Although no one can predict the future in the short run we are committed to the belief that real estate is an excellent long-term investment. We believe that people who own investment single-family homes, duplexes, quads, and small apartment buildings will build wealth that they can count on in the future. If owning investment real estate is part of your financial strategy, we have much to offer.
The first step to a successful real estate investment is to buy right. Our staff has the experience and savvy to assist you in locating the best investment properties. It is equally important to manage the rental process well. We know how to maximize your returns and minimize your risk. Our professional property managers will locate a resident and/or manage the property. Our affordable property management services save you time, money and hassles.
Why Invest in Residential Real Estate?
As an investor, you have the choice of a variety of investments, including real estate. Residential real estate offers advantages unavailable with most other investments, including:
• Leverage of your investment
• Rental income generates cash flow
• Little or no savings to get started
• Tax advantages
Leveraging Your Investment
Unlike most other investments, an investor can purchase a rental property with a down payment of twenty percent of the purchase price, or in some circumstances even less. Therefore, a relatively modest investment permits the investor to control a valuable rental property. Further, as the value of the investment increases, the investor’s return on his investment increases at a multiple of the increase in the values of the property.
For example, assume that an investor purchases a rental home for $100,000 with a down payment of 20% or $20,000. Five years later, the investor sells the property for $110,000, for a net increase of $10,000. Over the five-year period, the value of the property has increased a modest 10%. However, the investor’s return on his initial investment of $20,000 is 50%; all because the investor was able to leverage the initial investment.
The above example ignores a variety of costs associated with the purchase and ownership of rental property. But, with today’s low interest rates, it is quite realistic to presume that rental income can cover mortgage payments, insurance, taxes and necessary repairs.
While the preceding section addresses leverage, rental property also creates cash flow. Cash flow can be defined as the excess of rental income over expenses. Cash flow from a rental property will be maximized when the property is not leveraged and minimized when the property is highly leveraged.
To go back to the example above, presume that the investor has purchased a rental property for $100,000. The property generates $750 per month in rental income. Taxes, insurance, estimated repairs and maintenance, and estimated vacancy reserve cost $200 per month. Therefore, the property generates a positive cash flow of $550, before payment of principal and interest on the mortgage. The net cash flow generated by the property is dependent of the principal and interest payment; or in other words, how highly the property is leveraged.
If the investor has an $80,000 thirty-year mortgage at 7.00 %, the monthly principal and interest payment is $532 with a net positive cash flow of $18 per month. If the investor has a $60,000 mortgage with the same terms, the monthly payment is $399 and the rental generates a positive cash flow of $151 per month.
No matter what the cash flow generated by the property the first years, it can safely be presumed that the cash flow will increase over time because the principal and interest payment is fixed and rents have historically increased over time. Further, should the investor hold the property until the final mortgage payment is made, the cash flow generated by the investment will greatly increase because the principal and interest payment is by far the largest portion of the expense associated with ownership of the property.
Little or no Savings to Get Started
The conventional method of purchasing rental property is to make a down payment of at least 10% of the purchase price and finance the balance with a twenty to thirty year mortgage. There are, however, a variety of other ways to purchase rental property including real estate contracts, seller carry-backs, lease purchases, and lease options. A full discussion of these methods of purchasing rental property is outside the scope of this discussion; however, it can be safely said that it is realistically possible to purchase quality rental property with little of no money down.
All income generated by rental income is taxable and must be reported to the Internal Revenue Service. However, all expenses associated with the property, including depreciation, are deductible. The IRS presumes that the property, excluding the value of the land, has a useful life of 27.5 years and allows the investor to deduct this presumed decrease in value as an expense on the investor’s tax return. Because depreciation is a non-cash expense, it is very possible for a rental property to generate a positive cash flow and a taxable loss at the same time.
Criteria for a Successful Rent Increase
Using rental property as an investment is like any other business; to improve cash flow, you must either reduce expenses or increase income. Increasing income is usually easier to achieve, but unless the residents are on a month-to-month lease, the only times you can increase the rent is when the lease expires, assuming the rental market will allow an increase.
