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The Landlord’s
Financial Tool Kit
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American Management Association
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The Landlord’s
Financial Tool Kit
Michael C. Thomsett
01LL-FM-03 7/21/04 3:26 PM Page iii
Special discounts on bulk quantities of AMACOM books are
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This publication is designed to provide accurate and authoritative
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the understanding that the publisher is not engaged in rendering
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person should be sought.
Library of Congress Cataloging-in-Publication Data
Thomsett, Michael C.
The landlord’s financial tool kit / Michael C. Thomsett.
p. cm.
Includes index.
ISBN 0-8144-7235-4 (pbk.)
1. Real estate investment. 2. Real estate management. 3. Rental housing—
Management. 4. Real estate investment—Accounting. 5. Landlord and tenant.
I. Title.
HD1382.5.T5645 2005
333.33'8—dc22
2004006149
01LL-FM-03 7/21/04 3:26 PM Page iv
LIST OF
FIGURES AND
TABLES VII
INTRODUCTION: W
HAT T

HIS BOOK WILL DO FOR YOU 1
C
HAPTER 1
THE N
ATURE OF
REAL ESTATE INVESTING 3
C
HAPTER 2
GETTING
STARTED IN RENTAL REAL ESTATE 21
C
HAPTER 3
C
ASH FLOW: THE ESSENCE OF RENTAL REAL ESTATE 51
CHAPTER 4
PICKING THE BEST INVESTMENT FOR YOU 69
CHAPTER 5
BOOKKEEPING BASICS FOR RENTAL PROPERTY 89
CHAPTER 6
KEEPING TRACK OF REAL ESTATE TRANSACTIONS 121
CHAPTER 7
CREATING A TIMELY AND EFFICIENT ACCOUNTING SYSTEM 137
Contents
v
01LL-FM-03 7/21/04 3:26 PM Page v
CHAPTER 8
HANDLING DEPRECIATION FOR RENTAL PROPERTIES 155
CHAPTER 9
UNDERSTANDING THE TAX RULES FOR REAL ESTATE 179
CHAPTER 10

TAX REPORTING FOR ANNUAL INCOME AND EXPENSE 193
CHAPTER 11
I
NCLUDING REAL ESTATE IN YOUR PORTFOLIO 225
G
LOSSARY 237
INDEX 241
vi
C ONTENTS
01LL-FM-03 7/21/04 3:26 PM Page vi
FIGURES
Figure 1-1. Sample rental application. 17
Figure 2-1. Average sales prices, new homes. 37
Figure 3-1. Worksheet for cash flow calculation. 55
Figure 4-1. Questions for judging conditions of the real estate market. 74
Figure 4-2. Questions for judging conditions of the rentals market. 75
Figure 5-1. Investment receipts journal. 93
Figure 5-2. Worksheet for loan payments. 95
Figure 5-3. Rental payments journal. 99
Figure 5-4. Year-end worksheet, expense summary. 100
Figure 5-5. Year-end worksheet, expense allocations. 104
Figure 5-6. Sample rental agreement. 112
Figure 5-7. Statement of Condition. 117
Figure 6-1. Automobile log. 123
Figure 6-2. Worksheet for mixed-use expenses. 131
Figure 7-1. Account with subaccounts. 140
Figure 7-2. Account with subaccounts (filled-in example). 141
Figure 7-3. Worksheet for after-tax profit or loss. 150
Figure 8-1. Depreciation limits for passenger automobiles. 167
Figure 8-2. Depreciation limits for trucks and vans. 168

