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What you need to know before converting your home into a rental

(Andrew Harrer/Bloomberg News)

Justin Pierce is a real estate investor who regularly writes about his experiences buying, renovating and selling houses in the Washington area.

I just recently had two clients contact me because they know I’m an active investor and a real estate agent.  They are government employees who expect to live in the homes they are buying for just two to four years. After that, they would like to hold the homes as investment properties.

Buying your home like an investor is an extremely powerful wealth-building strategy. By living in the home first, you get premium financing terms. You get the best rates and the lowest down-payment requirements. It also helps you to be extremely practical in your property selection. Keeping the end in mind helps you to rein in any tendencies to overindulge or overpay. It helps you focus directly on the financial and separate your needs from your wants.

If you obtain a lower-rate mortgage under the conditions of being an owner-occupant, then it’s important that you actually live in the home and not rent it out initially. You can get into big trouble — including charged with fraud and possibly be forced to pay the mortgage balance in full — if your lender discovers that you never lived there and that the property is being rented out.

It’s best to live in the property at least a year and then contact the lender to let them know that the property is no longer your primary residence. However, your lender will probably not have a problem with your renting out the property if your job suddenly moves you out of town.

[A little lie on mortgage application can cost you big]

I love the idea of always having multiple exit strategies for any real estate purchase. There are a lot of accidental landlords in our area. I know too many people who couldn’t sell their homes so they had to rent them out when they outgrew them or relocated.

The problem is that attributes of a good rental property are often at odds with what a buyer wants and needs for his or her family residence.

People take pride in their home. They want a home that is impressive to their friends and family. They want comforts and amenities. They would like high-end appliances and finishes.

The best rental properties, however, are simple, durable and easy to rent and to maintain.

For example: A family might really want a five-bedroom home. In some areas, a five-bedroom home may cost significantly more than a four-bedroom home but bring in virtually no extra income as a rental.

From a strictly practical perspective, every additional amenity is an added potential maintenance expense that won’t necessarily bring in more rental income. For instance, a jetted bathtub is highly desirable to some people, but it will probably not bring in any additional rent. It will, however, create significant repair costs if it is not properly maintained.

Balancing these two very different buying strategies is a real challenge, and many buyers in the end cave to their wants and then cram those wants into the rental equation. They often don’t balance.

[For rent by owner: A landlord responds]

The first step in buying any rental is to determine the income and expenses and then placing that criteria at the top of your buying priorities. Most people, including real estate agents, drastically underestimate expenses. They believe that they take their rental income, deduct their mortgage payment and the amount left over will be their income. They may account for management. Here’s what most people think a rental income expense ledger looks like:

Rent: $2,000 per month

Mortgage payment: $1,600 per month (This includes a tax and insurance escrow.)

Management: $200 per month

Profit: $200 per month

In reality, most landlords anticipate that their expenses will average about 40 to 45 percent of their monthly income, not including their principal and interest payments.

[For rent by owner: Legal landmines for landlords]

There are other real expenses that you will commonly incur and you can average out an estimate of those expenses:

• Vacancy: You will have vacancy, and it will cost you. This will be based primarily on the turnover rate for your area. If you have a starter home in a fairly transient area like ours, you can count on your tenant moving out after a year. Even if you have a really desirable rental, it will probably take you a month to prep the property and get your next tenant in place. That equals one month of vacancy for every 13 months or about 7.8 percent vacancy rate. You can round that down to 7 percent on an annual basis.

• Maintenance and repair: Maintenance and repairs will depend on several factors. For instance, if your home is 15 years old and all the appliances, furnace, AC and water heater are original, then you can anticipate having to replace all of those in the next five to 10 years. If the costs for all of those are estimated at $10,000, then you can divide that by 10 years (for easy math) and find you should be setting aside about $1,000 per year for these repairs. I also like to put in at least $300 to $500 per year for the occasional leaking faucet. So that’s $1,500 per year, or about 6.25 percent of your monthly income.

• Management: Management is typically 8 to 10 percent of your gross monthly rate, but your manager will probably take at least half or maybe all of your first month’s rent to pay for finding a tenant and paying Realtor commissions. So the cost to you is not 10 percent per month. If you anticipate having to find a new tenant every year, then your management costs will be closer to 11.5 percent of your anticipated income.

You can manage your property yourself, but there is a real-time expense here that you should account for. I never recommend leaving out management. You need to be paid for your time, and there is always a chance that your circumstances will change and you’ll need to bring in a manager at a later date.

Here’s how I generally initially estimate my expenses on a rental property:

Management: 11 percent

Vacancy: 7 percent

Taxes and insurance (for Virginia): 13 percent

Maintenance and repairs: 6 percent

Total expenses: 37 percent

This is typically on the low end, but it gives you a good starting point to quickly evaluate a property. If a property passes this quick back-of-the-envelope accounting, then you can delve more deeply into the specific costs you can expect for a given home in its given location.

Looking back at our original income analysis and applying our new general expenses, you’d get something closer to this:

Rental income: $2,000 per month

Mortgage payment: $1,600 per month (This includes a tax and insurance escrow.)

Expenses above 23 percent: $480 per month

Monthly loss: $80 per month

This still may not be a bad deal if you got the home for no money or little money down and you consider the fact that a tenant is paying down the principal on your loan and the many tax benefits. You just need to know the facts ahead of time.

Knowing your expenses is the first and most important step in finding any rental property. Once you know that, you can then determine your wants and needs and evaluate those items that will make a good rental property. Buying your home like a rental often requires you to forgo many of your wants and to think simple. This is easy if you plan to live in a home only for a couple of years. It is difficult if you have very specific wants.

The two clients I had closed on their purchases last month. Client one already had four rental properties. He started out with a budget and was willing to settle for a smaller, more modest home. He stuck pretty well to his plan, and we found him a nice little single-family home in Fairfax that should rent out nicely for a good return.

Client 2 started out looking for an 1,800-square-foot home for about $250,000 in Stafford. As we looked at homes, he decided he wanted to be in a specific school district, which isn’t bad and can be very helpful with renting out a home. But then he started looking at bigger and fancier homes. He ended up buying a home that was nearly 4,000 square feet and close to $400,000.

It will still rent, and the fact that it’s a nice home in a great school district will really help him retain good renters. But the likely rental income on the home is pretty tight, and I’m afraid the maintenance will be a nagging headache for him in the future.

Buying a home like a rental is a great idea but often hard to do. Regardless, everyone should keep in mind that their home now is a major investment. You should be highly focused on the investment aspect of your purchase to ensure that your home is truly an asset to your family and not a burden.

Catch up with some of Justin’s previous columns:

Why the real estate business has jaded me

How to save money on your bathroom remodel

How to get a high-quality kitchen without the sticker shock