Rent increases in the 4-6% range are usually common, but it is not abnormal to see hikes as small as 2% or as high as 10%. It usually best to increase the rent even if only a minimum amount each time the lease renews. This way the resident is used to expecting an increase. Also the owner avoids having to tack on a large increase when the resident has been in the property for several years at below market rent. A large increase is more likely to cause a resident to move then several smaller increases. It is also recommended to increase the rent when a resident request that they lease the property on a month-to-month basis. A Month-to-Month lease is normally an advantage to the renter and a disadvantage to the landlord as residents normally expect to pay a little more.
When considering the amount to increase, figure what your market rent would be. The increase should not be substantially higher than what a comparable house would be renting for. A comparable property would be a house that closely resembles your house in size, age, location, and amenities.
Despite your best efforts, some renters will choose to move away anyway regardless of an increase.
Maximizing Profit and Limiting Liability in Real Estate Investing
How should I buy and sell real estate? What entity gives the best tax benefits? How can I limit my liability? These are common questions posed by both beginning and experienced real estate investors. The following are answers to common questions about maximizing profit and limiting liability in real estate investing.
How should I take title?
The first and biggest mistake you can make as an investor is taking title in your own name. All deeds are public record and free for prying eyes to see. Having property in your own name makes an easy target for tenants, creditors and attorneys. If a liability is created on your property, the owner (you) are liable. Make sure than you have a buffer zone between you and your properties. Keep your ownership private. The simplest, yet most effective device for taking title is the land trust (a.k.a. “Illinois Land Trust”). The land trust is a form of revocable, living trust used to take title to real estate. The trust, rather than you, can assume liability for loans. Using a different trust for each property (e.g., “The 2537 Clarkson Street Trust”) allows you to own, manage and transfer property with anonymity.
Keeping a low profile is very important for investors who don’t want the world to see their business. Land trust agreements are not recorded in any public register so the beneficiaries of the trust are not easily discoverable. The beneficiaries of a land trust can be you, a corporation or some other entity (see below). The trust itself is not considered a separate taxable entity from the beneficiaries (see I.R.C. Sec 671-678). Thus, there are no tax consequences of transferring a property into or out of a land trust.
How can a corporation be used to limit liability and maximize tax advantages?
A corporation is an effective device for buying and selling real estate on a short term basis (also called “flipping”). A land trust is an effective device for taking title, but it will not protect the beneficiaries from personal liability (since the beneficiary of a land trust reserves the right to direct the actions of the trustee, the beneficiaries can be held liable for mishaps on the property). Thus, if you “buy and flip” property, you should have the beneficiary of the trust be a corporation to limit your liability.
A corporation will limit the problem of IRS “dealer” status. A dealer is one who regularly buys and sells real estate as a business. If an individual is tagged as a “dealer,” the profits on his sale of property are subject to self employment tax (approximately 15%). Corporate dividends, on the other hand, are not subject to self employment tax (although the investor may have to take some salary, subject to self employment tax, to satisfy the aggressive IRS auditor).
What’s the difference between a “C” and “S” corporation?
There are essentially two types of corporations for tax purposes, “C” and “S.” A corporation is a “C” corporation by default; the “S” status must be elected. A “C” corporation files its own tax return and pays taxes on its profits. When the corporation distributes profit to its shareholders (called a “dividend”), the shareholders pay additional tax on their personal income tax returns (called “double taxation”). An “S” corporation is not taxed at the corporate level. Like a partnership, it files an informational return and the shareholders report their share of profit or loss on their personal income tax return.
Which is better for real estate?
An “S” corporation is not necessarily better than a “C” corporation, but rather it depends on the investor’s particular tax situation. For example, an investor who has a working spouse may benefit from an “S” corporation, since a loss from the corporation’s operations can be used to offset the working spouse’s income. On the other hand, if an investor has a large profit, she will have income tax on all profits, whether or not they are reinvested or distributed. With a “C” corporation, the individual shareholder is not taxed on profits until they are distributed (the corporation itself pays tax on its income, but the first $50,000 of “C” corporation income is only taxed at the rate of 15%, which is much lower than personal income tax rates).