Figure 8-3. Schedule of annual depreciation. 173
Figure 8-4. Schedule of annual depreciation (filled-in example). 174
Figure 8-5. Depreciation worksheet. 175
Figure 9-1. Worksheet for calculating profit on sale of real estate. 183
Figure 10-1. Form 1040. 194
List of Figures
and Tables
vii
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Figure 10-1a. Form 1040 (cont’d). 195
Figure 10-2. Tax reporting for real estate transactions. 196
Figure 10-3. Schedule A. 197
Figure 10-4. Schedule E. 200
Figure 10-4a. Schedule E (cont’d). 201
Figure 10-5. Form 8582. 203
Figure 10-5a. Form 8582 (cont’d). 204
Figure 10-5b. Form 8582 (cont’d). 205
Figure 10-6. Form 4562. 208
Figure 10-6a. Form 4562 (cont’d). 209
Figure 10-7. Form 4797. 213
Figure 10-7a. Form 4797 (cont’d). 214
Figure 10-8. Tax reporting for capital gains or losses. 215
Figure 10-9. Schedule D. 216
Figure 10-9a. Schedule D (cont’d). 217
Figure 10-10. Form 8824. 219
Figure 10-10a. Form 8824 (cont’d). 220
Figure 10-10b. Form 8824 (cont’d). 221
Figure 10-10c. Form 8824 (cont’d). 222
TABLES
Table 3-1. Loan amortization, one year. 59

Table 5-1. Loan payment breakdown, one year. 96
Table 5-2. Impounds accumulated and paid. 97
Table 7-1. Single-entry bookkeeping journal. 143
Table 7-2. Timing differences, impound accounts. 146
Table 7-3. Impound account entries. 148
Table 8-1. Depreciation schedule, 5-year recovery period, 200 percent
declining balance. 169
Table 8-2. Depreciation schedule, 27.5-year recovery period. 171
Table 8-3. Depreciation schedule, 39-year recovery period. 172
Table 8-4. Depreciation schedule, 5-year recovery period, 150 percent
declining balance. 176
Table 10-1. Summary, rental income and expense. 207
Table 10-2. Supplemental schedule, depreciation expense: straight-line
(SL) method (deductible portions in italics). 210
viii
L IST OF F IGURES AND T ABLES
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The Landlord’s
Financial Tool Kit
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1
Real estate investing is a practical alternative to the stock market
for many reasons. If you have lost money by investing in stocks, you already
know how quickly paper profits can turn into actual losses, so solid, long-
term, and
safe investments are paramount in importance. The more capital
you have to invest, the more critical it becomes to diversify away from high-
risk exposure.
Besides the historical profitability of real estate, there are other good

reasons to invest in income property. Real estate is unique because it is the
only investment that allows you to shelter income
and reduce your income
taxes. It’s true that as a stockholder, you can control your taxes by planning
when to sell or when to wait, but you cannot “shelter” income (that is to
say, stock investments do not reduce your tax liability). Real estate investors
are allowed to create legitimate tax losses by depreciating property. While
depreciation does not require you to pay out cash, it does reduce rental
income and may even create an actual loss. Real estate is the only invest-
ment that allows you to claim a loss above the limited $3,000 you can claim
each year when you lose money on stocks. Another important difference is
that stock losses tend to be associated with actually losing cash, whereas
real estate losses often consist entirely of depreciation benefits.
Before you can realize the many advantages of investing in real estate,
though, there are complex reporting demands. You have to keep books and
records, not only of the money you spend on maintaining property, but also
of the calculations you use to divide expenses among several properties, to
figure depreciation expense, and to break down mortgage payments
between principal and interest. The tax-reporting rules are also complex,
INTRODUCTION
What This Book Will Do
for You
02LL-Intro-03 7/21/04 3:00 PM Page 1
requiring you to fill out many schedules that most people never have to deal
with in their tax returns. You have to report gain and loss on the sale of
property, income and expenses, and depreciation—all of which have their
own tax schedules.
This book is not aimed at the tax or accounting expert. It is designed
for the individual who simply wants to invest capital outside of the tra-
ditional but risky stock market and apart from the safe but low-yielding

