Do you dream of retiring early on rental income?
I did, and still do, at least as one source of passive income among many. But before you dial your real estate agent or make an offer on Roofstock, you need to know exactly what you’re getting yourself into.
Because being a landlord isn’t the cushy gig that the average cynic assumes.
11 Issues with Becoming a Landlord
People love to hate landlords. But beside providing a needed service, landlords put up with more than their share of headaches and hassles.
You should fully understand these challenges before committing tens of thousands of dollars toward a down payment and closing costs.
1. Investing Capital
The best understood of the challenges involved in being a landlord is that it takes cash to buy investment properties. A lot of cash.
According to the Federal Reserve, the median home price in the second quarter of 2021 was $374,900. Even if you borrowed 80% of that, you’d still need to cough up roughly $75,000 for the 20% down payment. And that says nothing of the thousands of dollars in closing costs you’d incur, any update or renovation costs, plus the carrying costs for the first couple months while you clean up and advertise the property for rent.
You can’t even assume that a turnkey or move-in ready property doesn’t need any modifications. Your state’s landlord and tenant laws might require that you add safety features to the property before you advertise for tenants. They may also require you to register the property as a rental, pay fees, or get inspections — and then you can only pray your inspector doesn’t just nitpick punch-out items in order to prove to their supervisor that they hit every house on their schedule. (I’ve seen that happen, and more often than not.)
Word to the wise: Keep a deep cash cushion for unexpected expenses when you buy a rental property.
2. “Surprise” Costs and Negative Cash Flow
After you place a tenant in the property, you can kick back, collect rent, and get rich, right?
Hardly. Most novices and laypeople so quick to slander landlords just assume that their cash flow equals the rent minus the mortgage payment. They couldn’t be more wrong.
In the industry, property owners refer to the “50% Rule” — you can expect about half of the rent to go to non-mortgage expenses. Those include vacancy rate, repairs and maintenance, capital improvements, property management costs, insurance, property taxes, accounting and bookkeeping, travel, legal, and other miscellaneous expenses.
Most of those expenses don’t hit you every single month. But this month, it’s a $700 furnace repair. In three months from now, it’s a $200 plumbing leak. In six months from now, it’s an expensive turnover, where you have several months’ vacancy and a series of ugly turnover costs including fresh paint ($2,000) and a deep clean ($400).
New landlords repeatedly tell themselves after each “surprise” cost that their cash flow is going to turn around — that they just got hit with a string of expenses in a row as bad luck. Luck has nothing to do with it. These expenses are the norm, and you have to budget for them as a long-term average when you calculate a property’s cash flow.
That’s a calculation ideally performed before you buy, not after.
3. Rent Collection and Defaults
The fantasy of kicking back and collecting rents falls apart for another reason — not all tenants bother paying them. At least not on time, without repeated coaxing, cajoling, and legal threats.
Don’t assume that just because you always paid your rent on time as a tenant that every other tenant in the world thinks and acts like you do. In some neighborhoods, late rents are the rule, rather than the exception.
Sure, sometimes you’ll have great tenants who pay the rent on time every month. Others will pay on time sometimes, and then there are the tenants that don’t pay and don’t call. Trust me, you won’t enjoy playing the role of bill collector, trying to convince people to do what they should have done in the first place.
Ask yourself if you feel comfortable confronting your tenants before you buy a rental. Even more importantly, ask if you can and will file for eviction on the day the grace period expires, every single time a tenant fails to pay. Then ask yourself the question again, but this time in the face of repeated tears and pleas from tenants begging for “just one more week.”
If you aren’t absolutely confident you will file that eviction every time, then you shouldn’t become a landlord. It’s all too easy to bend when confronted with the tears, because that compassion serves you well in the other facets of your life.
As a landlord, it’s a recipe for being manipulated and losing money. Your mortgage lender won’t be swayed by a teary phone call, nor will your utility companies, your car lender, or any other company providing a service. You need to operate from the same mindset: the implacable machinery of a business running. When you provide a service but don’t get paid for it, you’re the one getting stiffed, not the other way around.
