Is buying real estate--such as a condominium, or a duplex, or other small multi-unit building a smart and clever way to invest? What is it like to be a landlord? Is the hype true when you hear the refrain that you should let your tenant pay the mortgage?
I have been practicing landlord and tenant law in Ontario for about 17 years now. I have seen all manner of odd situations and even after all of this time I regularly come across scenarios that you couldn't even conceive to make up. Being a landlord is a "people" business and where you have people you have unpredictable behaviour.
I thought about writing an article like this as I have so often heard the views and opinions of people who are in the "Landlord" business. The landlords I've interacted with run the gamut from the person who inherits a house and decides to rent it out, to the condo buyer turned landlord, to the landlord of smaller single, double triple units, to the corporations or partnerships that own and manage large buildings and literally thousands of units.
This article today, concerns itself with only some of the issues facing a new landlord or someone who is considering buying a residential unit and renting it out. Is this a clever way to invest, save for retirement, and to become a real estate tycoon? If you have your heart set on this kind of investment you may want to stop reading now and put on the rose coloured glasses. For the reasons discussed below, my personal and entirely unscientific view is that real estate investing for the purpose of renting out residential property is an incredibly risky venture that more often than not leads to sleepless nights and a significant amount of regret.
My bias against becoming a landlord flows from my experience in dealing with landlord and tenant disputes. While I'm sure that there are "good" landlord and tenant relationships they are something that for obvious reasons don't cross my desk. That being said, I am fairly certain that even if you are lucky and have good tenants, all of that good fortune can evaporate with one bad rental and one bad tenant.
The biggest regrets seem to come from new landlords who start out with only one, two, or three rental units. These landlords, especially when they start out, have a business plan that at its core relies on rental income to cover estimated expenses in operating the rental unit. Typical costs for operating a rental property are the same costs as running a home in the same kind of unit with the additional expenses associated with renting. Specific costs incurred to rent to tenants include rental commissions, legal fees for document preparation (leases, termination notices, etc,), background check fees (police, credit check), heightened maintenance costs as tenant's do not do their own maintenance, property management fees (unless you do it all yourself and you attribute no value to your time), condominium fees (if it's a condo), banking fees, accounting fees, book-keeping fees (maintain accurate rent ledgers, and expense ledgers for the accountant), utilities, government application fees, and soon licensing fees to have the privilege of being a landlord.
All of these expenses will at some point become part of the monthly carrying cost of the rental property. From the revenue (i.e. the rent), you need to cover these costs and in addition pay the mortgage. In my experience, when you start doing the math for the vast majority of rental properties, you will find that the market will bear a certain maximum rent and that rent will be entirely consumed by the expenses and mortgage payments---if everything goes perfectly and to plan.
Unfortunately, I have seen too many examples where the plan to have the tenant pay the mortgage doesn't quite work out that way and the would be landlord ends up having to cover the costs from his/her own pocket. How does this happen? The simple fact is that not all rental units are created equally and not all tenants are good tenants. It can, in fact, be extremely difficult to find a good tenant. You may own a chic new condo in a wonderful hip and upcoming "green" neighbourhood but if you don't have parking for the prospective tenant's Prius your unit is standing empty. While it stands empty you will be covering expenses yourself.
Having an empty apartment for rent causes many new landlords to do silly things. Seeing mounting expenses and no revenue, these landlords will fail to perform the necessary due diligence to ensure that the tenant is decent and credit worthy. The desperation to generate revenue leads to a tenancy, perhaps even with a discounted rent, that will cause endless stress and even more expense through non-payment of rent, damage, legal fees, and turn-over expenses when the troublesome tenant is finally evicted.
Alternatively, there are some new landlords who suffer from "idealism" and who believe that a relationship built on trust, good will and mutual respect will result in a long standing relationship where the tenant is like a partner in this endeavour. These new landlords often have an unfortunate naiveté with respect to people. They take nice looking and sounding people at face value. They empathize with the prospective tenant's hardships and accept the tenant's stories about why they were previously evicted, or how the tenant is trying really hard to get back to work and only needs a chance, or how the tenant is escaping domestic violence or overcoming an addiction, etc. etc.. The desire to help these prospective tenants is perhaps an admirable quality as a human being but it is a brutal flaw when running a property rental business.
I have seen far too often how the naive or compassionate landlord rents to the wrong tenant or doesn't pursue legal remedies in a timely manner for non-payment of rent because they wanted to give the tenant a chance to get a new job, get their tax refund, get their spousal support, child support, loan from parent, etc. etc. etc.. Certainly, for the financial independent new landlord who is getting into the business for fun or for something to do then being generous is within their prerogative. However, if the reason for charging rent is that you actually need it to pay expenses and the mortgage and perhaps to generate some income, then the inclination to be compassionate can become very expensive indeed.
The next thing worth thinking about is the over-all risk that you, as a new residential landlord, are taking in buying a unit to rent out. Think of the capital that you are required to pay to acquire the property. The down payment and the acquisition costs (legal, land transfer taxes, downpayment etc.) are significant expenditures that are tied up in the property. Imagine for a moment the down payment that you've made--likely 25% of the purchase price. How much could you earn with that money in a different kind of investment? Does your business plan show you earning at least the same rate of return on your capital that you could earn in a high interest savings account (around 1%)? If not, why not? Shouldn't your capital be earning you something if it is deployed in an investment?
Perhaps you are thinking that the return on your invested capital is the increase in value of the rental property over time and that you will get your return when you sell the property. Perhaps that is true, but in the mean time you make very little to no money and you are sitting on a fairly expensive and risky asset.
What is so risky? When you are a new landlord with a single, duplex or triplex rental unit your success is directly proportional to the good fortune and ability of your only tenant (or 2 or 3 tenants) to continue to earn income so that they can pay your rent. Having a single tenant or very few tenants can be analogized to having all of your eggs in one basket. And to finish the analogy, if that basket breaks, or falls, everything is broken.
The risk then is a lack of diversity in the investment. The investment is a significant commitment of hundreds of thousands of dollars to acquire the property and the assumption of a significant responsibility to maintain the property in accordance with law and to deal with the tenant in accordance with the Residential Tenancies Act which has a bias towards maintaining tenancies (security of tenure) even at the expense of a landlord's interest. Time and again you will hear landlords asking an adjudicator at the Landlord and Tenant Board for help to get rid of a tenant because the tenant isn't paying the rent and the mortgage is going into arrears and the whole situation is ruining the landlord. Instead of getting the help they need, the Landlord then in astonishment sees the Board concerning itself with granting relief to the tenant with payment plans, delayed evictions, or other remedies that function to preserve the tenancy. When these landlords object, you will from time to time hear an adjudicator speak candidly to the landlord and say that "if you can't afford to be a landlord get out of the business".
WHAT IS GOOD ABOUT BEING A LANDLORD
For the small, new landlord, with only a unit or two, I do believe that it is an extremely risky enterprise. The risk is only taken out of the equation by getting bigger and having many units and lots of tenants. In those circumstances, the risk of one or two tenants doing you excessive damage are ameliorated.
Aside from that, I do think that a benefit of buying a property and renting it out is that it functions like a forced savings plan. Much like a buying a house, the mandatory nature of the mortgage payment means that one way or another you will make the payment and hence build equity in the property. That equity is a savings plan that most people are unlikely to accumulate without the forced nature of the mortgage expense (i.e. pay it or lose the property to the bank).
For now, those are my two cents on this topic. I'd be interested to hear different viewpoints in the comments and I'll publish the interesting ones.
Michael K. E. Thiele
Tuesday, 24 December 2013
Invest in Property: Becoming a Landlord
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