Buy and Hold Real Estate: Ultimate Investor Guide — Income Insider

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“Buy and hold” is the classic method of investing in real estate. There are many other strategies, such as fix-and-flip. But the value of real estate, ultimately, is in its capacity to generate income.

The buy-and-hold strategy is essentially the strategy of buying real estate and renting it out over long periods of time.

Whether you buy the property with a mortgage, or you pay cash outright for it, the approach is the same: The buy-and-hold real estate investor seeks to profit directly from the income the property generates. The potential for capital appreciation, while hoped for, is a secondary consideration.

‘Buy-and-Hold’ vs. ‘Fix-and-Flip’ Real Estate Investing

Essentially, buy-and-hold investing is the inverse of the pure “fix-and-flip” strategy. The fix-and-flip investor seeks to benefit from short-term capital appreciation ­- that is, price increases. The pure fix-and-flip investor doesn’t normally seek to rent the property out at all.

Their aim is to unlock value in the property by making repairs and improvements and positioning the property to sell at retail prices, if possible. The flipper is all about maximizing the property’s capital appreciation, net of costs. Then selling as quickly as possible to unlock their capital and make another flip.

For the flipper, rental income is a secondary concern, if it’s a concern at all. Their income is in a steady flow of deals.

‘Active’ vs. ‘Passive’ Real Estate Income

Both the buy-and-hold and fix-and-flip approaches have advantages and disadvantages. And many real estate investors do a little bit of both.

But for many investors, buy-and-hold has an important and lasting advantage over fix-and-flip investing: Fixing and flipping properties requires constant activity.

Flippers are incessantly trying to find new properties to acquire at a discount, constantly working with contractors and making repair decisions and writing checks to get the work done, and constantly trying to market their completed properties to be sold.

Flippers are constantly juggling dozens of activities. It requires a tremendous amount of work to bring a successful flip to conclusion, and to do it again and again to generate a reasonable stream of income.

Even then, the timing and precise amount of those cash flows from flipping is very uncertain.

In contrast, buy-and-hold investing is relatively passive. Once you acquire the property and successfully market it to a renter, the investor can often go the whole year without expending much time, effort, or additional capital on the property. Meanwhile, the tenant generally makes regular and predictable rent payments to the investor, in his or her role as the landlord.

Many people live on the regular income generated by rental real estate property. Buy-and-hold investing is a proven source of income for real estate investors and retirees.

It’s not a foolproof source of income, however, and buy-and-hold rental real estate investing isn’t easy. Many smaller landlords have learned painful lessons about how fragile real estate rental income can be: Government moratoriums on evictions made it difficult or impossible to evict tenants for non-payment over most of 2020 and much of 2021.

Even under normal economic conditions, rental real estate investors must keep up with repairs, invest in capital improvements in their properties, and deal with vacancies and the occasional problem renter. Maintaining a steady stream of cash flow from an investment property, net of expenses, can be very challenging.

Buy-and-Hold Sources of Return

In most cases, the primary source of income for the buy-and-hold real estate investor is the rental income from tenants. However, there are a number of others:

• Crops
• Grazing
• Mineral rights (oil and mining)
• Special events (e.g., music festivals, fairs, and carnivals).
• Vending machine income
• Laundry machine income
• Advertising (e.g., putting a billboard on the property)

Obviously, creative and resourceful landlords can combine multiple methods to maximize their overall return on the property.

Also, there is nothing to prevent a buy-and-hold investor from selling at a good price and realizing the capital appreciation on the property. In fact, if the price offered is well above the discounted present value of the future rental income stream from the property — and it’s possible to profitably reinvest the cash received — it’s very likely a good idea to do so.

Advantages of Buy-And-Hold Real Estate Investing

There are many advantages to taking the long-term, buy-and-hold approach to investment real estate. Here are some of the most significant:

Income. In the aggregate, rental property generates a stream of income. Any individual property can become distressed, go vacant, or have a non-paying renter. But in the aggregate, landlords receive a steady income from rental property.

This income may or may not be sufficient to offset the expenses of buying and maintaining a property — especially for a property with a significant mortgage on it. But as that mortgage is paid down, it’s easier for buy-and-hold landlords to generate cash flow from a given property.

