If you’re mulling over investing in a rental property, you’re not alone. Real estate has produced many of the world’s wealthiest individuals, so there are plenty of reasons to think it is a sound investment. Experts agree, however, that it’s better to be well-versed before diving in with hundreds of thousands of dollars as with any investment. Here are some factors and challenges you should consider before putting in an offer on your first rental property.
Decide If You’re Cut Out to Be a Landlord
Do you have the know-how to replace a faucet or repair drywall? How about unclogging a toilet or clearing a clogged drain? Of course, you can always call somebody to do it for you or hire a property manager, but both options will take away from your profits. Property owners who own one or two homes often do their own repairs to save money.
Pay Down Personal Debt
Savvy investors might carry debt as part of their investment portfolio, however, the average person should avoid it. If you have student loans, unpaid medical bills, or children who will attend college soon, purchasing a rental property may not be the right move for now.
Secure a 20% (or Larger) Down Payment
Investment properties generally require a larger down payment than owner-occupied properties do; they have more stringent approval requirements. Whereas the 3% you may have put down on the home where you currently live wouldn’t be sufficient for an investment property. Instead, it will require a 20% down payment, as mortgage insurance isn’t available on rental properties. You can still obtain down payment through bank financing, such as a personal loan.
Find the Right Location
When picking a rental property, seek a place with a low property tax, a decent school district, and plenty of amenities, such as restaurants, coffee shops, shopping, trails, and parks. In addition, choose a neighborhood with a low crime rate, easy access to public transportation, and a growing job market to increase the pool of potential renters.
Should You Buy or Finance?
Is it better to buy with cash or credit for your investment property? That depends on your investing goals. Paying in cash can help generate positive monthly cash flow. Take a rental property that costs $100,000 to buy. With rental income, taxes, depreciation, and tax, the cash buyer could see $9,500 in annual earnings—or a 9.5% annual return on the $100,000 investment.
Beware of High-Interest Rates
The cost of borrowing money might be reasonably cheap in 2021, but the interest rate on an investment property is normally 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 much.
Calculate Your Margins
Wall Street firms that purchase distressed properties aim for returns of 5% to 7% because 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 and repair expenses.
Factor in Unexpected Costs
While most rental costs are predictable, such as maintenance and upkeep costs, there is always the potential for an unexpected expense to crop up—roof damage from a hurricane, for instance, or burst pipes that destroy a kitchen floor. Plan to set aside twenty percent to thirty percent of your rental income for these types of costs so you have a fund to pay for timely repairs.
Avoid a Fixer-Upper
It’s always tempting to look for the home that you can acquire at a bargain, and then flip it into a rental property. However, if this is your first property, that’s likely a bad idea. Unless you have a contractor who does quality work on the cheap—or you are skilled at large-scale home improvements—you likely would pay too much to renovate. Instead, look for a home that is priced below the market and needs only minor repairs.
Calculate Operating Expenses
Operating expenses on new property will be between 35% and 80% of your gross operating income. If you charge $1,500 for rent and your expenses amount to $600 per month, you’re at 40% for operating expenses. For an even more favorable calculation, use the 50% rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total operating expenses.
Determine Your Return
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% annual return in your first year as a landlord is considered healthy, especially because that number should rise over time.
Buy a Low-Cost Home
When purchasing a home, one’s ongoing expenses will be directly dependent upon the value of that home. Many experts recommend starting with a $150,000 to $200,000 home in a rejuvenating neighborhood. In addition, experts advise never to buy the nicest house for sale on the block—and ditto for the worst house on the block.
Is buying a condo a good investment?
Condos can be a great option for real estate investors as they tend to be more affordable than comparable single-family homes, and they are often located in desirable locations (think: at the beach or a ski resort). Additionally, condos often have lighter maintenance demands because owners are not responsible for taking care of the grounds or the building’s exterior.
Know Your Legal Obligations
Owning rental property requires knowledge of the rental laws for your state and locale. For example, it’s important to know your landlords’ obligations regarding security deposits, lease requirements, eviction rules, fair housing, and more to avoid legal hassles.