One must look at the entire picture if you're going to play and stay in the game of rental property. As landlords, we have a tendency to focus on what's in front of us, and on a rental property that is normally maintenance and vacancy. We all hate is repairs, correct? Yes, we all hate them. I don't like repairs either but we found the main reason landlords hate them is because they don't have money set aside to pay for them. Lack of funds causes a lot of stress and inconvenience. Repairs can put stress on your family and the family's budget when these unexpected things come up.
Wouldn’t it be incredible to NOT stress when a repair is needed? Or fret over your resident vacating your rental property? Well, it is possible to have your cake and eat it too, when it comes to owning a rental property.
I am going to share with you the secret to always having funds for repairs and vacancies, the secret to having peace of mind, and the secret to having Real Estate investments and live life at the same time.
Landlords have a hard time wrapping their heads around why renters don't care for their property like we would. I have the answer to that, and it's called the rent a car mentality. In other words, residents take care of our properties like we all drive or rent a car. I want to ask you a question before you returned the last rental car, did you take it through the car wash making sure it was perfect? When you went to the supermarket, did you make sure you parked it out away from all the other cars so nobody would give you a door ding? The answer is probably not.
When owning a rental property, it’s important to look at the whole picture, or as I refer to it, “looking at the entire Mona Lisa”. You cannot really appreciate the art of the Mona Lisa if all you see is the corner of the picture. In owning a rental property, that corner is maintenance and vacancies.
I spent the last 36 years, helping thousands of landlords achieve wealth and setting up a successful Real Estate retirement plan. What I found was, most landlords don’t understand the whole picture of owning a rental property. To see the whole picture, one should understand all five major quadrants of a rental property.
The 5 Quadrants include:
- Reduction of Principal on your loan
- Rent Increases
- Maintenance Repairs
Don't want to read a HUGE blog, no problem, Ron has you covered! Click here to watch the video.
How it Works:
You can depreciate your rental property excluding the land over 27.5 years. For example, if you have a $400,000 property minus the land value which most of them figure about 25% or $100,000, you'd be able to write off $300,000 over 27.5 years. That breaks down to roughly $11,000 each year if you are in a 25% tax bracket. You may be well over the 25% but we are going to use that number as our base. If you fall into that you are going to save approximately $2700 a year in income taxes. You saved that $2700 because you own a rental property, and most of us forget about that savings because it is mixed into our personal taxes.
Technically, you should put that $2700 each year in your rental account each year, but I will get to that in just a moment.
Let’s say you had a $300,000 loan at 4% interest, your payment is approximately $1432 per month. However, $432 dollars of that is going to pay down your principal. For easy figuring, let’s just say it’s $450 a month, times 12 months, that’s another $5400 a year that you’re not paying. Essentially, a forced savings account. Basically, as time goes on that resident is going to pay that property off. You can use the depreciation money because you're going to get it back on your tax return. However, it’s real money and you will see it at some point.
How they Work?
A whopping 95% of landlords who manage their own properties never raise their rent. If they do raise it, it’s about every five years. Typically, the increase is excessive because they realize the rental rates is drastically below market value. Would you be shocked if I told you that only 7% of residents will move when you increase the rent moderately? According to a survey by Buildium, “93% of residents expect a moderate increase of 2-5% annually”. The biggest reason they move is maintenance repairs and improvements not done timely or not done at all. That's why it is a myth that people will move if you raise their rent, it’s been proven that they won’t if you stay in the 2-5% range.
Over the last three decades, we have debunked this myth time and time again. We successfully increase rents annually for nearly all our properties.
If we raise the rent a mere $50 a month each year consecutively over six years, which is only a 2.5% increase on a $2000 rent, how much money would you have?
At the end of that six years, you’re going to have a mind-blowing $12,600 in your account. That is 12,600 reasons why, raising the rent a scant $50 a month per year, is essential when owning a rental property. There will always be maintenance, just like there is always maintenance on your car. And just like your car, you need to tune up your investment property, so it doesn’t deteriorate.
A Real-Life Example
We have managed a property on Whispering Winds in Moreno Valley, CA. Rent started at $700, 29 years ago in 1991. The resident just moved out in 2020 and the rent was $1635. Yes, the same resident was there for 29 years. The average rent increase was $32 a year each year for 29 years. You might be asking yourself, “why bother with $32 a month per year?” Why even take the time writing up the paperwork? Well, here's why, because if you do increase the $32 per month each year, over 29 years it adds up to an incredible $166,000 that you have in your pocket. Again, residents don't leave because you raise your rent moderately, they leave because you don't take care of them.
Now all this seems pretty good right, it gets better, it gets a lot better. The property was purchased in 1991 for $89,000 it just sold for an astounding $385,000! More than four times what it was purchased for back in 1991. It gets better from here. The resident paid the mortgage off for the owner with no vacancy and no rehab of the property in 29 years. I know this is an exceptional case but my point in this scenario is that residents will stay when you raise rents moderately on an annual basis.