Potential for capital appreciation. Over long periods of time, house prices typically rise by more than the rate of inflation. This isn’t true at all times, nor in all markets. For example, Detroit housing was hit extremely hard by the 2008–2009 mortgage crisis. Individual cities and even neighborhoods can have wildly different price returns at any given time, and sometimes for years at a stretch.

But in the aggregate, house prices in the United States have succeeded in generating a positive long-term real return. And meanwhile, tenants provide buy-and-hold investors at least some income while they wait out any downturns in the real estate market.

Increasing income. If you buy a bond, you’re stuck with the same coupon payment for the duration of the bond. But a rental property offers the potential for gradually increasing income every year. For example, landlords often increase rents by 2–3% or more each year or so, when a tenants’ lease expires.

If mortgage payments and repair expenses remain relatively constant, the property can become a better and better cash flow generator. And once the mortgage has been paid off, they can be a powerful source of cash flow, and help you build generational wealth.

Long-term capital gains rates. If you fix and flip a property you hold for less than a year, you must pay high short-term capital gains tax on your profits. If you hold a property for longer than one year — routine among buy-and-hold investors — you can qualify for lower long-term capital gains tax rates.

Tax deferral. While property income net of repair, marketing, and interest expenses is taxable as ordinary income, you don’t have to pay taxes on capital gains until you sell the property at a profit. Even then, you can continue to defer capital gains taxes if you exchange your investment property for one of ‘like kind’ under Chapter 1031 of the Internal Revenue Code.

Depreciation. Buy-and-hold investors can claim depreciation on rental properties. This significantly reduces the income tax due on rental income — especially in the early years of ownership. This, in turn, contributes to cash flow, which is the lifeblood of rental real estate investing.

You can’t claim depreciation on your personal residence, but you can claim depreciation on rental real estate — at a rate of 3.636% each year for up to 27.5 years on residential rental property.

That is, if you buy a property with a building on it worth $100,000, you can deduct $3,636 per year against your gross income from the property for the next 27.5 years. This increases your cash flow from the property.

Note: You can’t depreciate land. Only the buildings, components, and income-generating equipment you put on it.

Bankability. Real estate is a proven source of collateral. It’s excellent security for a loan. Unlike a truck, you can’t get in your rental property and drive it away. Even if a tenant isn’t paying, the house and land still have value. Bankers are usually eager to lend on real estate. Which helps you sell the property when the time comes.

And the fact that you can easily borrow against equity in real estate means bankers can help you meet short and medium-term liquidity needs. You can even borrow against one property to put a down payment on another real estate property, potentially expanding your rental income, and helping you benefit from the gradual price appreciation of another property.

Buy-and-Hold Real Estate Investing Considerations

Every rental property is different. But investors must be constantly mindful of cash flow (income minus operating expenses), tenant quality (because the quality of tenants directly affects the reliability of your income in the future), and potential for capital appreciation.

Rental Real Estate Capitalization Rates

First, investors should be aware of capitalization rates, or “cap rates.” This is a measure of the current cash return on the purchase price of a rental property. It’s defined as follows:

Capitalization Rate = annual net operating income / purchase price.

All things being equal, a high cap rate is better than a low cap rate. The higher your cap rate, the quicker you will reach a break-even point on your investment from rental income.

That said, computing your cap rate is just the beginning of analyzing a rental company. A good capitalization rate may still be poor compensation for an older property that is falling apart and will shortly need a large investment in repairs and capital improvements, such as a new roof and a new foundation.

You may also demand a higher cap rate if the home will be difficult to rent to a future tenant. For example, there may be a very elderly tenant in the home who has lived there for many years — but will not be there forever. If vacancy rates nearby are very high, you may look to discount the purchase price on the property to account for the fact that you may have to offer the home at a low monthly rent to attract another tenant down the road.

Appreciation Rates

Some areas have hotter housing markets than others. When house prices are increasing fast, rental prices may not have kept up. The result is lower cap rates throughout the market.

In many high-cost cities, such as Honolulu, San Jose, San Francisco, Los Angeles, Miami, Boston, and New York, high appreciation rates have made it very difficult or nearly impossible to find an investment property that will generate immediate positive cash flow with a 20% down payment on a property and a mortgage on the rest.