savings or money market accounts. You do not have to learn a lot of ac-
counting or tax rules to use this book. It takes you through all of the record-
keeping rules; shows you how to evaluate and plan ahead; helps you design
a simple but complete bookkeeping system for rental properties; and
explains, step-by-step, how to fill out tax forms. You may need to use the
services of a tax or accounting expert to complete your tax return; howev-
er, by being aware of how taxes have to be reported, you will be fully
equipped to supply your tax preparer with everything required, so that you
will be able to claim all of the deductions to which you are entitled.
In short, this book breaks down the complex matters you need to think
about: picking properties with financial concerns in mind, planning cash
flow, setting up an effective but basic set of books, keeping track of the
money you spend, planning ahead for taxes, understanding reporting and
depreciation rules and limitations on losses you can deduct, and working
with your accountant or tax preparer. This book cannot replace the expert
advice you need; however, it will help you to become a more informed real
estate investor. And the more informed you are, the more likely that you will
succeed in this potentially profitable market.
2
T HE L ANDLORD’ S F INANCIAL T OOL K IT
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3
Real estate is the most consistently profitable investment choice
you can make. As long as you research ahead of time, know your market,
and pick specific properties carefully, your investment should grow over time.
Most people start out with residential property investments. A single-
family house or small multi-unit property (two to four units) is manageable
and affordable, and you can always step up from there to buy additional
properties or exchange your initial investment for larger ones. To get start-
ed, you want to define what you hope to achieve by purchasing real estate.

Property is far more expensive than most other investments, so you will be
making a commitment in most cases to a mortgage. The majority of invest-
ment value will consist of borrowed money, so you will be depending on
rental income to make your investment affordable. Given the potential
affordability of real estate (with tenants essentially covering your mortgage
payment for you), the consistent historical growth of real estate values, and
the exceptionally good tax advantages, the benefits of real estate investing
are significant.
■ An Overview of the Market
Since residential property is, by far, the most common real estate invest-
ment, we provide examples of housing as a primary emphasis in this book.
Other choices (e.g., raw land speculation, commercial and industrial prop-
erties) are much more advanced and beyond the interest of most investors.
The residential housing market can be easily studied in any given area.
You can readily find information about the local population, employment,
CHAPTER 1
The Nature of
Real Estate Investing
03LL-Ch01-03 7/21/04 3:01 PM Page 3
4
T HE L ANDLORD’ S F INANCIAL T OOL K IT
rental occupancy and vacancy rates, and level of new construction under
way. These factors add up to the supply and demand for real estate in your
city or town. This, then, is the logical starting point if you are thinking of
investing in real estate.
Key Point: Information about local supply and demand for rental property can be
found through local real estate brokers, appraisers, and bankers. Multiple Listing
Service (MLS) publications also provide detailed information about property pric-
ing and trends.
Supply and Demand

The supply and demand for residential property involves two separate mar-
kets. One is the market price trends of housing, and the other is demand for
rental units. The first can be evaluated in terms of how prices are changing
over time. Are houses selling for more this year than last year? What is the
percentage of growth?
Housing prices have consistently beaten inflation over many years, put-
ting housing among the strongest growth investments. Assuming, of course,
that you’ve selected property on the basis of good research and sound mar-
ket analysis, you can expect real estate to be less volatile than the stock mar-
ket, consistent in its growth rate, and safer by far than other alternatives. In
some areas, prices have remained flat or even declined, so using national
averages is not a safe way to pick a market. You need to check the region-
al trend to ensure that real estate in your town represents a viable invest-
ment. In areas where employment is strong and the population is growing,
real estate values tend to grow as well.
Market value of property is only the first of two important “markets” in
real estate. The second market involves demand for rentals. What is the
average vacancy level? A very low vacancy rate is a positive sign, but a fluc-
tuating or high vacancy indicates that there is more supply than demand. If
that is the case, then the timing would not be good for investment, at least
not right in your city.
Key Point: These supply and demand features of real estate are going to vary
from one location to the next, often drastically. The next town over may have vast-
ly different real estate features, and even within one city, the supply and demand
can (and does) vary from one area to the next. It is essential to understand the
population, employment, market value, and vacancy trends—in advance of com-
mitting your money.
03LL-Ch01-03 7/21/04 3:01 PM Page 4
The Basic Equation
More details on these investigative ideas are covered in later chapters. As an