4. Slow, Costly Evictions
Your state’s landlord and tenant laws make evictions seem simple. To start one, you go to the local court, file a notice, schedule a court date, and show up on that date. The judge then tells the tenant to leave. The tenant heads straight back to your property, packs their worldly belongings, cleans the unit thoughtfully, and walks whistling out the door.
The words “fairy tale” come to mind.
In reality, evictions are usually expensive and time consuming. Even if you evict your tenant successfully — far from guaranteed, even if they clearly violated your lease agreement — you can expect months of unpaid rents and utility bills, a messy rental unit, and possibly property damage or legal bills.
First, most states require landlords to provide a grace period before you can even serve a warning notice. If the rent is due on the first day of the month, you can’t even send a threatening letter until after the waiting period of five, 10, or even 30 days depending on your state.
Then you have to sit tight for a second waiting period, again based on your state’s landlord-tenant laws.
After the second waiting period, you can file in court for eviction. Then you wait some more for the court to schedule a hearing date, which takes weeks or months.
At the hearing, the judge may or may not rule in your favor. Many judges give tenants more time as a matter of policy, regardless of the law or the fact that you’re paying for them to live for free. I’ve seen it many times firsthand.
Eventually, a judge signs off on the eviction, and you get approved to schedule the actual eviction date or put-out date. Which takes more weeks or months to schedule.
I’ve had evictions take 11 months before. All while paying the mortgage, insurance, property taxes, maintenance, and other ongoing costs myself.
5. Tenant Damage
It was the 11-month eviction that caused me to sell off all remaining properties in tenant-friendly jurisdictions. In that particular case, the tenant destroyed every cabinet in the kitchen and broke as many floor tiles as they could, out of pure malice and spite.
I know landlords who have had vindictive tenants pour concrete down the drains to destroy the plumbing.
And that says nothing of accidental or neglectful damage, which is of course far more common. Expect carpets to last a single tenancy, as renters spill red wine or fail to clean up promptly after their pets. Avoid putting real hardwood floors in a rental unit, because tenants don’t bother putting felt pads on their furniture feet and end up scratching it to splinters.
I can’t tell you how often tenants call complaining of clogged toilets, only for the plumber to show up and find paper towels, tampons, pads, and far stranger items embedded in the pipes.
And then there are the walls. From scuffs and scratches to nail holes, screw holes, and fist holes, expect to pay thousands to patch up and repaint the unit between each tenancy.
You can hire a property management company to run background checks to try and find good tenants, but unless they physically inspect prospective tenants’ homes, they won’t necessarily find renters who treat their homes respectfully.
6. Tenant Lawsuits
Tenants love to sue landlords. For that matter, so do neighbors.
Never mind that the tenant was standing on a wobbly chair when they fell and hurt themselves. Or that it was their dog that bit the neighbor’s toddler. When suing others for a quick win, the first rule is always “Go after the deepest pockets.”
To limit your risk, do some basic research on asset protection strategies. Speak with an attorney if you get serious about it, because just buying a property under an LLC name doesn’t cut it.
You also need to know the building and safety codes in your jurisdiction and follow them to the letter. That costs both time and money, in your initial property updates and by attending to regular maintenance and checking on your properties periodically.
As another way to prevent lawsuits, I also ask all applicants if they’ve ever sued someone before, and I look up their names in public records. Someone else can make the mistake of renting to serial litigants.
7. Antagonistic Local Laws
After that 11-month eviction, I divested all my properties in tenant-friendly jurisdictions.
Many major cities impose landlord-tenant laws weighted heavily in favor of tenants. They can include lengthy eviction periods, bans on “no fault evictions” (an intentional misnomer), rent controls, rigid security deposit limits and rules, even forcing landlords to pay for tenants’ abandoned junk to be stored after eviction.
