Passive Income and Rental Property: Oxymoron!

A very smart friend of mine was filling me in on her “three year plan” for her finances. She’s an accountant and holds a very responsible management position in a fairly large firm…when it comes to money, she’s no dummy. But she said something that disturbed me—her next plan (this one is drawing to a close) is to create for herself some “passive income,” an excellent goal—but in the same breath she mentioned buying a second house for that purpose.
As a landlord and rental property manager, I had to tell her than owning rental property is anything but passive! There is nothing passive about 3 am calls that the geyser (hot water heater) has burst or that the roof is leaking onto the tenant’s bed! There is nothing passive about being on vacation and getting a call that the property has been burglarized and there are broken locks and windows all over the place. There is nothing passive about discovering your tenant has failed to maintain the garden, has broken a toilet, or stolen the satellite dish. In short, there is nothing passive at all about owning a house or flat that someone else—someone over whom you have virtually no control—lives in.

Tenants often surmise that because you own the property and rent it out to them, you must be rich. They assume that you own the property outright so that whatever they pay you in rent is pure profit to your pocket. To many of them, this means they don’t have to pay their rent on time or conserve power or water, and if they break something—oh, well—you’re rich, you can afford to fix it. The reality of owning rental property is often very different from the expectations—and different in ways many prospective landlords never dreamed.

First of all, it is unlikely you will turn a profit on the property in the first three to five years. Why? Because you are buying the property at market value which means your mortgage payments will most likely be more than the market value rent for the same property. It takes several years for rents to increase until the market rent is higher than your mortgage (bond) payment. And in a slow property market, that will be even more likely. When houses don’t sell, people rent them out, which puts a glut on the market and drives rents down. So, if you are planning to buy a property as a rental, you must expect to supplement the incoming rents in order to have enough to make your mortgage payments…and if you didn’t take out a PITI (principle, interest, taxes and insurance) loan, you’re going to have to dig even deeper for tax and insurance money.

Secondly, every dwelling has to have utilities: water, electric, trash, sewer, etc. It is tempting to tell the tenant that he has to transfer all these things into his name, thereby saving you the hassle of it. But that’s not always the smartest thing to do. The purveyors of water, electricity and the like tend to be pretty single-minded about getting paid for their services and if your tenant doesn’t pay the bills, the services get turned off. Not your problem, you say? Well, you’ll think differently when your tenant moves out and you find yourself with a mountain of refuse in the back yard—or worse, inside the house or apartment—(trash pick up was suspended for non payment), a dead garden (water was cut off for non payment) and you can’t turn on the lights to clean the place up after you get home from work (electricity shut off for non payment). And you’ll think even more differently when you go to get them turned back on…this time in your name…and the entity demands that you bring the accounts current and pay a whopping deposit before they will transfer them.

So, with this lesson in mind, you rent the property out keeping the accounts in your own name…you will bill the tenant for usage. But now, if the tenant fails to pay, you don’t have the legal right to shut off services! And if the tenant has kids, you can’t just put them out on the street with three days notice, either, you have to take them to court, which can take months—months during which the tenant continues to not pay the utilities and may even stop paying the rent.

Small claims courts have a rather low limit on what they will allow you to sue for, and that low limit will be reached very quickly if your tenant is using water and electricity at an alarming rate and not paying you for it. If the tenant also stops paying rent, you will end up having to fund a lawyer and pay court costs just to get the deadbeat tenant out of your property—and if you think you are going to recover that money from the tenant, think again. Unless you have the funds to hire a lawyer and take the person to court, you get nothing. In fact, even if you do have the money to take the person to court and you win, now you have to hire someone to collect for you! And the grim reality is, if the person is renting, they probably don’t have much in the way of assets for you to seize, nor a fat income to garnish: people who have fat incomes and valuable assets tend not to be renters.