overview, however, this is an important starting point. The short-term mar-
ket attributes of rental property are going to affect how well you can afford
to invest money now. The whole market is likely to look different in a few
years, but you want to make sure you have a reasonable expectation of
keeping tenants in the property each month. The equation worth keeping in
mind is a balance between how much money you receive (in rent) and how
much you have to pay out (in mortgage payments and expenses). For that
equation to work, you want to keep the property occupied as consistently as
possible. Any time the property is vacant represents lost income, but your
mortgage payment continues from month to month.
A Landlord’s Point of View
The market for residential real estate is not difficult for most of us to under-
stand. Anyone who owns his or her own home knows all about mortgage
payments and the importance of being able to afford the house. Anyone who
has not yet bought his or her own home knows that landlords expect rent
to be paid on time. So the basic economics of real estate are familiar to
everyone and are not as mysterious as the market forces at work in other
markets, such as the stock market.
In evaluating investments, though, you need to look at properties from
a different perspective. When you are shopping for your primary residence,
you are interested in comfort features, condition, and size of the property.
As a landlord, you might be willing to invest in a property that would not
interest you as a primary residence, but that is ideally suited for rental pur-
poses.
Example: You have a growing family and need a house with several bedrooms
for your own use. However, you have discovered that relatively small houses
make excellent rentals. A two-bedroom house in modest condition is relative-
ly inexpensive compared to other types of properties, and easy to keep occu-
pied. A married couple or single person is drawn to such rentals and can afford
what you will need to ask in rent, so such properties are easier to keep occu-

pied than more expensive, larger homes would be.
In this example, your revaluation of the market would be made with
rental income and payments in mind, rather than from the point of view of
a homeowner. The investment attributes of your decision are going to be far
different from your personal requirements.
THE NATURE OF REAL ESTATE INVESTING
5
03LL-Ch01-03 7/21/04 3:01 PM Page 5
Key Point: When you search for investment properties, your criteria are far dif-
ferent from what they are for your primary residence—an important distinction to
keep in mind.
The real estate market has grown in value consistently over time. This
is a national average, of course, and all real estate is local. This means that
it is essential to understand the local features of supply and demand before
investing. You cannot depend on national averages or even on local trends
for the long term. If local property grows in value over fifteen or twenty
years in the future, that is a promising feature. At the same time, you need
to ensure that rental demand is strong right now, in order to cover your
mortgage payments. As you look for potential rental investments, you
should be interested in locating properties that are affordable, are most like-
ly to maintain value (and grow in value), and are appealing to likely tenants.
■ Reasons to Invest in Real Estate
There are many good reasons to buy real estate. Among the most important
reasons—assuming the local market conditions make it a viable choice—
are the following:
❒ Diversification and Asset Allocation. Sound investment requires spread-
ing capital over dissimilar investments. You would not want to put all of
your capital into a low-yielding savings account, or a single stock, or real
estate. You are better off diversifying your capital. You may wonder: If
real estate is sure to grow over time, why not put all of your money into

rentals? Diversification is important because different investments have
different attributes. The stock market is volatile and you can make
or lose money quickly; however, your money can be invested or taken
out quickly. Savings accounts are very safe but yield very little. Well-
selected real estate is going to increase in value over time, but it is very
difficult to get your money out if you need it for an emergency. You need
to diversify your capital so that you have some funds available as you
need them, some funds in very safe investments, and some in invest-
ments likely to grow over time.
A somewhat more sophisticated view of diversification is called asset
allocation. This is a strategic planning technique in which a portfolio is
spread among many different markets or segments. While diversification
usually refers to spreading risks within one market (e.g., buying many
different stocks), asset allocation is broader. For example, you may want
6
T HE L ANDLORD’ S F INANCIAL T OOL K IT
03LL-Ch01-03 7/21/04 3:01 PM Page 6
to have some money in ready-cash accounts as an emergency reserve
fund; other capital invested in stocks, whether owned directly or pur-
chased through a mutual fund; and yet more of your capital invested in
real estate. These three markets represent completely different markets,
and each is going to perform according to very different market forces.
Real estate is a superb market for asset allocation because of its strong
historic attributes. Your ability to allocate capital among dissimilar mar-
kets protects your capital from cyclical changes. In times when the stock
market is weak or falling, real estate may be strong. In fact, it is likely.
We have seen the offsetting effects of stocks and real estate time and
again. When investors want to take money out of the market, they will
normally turn to either money markets or real estate. Money markets or
savings accounts, for example, are not suitable alternatives if interest

