Thinking about purchasing an investment property? Real estate has produced many of the world's wealthiest people, so there are plenty of reasons to think that it is a sound investment. Experts agree, however, it's better to be well-versed before diving in with hundreds of thousands of dollars. Here are the factors and challenges you should consider before buying your first rental property.
Being a landlord can be a good way to earn real estate income, but it's not easy or glamorous. In addition to choosing the right property, prepping the unit, and finding reliable tenants, there are always maintenance hassles and headaches.
Do you know your way around a toolbox? How are you at repairing drywall or unclogging a toilet? Sure, you could call somebody to do it for you or you could hire a property manager, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money. Of course, that changes as you add more properties to your portfolio.
Investment properties generally require a larger down payment than owner-occupied properties do; they have more stringent approval requirements. The 3% you may have put down on the home where you are going to live isn't going to work for an investment property. You will need at least a 20% down payment, given that mortgage insurance isn't generally available on rental properties. You may, however, be able to refinance your owner-occupied property to obtain the down payment.
The last thing you want is to be stuck with a rental property in an area that is declining rather than stable or picking up steam. A city or locale where the population is growing and a revitalization plan is underway represents a potential investment opportunity.
When choosing a profitable rental property, look for a location with low property taxes, a decent school district, and plenty of amenities, such as restaurants, coffee shops, shopping, trails, and parks. In addition, a neighborhood with a low crime rate, easy access to public transportation, and a growing job market may mean a larger pool of potential renters.
Is it better to buy with cash or to finance your investment property? That depends on your investing goals. Paying cash can help generate positive monthly cash flow. Take a rental property that costs $100,000 to buy. With rental income, taxes, depreciation, and income tax, the cash buyer could see $9,500 in annual earnings—or a 9.5% annual return on the $100,000 investment.
On the other hand, financing can get you a greater return. For example, say an investor puts down 20% on a house, with an interest rate of 4% on the mortgage. After taking out operating expenses, the earnings add up to roughly $5,580 per year. Cash flow is lower for the investor, but a 27.9% annual return on the $20,000 investment is much higher than the 9.5% earned by the cash buyer.
Though a rental property mortgage is basically the same as a primary residence mortgage, there are some key differences. For starters, there are higher rates of default on rental property loans because borrowers facing financial troubles tend to focus on a primary home's mortgage first. The added risk means lenders typically charge higher interest rates on rental properties.
Then there are the underwriting standards, which tend to be stricter for rental properties. In general, mortgage lenders focus on the borrower's credit score, down payment, and debt-to-income ratio. The same factors apply to rental property mortgages, but the borrower will likely be held to more stringent credit score and DTI thresholds—and a higher minimum down payment. Additionally, the lender may take a closer look at the borrower's employment history and income and want to see prior experience as a landlord.
In general, here's what lenders require from borrowers to approve a rental property mortgage:
Credit score: A minimum score of 620, with better rates and terms offered with credit scores of 740 and higher.
Down payment: It's possible to put down as little as 3% on a conventional mortgage for a primary residence, but borrowers must pay private mortgage insurance (PMI) if the down payment is less than 20%. PMI doesn't apply to rental property mortgages, so borrowers generally have to put down at least 15% to 20% down.
Debt-to-income ratio (DTI): DTI represents the percentage of the borrower's monthly income that goes toward paying off debt. Though limits are more flexible for primary residence mortgages, borrowers should have a DTI that falls between 36% and 45% to qualify for a rental property mortgage.
Savings: In addition to showing a favorable debt-to-income ratio, borrowers should also have enough money in the bank to cover three to six months of mortgage payments, including principal, interest, taxes, and insurance.
The cost of borrowing money might be relatively cheap in today, but the interest rate on an investment property is generally higher than it is for a traditional mortgage. If you do decide to finance your purchase, you need a low mortgage payment that won't eat into your monthly profits too much.
Wall Street firms that buy distressed properties aim for returns of 5% to 7% because, among other expenses, they need to pay staff. Individuals should set a goal of a 10% return. Estimate maintenance costs at 1% of the property value annually. Other costs include homeowners insurance, possible homeowners association fees, property taxes, monthly expenses such as pest control, and landscaping, along with regular maintenance expenses for repairs.