You may need to put down more cash up front to get a positive-cash-flow investment property or accept that the home will have a negative cash flow until your mortgage is paid off or you can refinance to a lower payment. Meanwhile, you are hoping for house price appreciation, which may allow you to sell at a profit sometime in the future.

Interest Rates

If you’re buying a rental property with a mortgage, you need to account for interest rates on the loan. The higher your interest rate, the lower your cash flow on the property is going to be, all other things being equal.

You can get a lower interest rate in the short-term by opting for an adjustable-rate mortgage. But then you run the risk of your payment increasing if interest rates go up. A fixed mortgage has an interest rate and payment that won’t change — reducing your exposure to interest rate risk.

If interest rates get lower in the future, you may be able to refinance and lower your payment, or even get cash out of your investment property that you can use for any purpose.

Interest rates are a relatively minor consideration for a fix-and-flip real estate investor who doesn’t plan to hold the property for very long. But interest rates are a significant factor for buy-and-hold landlords, who must consider the sustainability of their mortgage payments potentially for many years in the future.

Other Real Estate Costs of Carry

It costs money just to own a piece of real estate. Even if you never collect a dime from a tenant, you will still incur costs from a variety of sources. Investment professionals call these “carrying costs.” And you should include them in your cash flow calculations.

Examples of carrying costs include:

• Property taxes
• Interest
• Insurance premiums
• Homeowners/landlord insurance premiums
• Flood insurance premiums
• Fire insurance premiums
• Earthquake insurance
• Windstorm/hurricane insurance
• “Sinkhole” (catastrophic earth movement) insurance
• Sewer insurance
• Construction insurance
• Vacant property insurance
• Homeowners Association or Condominium Association Fees
• Special assessments
• Trash pickup
• Security

Each of these line items contribute costs and detract directly from your rental income. They add up, and you should definitely account for them as you are running your numbers when considering an investment property.

Repairs

Entropy is a constant threat: Houses are always gradually falling apart. Between natural wear-and-tear and occasional tenant negligence or even outright vandalism, you will experience substantial expense just to keep your property in a habitable and rentable condition.

You’ll have to repair plumbing problems, fix broken thermostats, replace garbage disposals, change lighting in common areas in your apartment buildings, maintain the pool, replace fire alarms, and keep the lawn mowed and the leaves raked.

All that costs money.

If you’re buying a multi-family property, you can get a decent sense of monthly repairs by reviewing expense records for the last year or two. But these costs may not reflect large amounts of “deferred maintenance.” You’ll need to catch this with a thorough inspection of the rental property you are considering.

A common rule of thumb for buy-and-hold rental property owners is to set aside 2 to 3 percent of their rental property income each month as a reserve against unexpected repair costs. If the property is older, you may need to budget slightly more.

Again, you should account for a repair allowance ‘sinking fund’ when you are calculating projected cash flows on a piece of rental property.

Capital Expenditures (CAPEX)

In addition to repairs, you may want to think about a long-term plan for making capital improvements to raise the market value of the property or change its purpose. A classic but example is converting an old apartment building in a gentrifying area into a retail space, or a struggling shopping mall or abandoned school building into apartments.

But capital expenditures can also mean upgrading a kitchen, adding a bedroom, converting a carport to a garage, or putting in a finished basement. You may want to begin setting aside some money to fund your CAPEX plan to maximize the long-term value of your property.

Taxation of Repair Costs vs. Improvements.

Buy-and-hold landlords must understand how maintenance/repairs and property investments are taxed. Both repair and capital expenditures must be deducted from cash flows. But the IRS treats both expenditures very differently.

Repairs and maintenance expenditures are done to keep the property in rentable and habitable condition. For example, to repair a clogged toilet, or fix a broken light fixture. The idea is not to improve the market value of the property, nor change its function. The intent with a repair/maintenance expenditure is to keep the property functioning as promised in your lease agreement with your tenant.

These expenditures are fully tax deductible in the current year. You can deduct the full amount directly against your declared rental income for the year.

Capital expenditures, on the other hand, is anything you do to increase the value of the property or change its basic function. For example, patching a leak on a roof is generally a repair cost. But adding a whole new roof is a capital expenditure.

Fixing a broken toilet is a repair. But replacing all the old plumbing with brand new copper plumbing is a capital expenditure.