rates are low. By contrast, real estate benefits from low interest rates, so
it is an excellent market for onetime stock investment capital.
Diversification within a single market, and asset allocation among many
different markets, are sensible portfolio management techniques. Real
estate is a good fit for strategic asset allocation. It is different from the
money market, however. Investors wanting to get out of stocks for the
moment, but who plan to go back in a few months later, may park cap-
ital in an interest-bearing account and move it around without charge.
Real estate is a longer-term investment, though. So if you plan to employ
real estate in your asset allocation plan, it should be treated as a longer-
term decision. You do not want to buy real estate in March and then look
to sell in June to put capital back in the stock market. That would be
expensive and, given closing-cost levels, a difficult move to make prof-
itably.
❒ Long-Term Growth. A second reason to buy real estate is for long-term
growth. You can expect real estate to increase in value over ten, twenty,
or thirty years. By holding property over that much time, you build
wealth for your own retirement, for college education expenses for your
children, or for more leisurely living later on. Individual goals dictate
how important it will be to accumulate wealth through real estate. Just
as different stock market investors will be drawn to short-term specula-
tion in some cases and long-term growth in others, your personal goals
and requirements will dictate how you use your investment capital. For
long-term growth, real estate has performed historically far above the
growth rates of other investments.
❒ Safety of Capital. Real estate is a safe place to invest your money because
it is well protected. You carry insurance to protect against losses from
THE NATURE OF REAL ESTATE INVESTING
7
03LL-Ch01-03 7/21/04 3:01 PM Page 7

fire and other catastrophes, so if such a loss does occur, you are pro-
tected. Maintaining condition also protects long-term value, so you must
keep an eye on your property on a regular basis, ensuring that tenants
are caring for the yard and building and not trashing the house. Land
values continue to rise in areas with a healthy economy. As long as your
local population continues to grow and jobs are available, you have every
reason to expect property values to climb steadily. This growth further
ensures the safety of your capital. If land values are not rising, your cap-
ital loses buying power because it is eroded by inflation. Well-selected
real estate also offsets inflation.
❒ Tax Benefits. Real estate may be thought of as the last remaining legal
tax shelter. You are allowed to deduct losses on your tax return (subject
to some limitations) whereas other investors are not. If you invest in
markets other than real estate, you usually are allowed to deduct losses
only to the extent that they offset other gains; the loss cannot be deduct-
ed from other income. If you have capital losses through stocks, your
annual losses are limited to only $3,000 per year under present rules, a
fairly small annual limit. With real estate, though, you can claim up to
$25,000 per year in losses in most situations. Because the computation
of profit and loss includes depreciation on your investment, it is often the
case that you can report a loss and, at the same time, be bringing in more
cash than you are paying out. So your paper loss is deductible, but your
cash flow is positive. No other investment can match these benefits.
Overall, the tax features of real estate make it attractive for many investors,
and the comparison to other investment choices is convincing.
❒ Cash Flow. With most investments, you place cash in someone else’s
care, then you receive dividends, interest, or capital gains. You are 100
percent invested and there is little or no question of cash flow. With real
estate, you usually make a down payment and finance the lion’s share of
the investment; so cash flow becomes critical. Most real estate investors

