Real estate has produced many of the world’s wealthy people, so there are plenty of reasons to think that property is a sound investment. But like any investment, it’s better to be well-versed in the space before diving in. Unlike purchasing stock, which may cost a dollar or two per share, you could easily pour six figures into your first property. Arm yourself with the information below before starting your new career as a real estate tycoon. (See Tips for the Prospective Landlord for additional information.)
1. Make Sure It’s for You
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, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money. If you’re not a “get your hands dirty” type and you don't have lots of spare cash, being a landlord may not be right for you. (See Becoming a Landlord: More Trouble Than It's Worth? for more insights.)
Your first property will take a lot of your time as you learn the ins and outs of being a landlord. Think of it as another part-time job. Do you have the time?
2. Pay Down Debt First
Savvy investors might carry debt as part of their investment portfolio, but the average person probably shouldn’t. If you have student loans, unpaid medical bills or your triplets will soon attend college, purchasing a rental property may not be the right move.
3. Got the Down Payment?
Investment properties generally require a larger down payment than an owner-occupied building and have more stringent approval requirements. The 3% you put down on the home you currently live in isn’t going to work for an investment property. How much will you need? At least 20%, given that mortgage insurance isn’t available on rental properties.
4. Beware of Higher Interest Rates
The cost of borrowing money might be cheap right now, but the interest rate on an investment property will be higher. Remember, you need a mortgage payment that’s low enough so that it won’t eat too heavily into your monthly profits.
5. Calculate Your Margins
The big Wall Street firms that buy distressed properties aim for 5% to 7% returns because they have to pay a staff. Individuals should set a goal of 10%. Estimate maintenance costs at 1% of the property value annually. There’s also insurance (see A Quick Guide To Landlord Insurance), HOA fees (if applicable), property taxes and monthly expenses such as pest control and landscaping.
6. Don’t Buy a Fixer-Upper
It’s tempting to look for the house that you can get at a bargain and flip it into a rental, but if this is your first property, that’s probably a bad idea. Unless you have a contractor who does quality work on the cheap – or you’re skilled at large-scale home improvement – you’re likely to pay too much to renovate. Instead, look to buy a home that is priced below the market that needs mostly minor repairs.
7. Calculate Operating Expenses...
Overall, 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%. (See why paying a mortgage could wipe out your profits?) 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.
8. ...And “Cash on Cash”
For every dollar 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%. If you can get 6% in your first year as a landlord, that’s probably a win since that number should rise over time.
9. Get a Low-Cost Home
The more expensive the home, the higher your ongoing expenses will be. Some experts recommend starting with a $150,000 home.
10. Find the Right Location
Look for low property taxes, a decent school district, a neighborhood with low crime rates, an area with a growing job market and plenty of amenities, such as parks, malls, restaurants and movie theaters. See Top 10 Features of a Profitable Rental Property and How To Rate a Neighborhood When Buying a Home for more.
The Bottom Line
Keep your expectations realistic. Like any investment, a rental property isn’t going to produce a large monthly paycheck for a while and picking the wrong property could be a catastrophic mistake. Consider working with an experienced partner on your first property or rent out your own home to get your feet wet. For more, see 5 Common Problems of Buying a House with a Friend and The Pros & Cons Of Owning Rental Property.