These improvements are not 100 percent deductible in the first year. Instead, you must gradually amortize these expenses over the useful life of the new component and deduct their cost gradually over a number of years as depreciation.

These depreciation deductions lower your tax bill over the useful life of the property or improvement.

Your investment gets added to your cost basis in the property. But keep careful records. As you take deductions for depreciation each year, your cost basis in the property is gradually reduced accordingly. This, in turn, increases the amount of capital gains you may realize when you eventually sell the property.

Note: If you depreciate property and then sell it later at a profit, you can expect to pay depreciation recapture tax. For more information, see IRS Publication 544: Sales and Other Dispositions of Assets.

Insurance Considerations

If you’re renting a home, even for short-term vacation rentals like with AirBnB, you need to have landlord’s insurance. An ordinary homeowner’s insurance policy won’t provide proper protection for you, nor your tenant.

A landlord’s insurance policy costs more than a comparable homeowner’s insurance policy. But unlike a homeowner’s policy, a landlord’s policy will protect you against liability caused by your tenant. If your tenant’s dog bites somebody, your landlord’s policy will help protect you if the bite victim sues you as the landlord.

(Note that some landlord’s policies won’t cover bite claims from certain dog breeds. This is why some landlords have breed restrictions on tenants’ pets: Their insurance companies exclude dangerous breeds from coverage!).

Renters Insurance

It’s a good idea to require renters to maintain renter’s insurance, as well. Include the requirement in the lease. Have them list you as an interested party, so you get notified if your renter allows their insurance to lapse.

Otherwise, a renter may accidentally start a kitchen fire that causes tens of thousands of dollars in damage. Most renters can’t cover that — and it will be very difficult or impossible to collect it from them, especially if they move out.

If they have renter’s insurance, that can help protect your risk as a landlord.

Taxation of Rental Income

You can expect to pay ordinary income taxes on your net income from a property. For most traditional landlords this is going to be your rental income (though in some cases it can include vending machines, advertising, farming, and ranching activities, selling mineral, lumber, or grazing rights, etc.)

The taxable portion is your gross revenues minus your expenses in maintaining the property. Expenses include insurance premiums, interest, repairs, property management fees, advertising and marketing expenses, cleaning, and gardening.

You’ll also subtract depreciation for improvements you made in prior years to arrive at your net income. In the U.S., you’ll report your rental income on Schedule E of your tax return.

Property Management

Some rental real estate investors are die-hard ‘do-it-yourself’ investors. They like to save money by doing as much work on their property as they can, including repairs. But many other investors prefer a ‘hands-off’ approach. They delegate some or all of their landlording responsibilities to property managers.

A full-service property manager can take over essentially all the day-to-day and month-to-month responsibilities of managing your rental property, including:

• Advertising
• Tenant selection and screening
• Lease management
• Rent collection
• Lease enforcement
• Eviction
• Repairs
• Capital improvements
• Reporting
• ‘Rent-ready’ repairs and upgrades when turning a property over between tenants.

Many landlords use their property management companies to create a truly passive stream of income. The landlord doesn’t need to do anything on a month-to-month basis. All they need to do is make the major strategic decisions about what to do with a property.

However, even if you have a property management company doing practically everything on your behalf, you still need to write the checks for repairs and improvements. When the house needs a new roof, the property management company won’t pay for that for you. They’ll come to you with some bids, and you’ll need to come up with the cash needed to make the repair.

Normally, you and the property management company will agree on an amount of money they can spend on a repair or minor property issue without your specific approval. You’ll provide your property manager with that amount of money as a cash reserve. Any repairs or necessities above that amount will require your approval.

Pricing varies based on the quality of the property management company and the scope of work. But you can probably expect fees of between 10% and 15% of rent. This is in addition to repair and renovation costs, HOA and condo fees, property taxes, insurance, and the like. The more ‘hands-off’ you want to be, the higher the likely property management charge.

Don’t Violate Fair Housing Laws

Buy-and-hold real estate investors must abide by a number of laws, including the Fair Housing Act, the Americans with Disabilities Act, and their state and local equivalents. Mostly, these laws are designed to prevent unlawful discrimination in housing — especially if the landlord owns more than four units, or if the property is represented by a licensed real estate agent.