depend on rental income to cover their mortgage payment. The bad
news: If you do not keep the property rented every month, you have to
make the mortgage payment from your other funds. The good news: If
you keep the property occupied, then tenants’ rental payments are used
to make those mortgage payments. In this situation—and given no
unexpected extra expenses—the property pays for itself.
When you purchase properties at the right price for your local market,
and when rents are high enough to cover your mortgage payment, you
will have a positive cash flow. When you consider the tax benefits of
reporting losses (which are created because you are also allowed to
8
T HE L ANDLORD’ S F INANCIAL T OOL K IT
03LL-Ch01-03 7/21/04 3:01 PM Page 8
depreciate your rental property), it is possible to have positive cash flow
and, at the same time, a net tax loss. This seemingly contradictory situ-
ation is quite common. When the tax benefits from net losses with
depreciation create monthly tax savings, you can enjoy the best of both
worlds: having tax losses to deduct while you collect more cash than you
pay out.
❒ Leverage. Most individuals cannot afford to buy property outright and
pay cash, just as most homeowners cannot afford to pay for their own
homes all at once. One attribute of real estate investing is the need to
finance 70 percent or more of the purchase price in most cases. As a
strategic approach to investing, leverage is recognized as an important
and advantageous method to use. Leverage means employing a limited
amount of capital to purchase and control a greater value in investment.
You would not be likely to borrow money to buy stocks, because the
stock market is an uncertain and risky place. However, properly select-
ed and researched real estate is far less likely to lose market value. Not
only does real estate tend to grow in value over time when other eco-

nomic factors are positive; it is also insured through a fire insurance pol-
icy, and investors have direct control over the investment. Ownership in
stock is uncertain and less tangible; but given the features of locally
owned and managed real estate, leverage makes a lot of sense.
Weighing the Pros and Cons
The overall benefits to investing in real estate—combining growth, safety,
and tax features—make it a choice worthy of serious consideration. You
cannot expect this combination from any other investment. While cash
invested in real estate is difficult to take out (because it can be removed only
through refinancing in most cases), the overall benefits of real estate make
it worthwhile, especially if you balance your capital between real estate and
other areas.
Even with all of the long-term benefits of real estate investing, howev-
er, there are some problems you should expect to face as a landlord. The
need to borrow money to buy property is a significant risk, so you must be
prepared to live with debt. There can be unanticipated expenses, such as for
repairs, property tax hikes, or utility rate increases. Neighborhoods can
change for the worse, the local economy can fall apart, or a large employer
may close down or move away.
Another potential problem area involves dealing with tenants. The land-
lord-tenant relationship is usually amiable and fair. It is occasionally emo-
THE NATURE OF REAL ESTATE INVESTING
9
03LL-Ch01-03 7/21/04 3:01 PM Page 9
tional or illogical. As a landlord, you accept the risk that some tenants will
not be pleasant to work with. This is one feature of real estate that discour-
ages many people from proceeding. If your temperament is inappropriate
for dealing with tenants, then you should not buy real estate. At the same
time, if the risk of problems can be mitigated by checking references, and if
you are willing to go through those steps, then you will increase your

chances for a positive, enjoyable, and profitable experience.
Key Point: You should be aware of these potential problems, large and small,
before you get into real estate investing, but many people find that the positives
far outweigh the negatives.
■ The Importance of Tax Planning
The benefits of real estate are difficult to ignore, and they make a strong
case in support of including real estate in your portfolio. Equally important,
tax planning requires serious thought and continually looking ahead.
Anticipating potential tax-related problems in the future is always a neces-
sary move, not only in managing your investments, but generally as well.
Real estate investors need to plan. The obvious reason—to reduce current
year tax liabilities—is only one part of the larger picture. Of course, you
want to time decisions as much as possible to minimize taxes. The second
part has to be kept in mind as well: the limitation on annual deductions.
This comes in two forms: dollar amount and your income level.
Annual Dollar Limit
The dollar amount is set at $25,000. You can deduct that much per year as
long as your family income is at or below $100,000. If you are married but
separated, or if you are single, the dollar amount may be lower or it could
even disappear completely. So married couples living apart and contem-
plating divorce need to plan carefully to minimize the tax consequences of
divorce when real estate investments are involved.
In situations where you believe your tax losses will exceed $25,000, you
will have to carry the excess over to future years or to the time you sell your
investment property. You can do some planning. For example, you can defer
current-year expenses to next year to avoid spending money for deductions
you do not need. You can also extend the time you use to depreciate assets,
to reduce current-year expenses, and to move deductions to future years.
10
T HE L ANDLORD’ S F INANCIAL T OOL K IT

