Earn Big Bucks as a Landlord

August 2, 2009— -- Scott Patterson had his faith in the stock market severely shaken over the past year, so he decided to look around for something more solid in which to invest his retirement savings. The 43-year-old owner of a gutter-cleaning business settled last month on a three-bedroom house in Athens, Ga., which over the years has attracted a steady stream of renters from the nearby University of Georgia campus. Patterson put down 20% of the $127,000 sale price, or $25,400. After debt service, taxes, insurance and an allowance for repairs he'll clear $3,500 this year. That's a 12% return on the capital he invested (including closing costs). Depreciation deductions can shelter a good part of this from taxes.

"This just seems like a better bet right now than adding money to the IRA or SEP," he says of his retirement account alternatives.

Until the housing bubble filled investors' heads with the notion that real estate is a way to get rich quickly, the nation was populated by millions of investors, like Patterson, who valued properties based on the rent they could earn. With real estate prices down 50% or more in some areas, the landlord game is back in vogue. And like Patterson, many potential players are carefully comparing it with the returns they could reasonably expect by sticking their money in other places.

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Jeffrey Nimmer, 32, owns a lone one-bedroom apartment in Greensboro, N.C. that rents for $900 a month. In the past two years he has replaced the dishwasher ($500) and microwave oven ($100) and paid to have the chimney cleaned ($150). A deep cleaning, needed to attract new tenants, runs $250. "When you're a landlord, you come to expect things will go wrong. Badly wrong," he says.

Fire and liability insurance for a landlord will cost around $900 per year for an apartment building with up to four units, says Julie Parsons, vice president of Allstate's consumer household unit.

Here's how the numbers might work for a small building financed with a mortgage. You pay $500,000 for a structure with four apartments that generate $1,200 each in monthly rent, which comes to an annual total of $57,600. Take away a 5% allowance for vacancies and eviction costs and 10% for property management fees. That leaves $49,000. Put in property taxes at 0.8%, or $4,000, and capital improvements and ongoing maintenance of $7,200 ($1,800 per unit per year, according to Goldfarb). That leaves you $37,800 before debt service.

If you put down 20%, or $100,000, and take out a 30-year mortgage at 6%, principal and interest come to $28,800 a year. Subtracting the debt service leaves $9,000, or a 9% cash-on-cash return on the $100,000 down payment.

In vibrant metropolitan markets like Boston's, it may make sense to accept a relatively low return because it's reasonable to expect that, with the debt amortization and steadily increasing rents, the return will improve over time, says Biria St. John, an executive director at Cushman & Wakefield.

"You have to look for double-digits right off the bat in markets such as upstate New York where rents can hold steady for ten years at a time," he says.

Scott Weis was aiming to get in at the bottom of the market when he bought a home in Phoenix last August for $228,000. He knew the $1,500 a month he is collecting in rent wouldn't cover his expenses but assumed prices and rents would be on the upswing by this point. They aren't. Weis is hanging on for now.

"Phoenix is one of those places that will swing back," he says.

He's probably right, but given the deals available these days, savvy investors should be looking to turn a profit from day one.