What is a Limited Liability Company and how is it different from a corporation?
The Limited Liability Company or “LLC” is now recognized in all fifty states. People often confuse an LLC with a corporation, but it is much like more a partnership. It’s owners, called “members,” can equally participate in the management of the company without personal liability.
An LLC, if it has two or more members, is treated as a partnership for federal income tax purposes. Thus, like an “S” corporation, the profits and losses “flow through” to its owners. On rental activities, these profits are not subject to self employment tax (an LLC which engages in “buying and flipping” may not be considered “passive” activity and thus subject the members to self employment tax. Thus, a corporation may be better than an LLC for this purpose).
Most states now recognize “single member” LLCs, that is, an LLC with only one owner. The IRS treats a single member LLC as a “non-entity” for tax purposes. That is, the member would report as though the LLC did not exist. Thus, if the investor was reporting his rental activities on schedule “E” of his federal income tax return, a transfer of property from his own name to a single member LLC would not result in any change of reporting. Furthermore, an LLC between husband and wife can still be treated as a “single member” for federal income tax purposes. Thus, one could form an LLC for each property he owns and still file only one tax return!
Single Family Homes Always A Popular Investment
The most popular real estate investment for individuals is the single-family homes. The following discussion focuses on why so many individuals chose to invest in single-family homes over other forms of real estate.
• It is possible to buy a single family home with 10% or less down payment. This means that you can buy a $100,000 house for only $10,000 down. It is entirely feasible for the average person to save $10,000 to buy their first investment property.
• People are familiar with houses. Most people are not comfortable with shopping centers or apartment buildings. They don’t know what the rents are, what repair costs are, etc. On the other hand, most people do understand single-family homes.
• More flexibility. Let’s assume that for the same amount of money you could either have 5 houses or 1 apartment building. If you needed money, with the apartment you could either have to sell the whole thing, refinance the whole thing, or bring in a partner on the whole thing. With the 5 houses, you could sell one of them, refinance one, or bring in a partner on just one.
• Higher equity build up. There is usually more appreciation in single-family homes than in apartments and other types of real estate. Apartment buildings are valued based on the income approach (how much money they bring in). Single-family homes are valued based on comparable sales. This means that your investment houses are valued according to what the other homes in the neighborhood are selling for.
• More control. With an apartment building, all of the tenants know each other, and they will know what they pay in rent. That means it is difficult to charge one tenant higher rent than another. Plus, if one tenant plays the stereo too loud or causes other problems, YOU will get the complaints. With houses, they are generally scattered around the area. You can raise the rents individually; offer lower rents to excellent tenants, etc.
• Less risk. With single family homes, you don’t have all your eggs in one basket. The homes are usually scattered around the area. With an apartment building, if the area goes bad for some reason (i.e. a factory or freeway goes in across the street) you are sunk.
What Can A Professional Property Manager Do For You?
Historically, renting your home has been considered a relatively simple and low risk undertaking. However, in recent years, this apparently simple task has become progressively more complex and the risks associated with becoming a landlord far greater. While managing your rental is certainly within the abilities of most property owners, the time and effort involved in management may be greater than the cost of hiring a professional property manager.
The professional property manager is conversant with the applicable statutes and regulations relevant to the management of rental property. In addition, the manager will typically perform the following tasks as part of the management service:
• Advertisement of the rental property
• Screening of potential residents
• Preparation and execution of rental agreements
• Disbursal of funds to the property owner
• Collection of rents
• Monthly and year-end accounting
• Coordination of maintenance and repair work
• Periodic property inspections
• Disbursal of deposits in accordance with state law
• Eviction of residents for breach of the rental agreement
Advertisement of the Rental Property
Until recent years, advertisement of an available rental meant placing a “For Rent” sign in the front yard and possibly placing an ad in the local newspaper. Times have changed. Today, while the old stand-bys are still used, effective advertising also includes extensive use of the internet, making availability of the property known to real estate professionals, and targeted advertising to large employers.