03LL-Ch01-03 7/21/04 3:01 PM Page 10
Income Level
The second consideration is your own income. If your annual adjusted
gross income, as calculated for real estate tax purposes, exceeds $100,000,
you lose 50 cents in deduction for each dollar above. For example, if your
income this year will be $110,000 your ceiling will be reduced by one-half
of the income above $100,000. So half of $10,000, or $5,000, is applied
against the ceiling of $25,000, and your maximum loss will be reduced to
$20,000 for the year.
Planning Point: Deferring payment of expenses or extending depreciation until
later years makes sense if you cannot take full advantage of those deductions
this year. Planning for tax purposes is an essential and important feature of
investing in real estate. If you are not thoroughly versed in tax law (including the
laws in your state), you should consult with a qualified tax expert and get assis-
tance in planning ahead for tax benefits or the consequences of decisions you
make throughout the year.
■ Your Credit and Real Estate Investing
One important consideration for every real estate investor is often over-
looked or not mentioned at all. That is the quality of your personal credit.
Because you will be borrowing money to buy rental properties, lenders will
be keenly interested in your credit standing.
Homeowners, even those with poor credit, can usually find a lender
willing to carry a loan. This is because owner-occupied property is very low
risk and lenders recognize this fact. In comparison, investment property
loans are more likely to be foreclosed. If the demand for rentals falls and
investors cannot meet their mortgage obligations, it is possible that the
investor will simply walk away from the investment. So lenders are sensitive
to the possibility of default on investment property mortgage loans. If an
investor’s credit is not impeccable, it will be more difficult to find loans.
With the higher-risk levels in mind, lenders require higher down payments

for investment property; and lenders may also require higher loan points
and other fees, just to offset their higher risks. The standards are higher,
and for good reason.
What the Lender Might Require
If your credit rating is less than perfect, you may have to meet a series of
extra requirements. These could include:
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❑ Higher down payment requirements, so that you have more invested
capital at stake, which in turn reduces the likelihood that you will just
walk away from the loan obligation if the costs of keeping the property
get too high
❑ Higher loan origination and other fees, charged to reduce the lender’s
risk of default on your part
❑ Closer scrutiny of financial information and more reporting than usual,
so that loan underwriters will be confident that the information you pro-
vide is accurate and complete
❑ More appraisal, inspection, and other outside fees, to ensure that the
property being financed does not have hidden maintenance costs or is
not overvalued
❑ A higher interest rate on the loan itself, due to the higher level of risk to
the lender
Income vs. Obligations
If your income is too low to qualify for the loan you seek, you will have to
put more money down or simply wait until your income level rises. You may
also need to start out with a less expensive property so that your income will
qualify you for the investment. While different lenders employ many varia-
tions of the basic strategy, they all look at the numbers in the same way.
They calculate your net monthly income (your take-home pay) and then

take a percentage of that as the maximum obligation they will accept for
your mortgage payment. (The “obligation” usually includes mortgage prin-
cipal and interest, property taxes, and insurance.) If the payment goes over
that level, the loan will be rejected in its present form. You may need to
reduce the obligation by making a larger down payment, for example.
When you fill out a loan application, you are required to estimate
monthly obligations as well as monthly rental income. A lender is probably
going to reduce the estimated income you report to allow for possible
vacancies. The degree of adjustment will depend on recent vacancy levels in
the area, a statistic that the lender will know or have access to. So your total
net income will include your take-home pay, any other income (e.g., from
dividends and interest), and rentals (adjusted downward for the vacancy
factor). The net total of this calculation is then multiplied by a specific per-
centage that the lender uses to qualify investment property mortgage loans.
If the total obligation exceeds the predetermined percentage of total
income, the lender will not approve the loan.
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Key Point: The review of your loan application will be much easier if your credit
is excellent. The better your credit, the easier it will be to find acceptable financ-
ing. For anyone with poor credit, the flexibility to finance properties, without con-
cern of being rejected, is going to be curtailed. That does not mean it will be
impossible to find a loan, but the loan is going to be more expensive and review
time is likely to be greater as well.
Getting Preapproval for Your Loan
Prospective first-time homeowners can find a lender to prequalify them.
Based on his or her income level and credit history, the borrower can find
out what level of home the lender can approve. The lender reveals the max-
imum loan it will grant based on the borrower’s financial information. The