Chasing rents and utility payments is hardly a passive occupation, and there is nothing passive about trying to get a vacant unit rented out, either. Free advertising exists on the web, but my own experience was that I got better response from a paid newspaper ad! First you have to get people interested in the property…motivate them to answer your ad. Once they call, expect half of them to fail to show up for their appointment: you get to drive over to the property, tidy it up for the showing, wait an hour only to have the prospective tenant no-show and often even fail to call to cancel.

Once you give the address of the unit, expect people to drive by and look at the place in advance of their appointment. Some of the cancellations I have received were astounding: “Didn’t like green houses” (the house was white and behind a masonry wall!); “Too far for me to commute” (we had already established it was closer than the current residence); “No garage” (that was already disclosed on the phone); “Doesn’t have a pool” (yes it does, you just can’t see it from the street!); “the house is too small” (you haven’t even been inside and you can’t see the whole house from the street!). Once they have seen the place, expect negotiations—some of them outrageous: “I can’t afford this, can you drop the rent by 25%? I’ll sign a year’s lease so you’ll know it will be rented for that long…” (Sorry, but if you couldn’t afford the advertised rent, why did you even call? Why are you wasting my time and yours? And I always require a 12 month lease—so you bring nothing to the table with your offer.) “Can we adjust the rent for work I do around here?” (What work?? The place is in good nick and your lease requires you to keep up the garden. Are you suggesting you are going to break things and expect me to pay you, via a reduction in your rent, for fixing them?) “I know the ad said small dog OK…what about my German Shepherd?” (Only if he weighs 10kg (22lbs) or less at full growth…) “Are you going to fence the pool/garden/front yard/patio? I have a small child…” (No, we are not. If you cannot keep an eye on your child then this is not the rental for you.)

Some people will also want to fudge the deposit: “Can I pay the deposit in instalments after I move in? I don’t have that much cash right now…” Trust me, saying “yes” this question has been a problem every single time we have agreed. Every time. If they can’t come up with your deposit in a lump sum, expect them to be unable to come up with the rent on time and in full as well—and don’t expect the deposit to be paid—ever.

The deposit is important because more often than not, the tenant leaves the property in need of expensive services. If you are lucky, the worst you will need is a cleaning lady and a carpet shampooer. If you are not lucky, you may require the services of an attorney to sue for damages. We have had both experiences and neither of them are passive—nor are they income! One tenant, for whom we agreed to accept monthly instalments on the deposit, we had to evict after only four months for harassing and threatening another tenant on the property (complete with police visits and reports). During his four month tenancy he did not make a single instalment on the deposit and when he moved out, damage to the property exceeded what would have been the deposit, had he paid it!! To add insult to injury, he consulted an attorney and we received a letter demanding a refund on the unused portion of his rent! Fortunately his attorney knew a losing proposal when he saw one, as we responded that we had applied the unused portion of his rent to the unpaid deposit which was then spent to replace the broken toilet, window, and clean the filth that he had allowed to accumulate in only four months (including sacks of rotting garbage in the kitchen), and that he owed us an additional amount for cleaning and damages, as the excess rent did not cover our costs. We never heard from the tenant or the lawyer again.

Assuming you are lucky enough to get a good tenant who pays their rent on time and doesn’t damage property (and credit checks...which cost money...won’t tell you that!), entropy happens—even to new and recently remodelled properties. We have a flat that was completely remodelled less than a year ago at a cost that approximates what we collect in rents in a year. The tenants are perfect…but the flat continues to need visits from our handyman and from the Body Corporate’s maintenance people: leaking roof, leaking pipe, leaking sink, wobbly tiles, burst geyser (hot water heater)…the list goes on. Another absolutely perfect tenant had to tell me that her brand new kitchen stove suddenly isn’t getting any gas, necessitating a visit from the handyman. Another tenant never, ever pays her rent in full and on time, necessitating constant contact with reminders and even threats to get our money. Other tenants are profligate with the electricity in their units to the degree that the property is now operating in the red. None of this is passive and all of it reflects an outflow of money rather than income.

So, the next time you are thinking about “passive income” and the idea of owning some rental property seems appealing to you, think again. There is nothing passive about being a landlord and precious little “income” until the property appreciates enough for you to sell it at a profit!