By Brian Davis BiggerPockets.com
You’re intrigued by the idea of passive rental income. And for good reason: Passive income forms the building blocks of financial independence. Early retirement
. Freedom to ride off into the sunset and do whatever your heart desires.
But does that mean you should keep your old home and convert it to a rental when it comes time to move?
I’ve done it — and successfully so. My old home in the funky waterfront Fells Point neighborhood in Baltimore has made a great rental property.
With that said, I bought it with eventuality renting in mind. Not every home makes a good rental; for that matter, not everyone is cut out to be a landlord!
Here are four questions to ask yourself — and be warned: for these questions to be useful, you’ll need to set aside your optimism and do some honest introspection!
1. Am I Cut Out To Be a Landlord?
You’d be surprised how many people jump into rental investing only to find out that they simply don’t have that special balance of diligence and detachment.
Are you swayed by sob stories? Would you postpone filing eviction because your tenant called you with one?
You probably just shook your head and said, “No, of course not.” But let’s color in the details of what that could look like in reality.
A single mother calls you at 9:30 at night on the sixth of the month, crying. They’ve cut her hours at work — she tells you — at the worst possible moment. Her daughter broke her leg in a bike accident, and she doesn’t know how she’s going to pay all her bills.
She asks you, choking back the tears, if you can hold off on filing for eviction — just for another week?
Her story may be true. It also may not be true. But here is a fact: It takes two to six months to file and complete an eviction in most jurisdictions in the U.S.
Here’s another fact: People prioritize their bills based on the consequences that come with paying them late. Imagine the single mother above has $1,000 in her bank account, and $1,500 of bills to pay; how does she decide which bill to prioritize?
She’ll pay the one that has the direst consequences if she doesn’t
Tenants will push your boundaries. It’s human nature. Your job, as a landlord, is to defend those boundaries and operate with the smooth efficiency of a business. When someone is late on their payments, there are two consequences: a late fee and filing to begin the (long) process of eviction.
If you can’t do that, that’s completely fine. But you’re probably not cut out to be a landlord.
Related: 4 Reasons Your Home Would Probably Not Make a Good Rental
2. Will My Property Produce Adequate Cash Flow?
Instead of introspection, this question requires some research and calculation.
Beyond your mortgage payment of principal, interest, taxes, and insurance, you’ll incur plenty of other expenses:
- Property management
- CapEx & repairs
- Administrative, bookkeeping, and miscellaneous
…and possibly others, depending on your property.
As a rule of thumb, the 50-percent rule states that your expenses will run around 50 percent of the rent — not including any financing (principal and interest) that you pay. If the rent is $1,000, and your mortgage payment (P&I) is $400/month, you can expect roughly $500 in additional expenses, leaving you with a cash flow of $100/month.
The golden rule of cash flow with rentals is that it’s based on a long-term average of your expenses, not on what happens in a typical month. In a typical month, you’ll just pay your mortgage payment. Then suddenly you’ll be slapped with a $3,000 roof repair bill.
Get comfortable with the numbers in your neighborhood. How much can you expect to rent the property for? What’s the average vacancy rate? If your property has carpets, what will it cost to replace them between each tenancy?
And yes, include property management fees, even if you plan to manage the property yourself. It’s a labor expense, whether you’re doing the labor or someone else is.
3. What’s the Opportunity Cost of Leaving Money Tied up in Equity?
If you have $50,000 in equity in your property (beyond what it would cost you in closing costs to sell), then there’s an opportunity cost in leaving that money tied up in your old home.
We’ll keep running the same example from above. You can charge $1,000 for rent, with $100/month in average cash flow, for $1,200/year net income. You have $50,000 in equity in the property.
Keeping that property as a rental means you’re effectively investing $50,000 to earn $1,200/year. That’s an annual return of 2.4 percent.
What kind of return could you earn on that $50,000 elsewhere? In mutual funds perhaps?
Or perhaps in real estate? Which brings us to our final question.
4. Should I Sell my Home And Use the Money to Buy Better-Performing Rentals?
Just because your old home may not be a prime candidate for a rental investment doesn’t mean you shouldn’t become a landlord.
Imagine you sell your home and walk with your $50,000. You use $25,000 as a down payment on a fourplex, which cash flows $500/month. Then you turn around and do the same thing with the other $25,000.
Now you have $1,000/month in cash flow, instead of $100/month from your old home. Your annual return on that $50,000 is 24 percent, instead of 2.4 percent.
Yes, I made up these numbers to illustrate a point. Your situation might look completely different. Maybe your old home will cash flow beautifully. Maybe you don’t feel confident in your ability to buy rentals that will cash flow in your market.
Regardless, these are the questions you need to ask yourself before deciding whether to keep your old home as a rental.
Related: How to Best Prepare an Investment House for Rental (As Opposed to Sale)
Highest & Best Use
To commandeer a different real estate term, what’s the highest and best use of the equity in your property? Does it serve you best as a rental? Or invested elsewhere?
The last thing I would want for you is to keep your old home as a rental, have it cash flow poorly, and you throw your hands up and say, “Rentals are not for me.” Rental investing is both an art and a science, and just because a property made a good home for you, it may not make a good rental.
But that doesn’t mean you shouldn’t pursue passive rental income. I’m a staunch believer in the power of passive rental income to help people reach financial independence. So much so that I’ve dedicated my life to teaching others how to do it successfully and smoothly.
Run the numbers. If you like what you see, move forward. If not, sell the property and invest the proceeds elsewhere.
And if you decide that being a landlord is not for you, you have other options for investing in rental real estate. You can buy it and hire a property manager. You can become a silent partner and have your partner handle all management.
Or you can step back even further and invest in private notes or REITs.
Whatever you decide, make sure your decision is based on the numbers involved and on knowing yourself well enough to decide if landlording is a good fit.