Screening Potential Residents
Once an application for rental is received, it must be determined if the applicant is qualified to rent the property. Has the applicant been evicted from a prior rental? Does the applicant earn sufficient income to pay the rent? These questions, as well as others should be answered prior to approving the applicant.
A professional property manager will typically check four areas when screening an applicant. These are the applicant’s credit report, income, employment, and rental history. It has become almost universal that the applicant’s credit report be checked for late pays, judgments, liens, or bankruptcies. The applicant’s employer is typically contacted to verify income, and the applicant’s prior landlord is contacted to verify rental history. While there are few perfect applicants, the information gleaned through the application review process can greatly reduce the likelihood of renting to an unqualified resident.
Preparation and Execution of Rental Documents
After the applicant is qualified, the necessary rental documents must be prepared and executed. Gone are the days of going to the local stationery store and buying a preprinted, two-page rental agreement. Today, rental agreements are custom drafted to reflect specific state statutes, and sometimes, applicable local ordinances. In addition to the rental agreement, any required addendums are prepared and may include an addendum relating to pets, a no smoking addendum, an addendum relating to pool use, and if the property was built prior to 1978, a lead paint addendum. Further, a move-in inspection is completed and documented for review by the resident at execution of the rental agreement. Ancillary forms relating to transfer of utilities and trash pick-up may also be needed depending on the location of the rental property.
Collection of Rent
Every property owner would agree that timely payment of rent is critical. If the applicant was properly screened prior to acceptance, most poor rental risks will be eliminated. However, circumstance beyond the possibility of screening can adversely affect the resident’s ability to timely pay rent. These circumstances include loss of employment, injury, illness, and changes in marital status. When the resident is unable or unwilling to pay rent, the property manager has the ability to effective move forward with the collection process, or if that fails, terminate the rental agreement and locate a new resident in the minimum amount of time.
Disbursal of Rent to the Property Owner
Typically, the property manager will receive rent on the first day of the month, with disbursal of funds to the property owner between the fifteenth and twenty-fifth of the month. Because the property manager is required to hold all funds in trust, funds must be held until checks clear, which may take as many as ten working days. In addition, time is required for the accounting and statement preparation process.
Monthly and Year-End Accounting
The property manager will provide you with a monthly statement showing all income and expenses associated with your rental property. In addition, you will receive a year-end statement showing all income, and expenses broken out by category.
Coordination of Maintenance and Repairs
If you have ever had a resident at your rental property call you at 2:00 a.m. to tell you that the water heater is leaking and your rental is three inches deep in water, you will appreciate having a professional property manager. Most property managers maintain a twenty-four hour system for receiving emergency repair calls and relationships with a variety of skilled tradesmen capable of handling any emergency. For non-emergency repairs or preventive maintenance, you are contacted in advance to discuss the work and its potential cost to your.
Periodic Property Inspections
Does the resident have an unauthorized pet? How about six roommates not listed on the rental agreement? These, and other similar problems, can only be found through a physical inspection of the property. Typically, your property manager should have a representative inspect the property one to two times during the term of the rental agreement. Inspections may be conducted either as a scheduled appointment with the resident, or while repairs or scheduled maintenance is performed.
Disbursal of Security Deposits
After the resident moves out of the property, the condition of the property must be assessed and any damages charged to the resident’s security deposit. However, the property owner is not permitted to charge for “normal wear and tear.” What can be charged for that red wine stain on the white carpet? How much for the numerous nail holes in the living room wall? These, and similar questions are addressed by the professional property manager every day.
Further, did you know that if the resident is not provided an itemized statement of deductions from the deposit within thirty days of termination of the rental agreement, the property owner is precluded from making any deduction for damage to the property?
Eviction For Breach of the Rental Agreement
Probably the most difficult part of owning rental property is evicting the resident who has failed to meet their obligations as stated in the rental agreement. Typically, this means that the resident has failed to timely pay rent. The professional property manager can handle the eviction process efficiently, while making the process far less difficult for the property owner.
The professional property manager provides a cost-effective service in the rental and management of investment property. While the above discusses the functions performed by the property manager, it should also be noted that efficiently and competently performing these functions minimizes potential risk to the property owner and in the long term, maximizes returns from the investment property.