Protect your new investment: In addition to homeowners insurance, rental property owners should always purchase landlord insurance. This type of insurance generally covers property damage, lost rental income, and liability protection—in case a tenant or a visitor suffers an injury because of property maintenance issues.
Keep in mind that standard homeowners insurance policies may not cover losses incurred while the home is rented out. Contact your insurance agent to make sure you are adequately insured.
It's not just maintenance and upkeep costs that will eat into your rental income. There's always the potential for an emergency to crop up—roof damage from a hurricane, for instance, or burst pipes that destroy a kitchen floor. Plan to set aside 20% to 30% of your rental income for these types of costs so you have a fund to pay for timely repairs.
Operating expenses on your new property will be between 35% and 80% of your gross operating income. If you charge $1,500 for rent and your expenses come in at $600 per month, you're at 40% for operating expenses. For an even easier calculation, use the 50% rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total expenses.
For every dollar that you invest, what is your return on that dollar? Stocks may offer a 7.5% cash-on-cash return, while bonds may pay 4.5%. A 6% return in your first year as a landlord is considered healthy, especially because that number should rise over time.
Rental owners need to be familiar with the landlord-tenant laws in their state and locale. It's important to understand, for example, your tenants' rights and your obligations regarding security deposits, lease requirements, eviction rules, fair housing, and more in order to avoid legal hassles.
Rental property owners can manage the property themselves or hire a property manager. It can be a hard decision to make because property managers typically charge between 8% and 12% of collected rents, which can really eat into profits.
Still, hiring an experienced property manager can be well worth the cost. After all, it means less work and fewer headaches for you, as you take advantage of their industry expertise. In general, a property manager will:
Know how to market the property
Understand the local rental market and ensure you price the rental accordingly
Show the property to potential tenants (so you don't have to)
Screen tenants (for example, conduct credit checks and verify references)
Collect rent on your behalf and deposit the money into your bank account
Handle late rents and navigate the eviction process
Handle tenant complaints
Arrange maintenance and repair work
Pay property-related bills, such as property taxes, utilities, and insurance
To decide if hiring a property manager makes financial sense for you, ask yourself these questions:
Do I have time to manage the property myself? If you have another full-time job, you likely won't have the time or energy to manage a property on your own. This is especially true if you own multiple properties.
How close is the rental property to my home? Being far away from the rental takes more time out of your day and makes it more difficult to manage routine and urgent issues.
Am I willing to deal with tenants? Even if you do a good job of screening, it's likely you'll have to deal with unreasonable tenants, late rents, and evictions at some point. Is that something you're willing to do?
Is my rental property for short-term or long-term tenants? It might be easier to self-manage if you are looking for long-term renters. But if it's a short-term rental (for example, an Airbnb), you will be dealing with many different tenants—and potentially a lot of complaints and maintenance issues.
Do you need to be in control? If you will have a hard time handing over responsibilities such as choosing tenants and performing maintenance tasks, you may be better off managing the property yourself.
In every financial decision, you must determine if the payoff is worth the potential risks involved. Does investing in real estate make sense for you?
Because your income is passive, notwithstanding the initial investment and upkeep costs, you can earn money while putting most of your time and energy into your regular job.
If real estate values increase, your investment also will rise in value.
You can put real estate into a self-directed IRA (SDIRA)
Rental income is not included as part of your income that's subject to Social Security tax.
The interest you pay on an investment property loan is tax-deductible.
Short of another crisis, real estate values are generally more stable than the stock market.
Unlike investing in stocks or other financial products that you cannot see or touch, real estate is a tangible physical asset.
Although rental income is passive, tenants can be a pain to deal with unless you use a property management company.
If your gross adjusted gross income (AGI) is more than $200,000 (single) or $250,000 (married filing jointly), you may be subject to a 3.8% surtax on net investment income, including rental income.
Rental income may not cover your total mortgage payment.
Unlike stocks, you can't instantly sell real estate if the markets go sour or you need cash.
Entry and exit costs can be high.
If you don’t have a tenant, you still need to pay all the expenses.
Be realistic in your expectations. As with any investment, rental property isn't going to produce a large monthly paycheck right away, and picking the wrong property could be a catastrophic mistake. Still, rental properties can be a lucrative way to invest in real estate. For your first rental property, consider working with an experienced partner. Or, rent out your own home for a period to test your proclivity for being a landlord.