- They got a $166,000 in rental increases.
- Their property went up more than four times the purchase price.
- The resident paid off the mortgage.
- They had a hassle-free experience because Management One took the calls in the middle of the night for 29 years when the toilet wasn't working.
Appreciation of Your Property
How does this work?
By using the power of leverage, you really make out on this. The appreciation rate for the last 12 months in California has been 11.9% or 12%. If you buy a rental property and put down 25% or $100,000 on a $400,000 property you're buying, your appreciation on last year would have been $48,000.
On the other hand, if you took that same $100,000 and put it in a savings account, you might earn a meager 2% return on your investment, but not likely more like 1%. But since you bought a $400,000 property and received a 12% appreciation, you earned an amazing $48,000.
So, the appreciation year of your property for that one year was astonishing, but we forget about these things because we mainly focus on one area and that is maintenance.
Maintenance repairs is part of the five quadrants and it’s what makes it all work, without maintenance you can't have the other four amazing benefits. We focus all our attention on maintenance and it's what we all hate most of course. To avoid vacancies, you must improve your property and give it the resident a reason to stay. For the property to appreciate you must do improvements outside and inside. Let me share with you some statistics, out of 5200 work orders from 2019 to 2020 we did at Management One Property Management. The average general maintenance, such as faucets, fences, sprinklers, averages about $1500 a year or about a $125 a month. In some cases, you might go two years and only have one repair, and then in the third year you get hit with $3,000 but this is the average. What does this mean? It means you must prepare for a rainy day on warm sunny days. Remember all the other benefits I mentioned previously.
Why do landlords despise maintenance? It's basically because landlords have not set up the structure to pay for the maintenance repair. It's just that simple.
Let's recap one year on these five quadrants.
First, you're going to have maintenance so take $1500 off the top. However, this $1500 is a tax write-off so by the time you take Federal and State you're only paying 60% of that $1500. Next, you have a rental increase is $75 a month or $900 each year and in six years that'll put $19,000 in your pocket. The reason I used $75 is that is the minimum that we raise rents. The reason is that if you go on a $2,000 rent a $75 a month increase is somewhere around 3.7% to 5% depending on the average rent rate. Thirdly, the depreciation you're going to pick up $2700 a year due to depreciation. Next, another $5400 in principal reduction. I get it that you can't spend the $5400 right now but it's still real. Essentially, it becomes a forced savings account because if you sold that property today your loan is going to be less than what it was when you bought it, so that's real money. Lastly, we have an appreciation, an amazing $48,000. After you take the $1500 out you made a whopping $65,000 plus.
Now we're seeing the whole picture of the Mona Lisa aren’t we because you're seeing how beneficial it is. What does that mean? It means you’ve got to set up a structure so you can take care of these maintenance items. In this recap, you have $19,000 over six years on rent increases and you have $16,200 over six years on yearly taxes, that is an incredible $35,000 alone… so here's the secret to making it work.
Set up a separate rental property checking/savings account. Important to mention, don’t STEAL from it otherwise you will innocently squander it away.
Let me explain, you raise the rent by $75 a month, that check is coming direct deposit to your personal checking account, now you have more money each month. What do you do? You innocently squander it away. Now the management company or the resident calls you and says they need money for a repair and it's going to be $400. You are frustrated thinking, where am I going to get this money. I wasn't planning on this. We had these conversations tens of thousands of times on 10, 000 properties in 36 years, so we know how you're going to feel.
Here's How it Works.
You set up a separate rental checking savings account. The rent from your resident or management company goes in here automatically every month. Your tax refund from owning a rental property goes in here. Ask your CPA what your savings was because you owned a rental property. Then write a check to your Rental property account for that amount from that tax refund. If you think about it, that is not your money it is your retirement money in that rental property. If you do that, you're going to have $16,200 in six years just on that alone. Rent increases by $75 a month that's another $19,000. All mortgage payments, property taxes, insurance, and all repairs are paid from here in this account. We recommend that you put $5,000 to $10,000 in the account to start. If you can’t start with that, start with $100 but the point is to get started. If you do that when somebody calls you and says I need $15,000 for a roof you're going to have it with $35,000 sitting, there to pay it. We kid with landlords, but you cannot steal from the rental account, it's like taking money out of your kid's education fund or IRA and not paying the tax on it that's a no-no. Look at it as a Real Estate retirement account which it really is. With the separate account set up, you will never have to cancel a vacation, you'll still be able to put your kids through school, it's never going to affect your family life and you will end up owning more Real Estate than you could ever imagine.
Here is another fantastic article by Ron, expanding on the concept of "Stealing from Your Piggy Bank"