Generally, you cannot discriminate against specific protected classes of people. You cannot discriminate on the basis of age, sex, race, national origin, familial status, source of income, veterans’ status, sexual preference, and in most jurisdictions, by gender identity.

You also cannot discriminate on the basis of the tenant or applicant having a disability.

That means you should be very careful about the questions you ask applicants and tenants. For example, never ask an applicant where they’re from. Don’t ask a pregnant woman when the baby is due. Don’t ask an applicant about marital status, or whether the children are hers.

Don’t show disabled people or people with children a less desirable apartment, even if you think it would suit their needs better. This is called “steering,” and is illegal.

Have a Set of Objective Rental Criteria

To avoid allegations of illegal discrimination, it’s a good idea to develop specific rental eligibility criteria in advance, and to stick to them. You should then offer the property to the first applicant who completes an application and meets your minimum criteria.

Example of common rental criteria include:

• Verified monthly income of three times the monthly rental price or higher.
• Minimum credit score of 620.
• No evictions on record within the past five years.

You can also consider an applicants’ criminal conviction history in deciding whether to rent to them. But the U.S. Department of Housing and Urban Development has warned landlords that a blanket restriction against anyone with a criminal history or arrest record may violate the Fair Housing Act.

Evictions -What New Landlords Need to Know

Most tenants fulfill their obligations under their leases. You may have a couple of glitches with slow or late players, but if you are firm and consistent in enforcing your lease, most of them will catch up.

If you do buy-and-hold rental real estate investing long enough, however, or have enough tenants, you will eventually have a tenant who is a real problem. They may be non-payers. Or they may be disruptive or violate your no pets policy or your no smoking policy. They may run criminal activities out of the dwelling, such as drug dealing or prostitution.

Whatever the reason, you will eventually need to get a tenant out of your property.

It’s important you understand how eviction works in your state and county. Generally, you cannot evict unless your tenant is in violation of the terms of a lease or is overstaying.

If you want to get a tenant out, it’s critical that you follow the step-by-step process mandated by the laws in your state or municipality.

Don’t Do “Self-Help” Evictions

First, you can’t just cut off the power, shut off the water, or change the locks. This is called a “self-help eviction” and is illegal in all 50 states.

You cannot harass the tenant or become abusive.

Instead, you must serve the tenant with a notice to cure or quit and wait the prescribed number of days before filing for an eviction.

At that point, the court will schedule a hearing, and the tenant has a chance to mount a defense. If the tenant’s defense is successful, it’s back to Square One.

If you prevail and the judge issues an order to evict, the tenant still has a certain number of days to vacate the property. Usually, the Sheriff’s Department will send a deputy on the appointed day to make sure the tenant leaves.

As the landlord, you should stand by with a couple of helpers on eviction day. As soon as the tenant is out, you can change the locks, but not before then.

If the tenant leaves belongings in the home or outside of it, you may be obligated to put those belongings in storage for the tenant and pay for a certain amount of time, depending on your local laws.

State and local laws vary widely on these points. Most landlords don’t handle evictions themselves. It’s best to work through a law firm that deals with landlord-tenant law and evictions every day.

It can take months to evict a tenant. The process can cost hundreds and even thousands of dollars. Meanwhile, the tenant may cease paying altogether. This costs you months of rent revenue, since you could have rented the property to someone else. And sometimes disgruntled tenants vandalize the property on the way out.

Many times, both the landlord and tenant are able to come to an agreement to get the tenant to leave sooner. For example, a non-paying tenant may not have the cash to move out and come up with a deposit on the next property. They’re stuck. That’s why they aren’t paying rent for your place.

If you can get them out and rent the property to a paying tenant faster, and avoid high eviction fees, it may be a win-win to provide the tenant a cash payment to get out quickly and leave your property in good shape:

The tenant doesn’t have an eviction on their record, which makes it easier for them to find a new place to live. They have some cash to offset the cost of moving and renting a new home or apartment. They have an incentive not to vandalize your property.

And you can turn your rental property around and get it generating rental income again that much sooner.

Sometimes this arrangement works very well. Other times, you may need to go through the full eviction procedure, which is lengthy and costly.

Originally published at https://incomeinsider.org on September 11, 2021.