I don’t invest in these cities anymore. You can invest wherever you like, but consider yourself warned.
8. Permits and Inspections
Permits and inspections come in several varieties.
The first, which exist in most jurisdictions, include renovation permits and inspections. When you replace the electrical system in an older home, for example, you generally need to file a permit, pay a fee, and then schedule an inspection to approve the work. Whenever you need to pull a permit for work, you need to use a licensed contractor.
I’ve had problems with corrupt inspectors in the past. In the city where I once invested, it worked like this: you paid the inspector themselves a “convenience fee” for them to register your permit requests for you. If you failed to do so, they wouldn’t pass your inspections until you wised up and paid.
Some cities also require you to obtain use and occupancy permits, and register all rental properties (with a fee, of course). In my experience, cities that require you to register all rental properties tend to impose tenant-friendly rules and regulations. Proceed with caution.
9. Managing Contractors and Repairs
Contractors are notoriously difficult to manage.
Few show up when they say they will. Many hit you with “surprise” additional costs halfway through renovation projects. And most consistently blow their timetable on projects longer than two days.
If you live near your rental properties and you’re handy, you can spare yourself endless headaches and expenses by doing repairs yourself. I’ve never been particularly handy, and have found managing contractors even harder than managing tenants.
Just know before you invest that you’re going to go through many different contractors, and that once you find honest, skilled contractors that charge a fair price, you should foster and protect your relationship with them.
10. Clean, Separate Accounting
If you buy a property under a legal entity such as an LLC, you must open a separate bank account for it, and keep the accounting completely separate from your personal expenses.
That means never, ever charging any personal expenses to your business credit card or bank account. If you do, you invite two distinct risks.
First, commingling your business and personal funds and expenses can trigger an audit. That’s one love letter from Uncle Sam you never want to open.
Second, it nullifies any asset protection provided by your legal entity. Which, need I remind you, is the entire point of using a legal entity in the first place.
When an attorney brings a lawsuit, they usually list not only the company, but also all known individual owners of that company. It’s up to you, the defendant, to object to the judge and request that your personal name be removed from the lawsuit (and therefore limit your liability to your business-owned assets). If there’s any evidence whatsoever that you commingled personal and business funds, the judge will leave your personal name as a named party in the lawsuit.
If you can’t keep your books straight as an arrow, get help from an accountant or bookkeeper. It’s worth the expense to avoid hot water with the IRS and lose the protection of your legal entities.
11. Tax Complications
Among their many benefits, real estate investments come with plenty of tax advantages. And beyond those inherent tax advantages, investors can also get fancy with low-tax exit strategies like 1031 exchanges or holding their rentals in a self-directed IRA.
But the flipside of all the tax benefits is that investment properties add some extra wrinkles to your tax return. If you do your own taxes with a service like eFile, expect it to take you longer. Do you understand how rental income is taxed versus capital gains? On which schedule rental income should appear? How depreciation works, or depreciation recapture upon sale of the property?
Extra labor aside, you also run the risk of making mistakes that cost you extra money in taxes.
If you pay an accountant, expect your bill to go up, because it will take them longer to prepare your return.
On balance, I’d trade a slightly more complex return in exchange for the tax perks that come with investment properties. But it’s still a downside that you should understand before investing.
Being a landlord is not for everyone. Rental properties come with significant risks, costs, and time commitments. It takes time and effort to learn the skills needed to succeed, to find good deals buying rental properties, and to manage those properties (or the property manager) on an ongoing basis.
For all those downsides however, rental properties come with plenty of advantages. They generate ongoing income, which adjusts for inflation and grows over time. You can leverage other people’s money to build your own portfolio of income-producing properties. They come with tax advantages, and provide true diversification from stocks.
If you just want diversification, consider indirect real estate investments such as real estate crowdfunding. You can buy shares in diverse properties through Fundrise or Streitwise without having to put in the work required for direct ownership.