividend. I’m sure I’ll have a detailed post about REITs in the future.
So There You Have It
Several ways to invest in real estate without having to deal with tenants. However, you will notice a common theme among the options: with the exception of the REITs, all of these will require more money to make up for what you aren’t spending in time.
This is another great reason to start out in landlording. Assuming you have the stomach for it!