preapproval is conditional, because the lender also wants to ensure that the
property being purchased is worth what the homeowner intends to pay and
that condition is acceptable for lending purposes. Preapproval of a mortgage
loan for investment purposes is not quite as easy. Because the equation
includes rental income, it will be impossible for the lender to assess the bor-
rower’s overall income and obligation without the specific property in mind.
You may be able to find a very conditional preapproval from a lender.
The qualifications will include the usual appraisal and condition standards,
but will also go beyond that to place a condition on acceptable rental income
after deducting an estimated vacancy factor. Assuming that the lender
would qualify you on the basis of a comparison between total income and
mortgage obligation, you may receive a type of preapproval when your cred-
it is not perfect. At least a lender may be willing to stipulate that your appli-
cation will be given serious consideration. Some lenders won’t go that far,
making it clear that they will not approve loans if your credit is poor,
regardless of property value and condition.
Poor credit is also the reason lenders are less likely to approve an equi-
ty line of credit. Most lenders limit lines of credit to primary residences,
although some allow borrowers to take Home Equity Line of Credit
(HELOC) contracts on rental properties—but as a rule, this exception will
be allowed only if the borrower’s credit is exceptional.
■ Maintaining Investment Perspective
In every type of investment, you have to keep your perspective. For exam-
ple, if you buy shares of stock because a stranger on an investment chat
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room tells you its price will go through the roof, you have no one but your-
self to blame if you lose money. If you invest because a stockbroker tells you
it’s a “good” investment and that turns out not to be true, then it means

your trust was misplaced.
The same cautionary warnings apply to real estate. Success in investing
is the result of thorough research; identification of sound, sensible invest-
ments in strong markets; and proper ongoing maintenance. (In the case of
stocks, you want to hold shares as long as value is rising and the funda-
mental strength is high, and then sell when conditions change. In the case
of real estate, maintenance means finding the best tenants and then keep-
ing an eye on the property.)
There are no easy ways to accumulate wealth. Yes, some people have
made fortunes in real estate by buying in the right place at the right time;
but it is also true that those people took risks and had to work to acquire
and maintain their properties. If you discover that you are simply not satis-
fied with your investments, you should sell and get out. For a stock investor,
this means selling the shares if you spend your nights lying awake and wor-
rying. For a real estate investor, you should not have to dread your tele-
phone ringing, fearing it is a tenant calling with a complaint. If you have to
fight every month to get your rent, or if you even worry about the possibil-
ity of such problems, then real estate is not right for you.
Risk Tolerance
Maintaining your perspective also has to include an ongoing evaluation of
long-term goals and your personal risk tolerance. Keeping real estate for
the long term should be coordinated with a specific idea that you have about
your reasons for wealth accumulation, matched with your expectations for
growth in real estate values (all on an after-tax basis, of course, because real
estate tax benefits are significant). Risk tolerance has three major aspects
when real estate is involved. These are:
1. Tenant Issues. The most important level of risk involves your relationship
with tenants. This is far more important than investment value or cash
flow. Even if your investment works well on paper, tenants can affect
your quality of life—especially if they are giving you trouble. If your

experiences are negative, then you have exceeded your risk tolerance.
The problem has to be fixed (which may be as easy as replacing a poor
tenant with a good one); otherwise, it makes no sense to keep the prop-
erties. In the end, the whole experience has to be enjoyable for you.
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