Real estate has produced many of the world’s wealthiest people, so there are plenty of reasons to think that property is a sound investment. However, experts agree, as with any investment, it's better to be well-versed before diving in with hundreds of thousands of dollars.
- Purchasing a rental property to earn income can be a risky venture.
- Similar to purchasing a home, buyers will usually need to secure at least 20% downpayment for the property.
- Being a landlord requires a wide range of skills, which could range from understanding basic tenant law to being able to fix a leaky faucet.
- Experts recommend having a financial cushion, in case you don't rent out the property, or if the rental income doesn't cover the full mortgage on the property.
Are You Comfortable Being a Landlord?
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 the handy type and don't have lots of spare cash, being a landlord may not be right for you.
Of course, that changes as you add more properties to your portfolio. Lawrence Pereira, president of King Harbor Wealth Management in Redondo Beach, Calif., owns properties on the East Coast while living on the West Coast. As somebody who says he's not at all handy, he makes it work. How? "I put together a solid team of cleaners, handymen, and contractors," says Pereira.
This isn't recommended for new investors, but as you get the hang of real estate investing you don’t have to remain local.
Pay Down Personal Debt Before You Purchase
Savvy investors might carry debt as part of their investment portfolio, but the average person should avoid it. If you have student loans, unpaid medical bills or children who will soon attend college, purchasing a rental property may not be the right move.
Pereira agrees that being cautious is key, saying, "It's not necessary to pay down debt if your return from your real estate is greater than the cost of debt. That is the calculation you need to make." Pereira suggests having a cash cushion. "Don't put yourself in a position where you lack the cash to make payments on your debt. Always have a margin of safety."
Secure a Down Payment
Investment properties generally require a larger down payment than owner-occupied properties, so they have more stringent approval requirements. The 3% you may have put down on the home you currently live in isn't going to work for an investment property. You will need at least 20%, given that mortgage insurance isn't available on rental properties.
Beware of High-Interest Rates
The cost of borrowing money might be relatively cheap as of 2020, but the interest rate on an investment property will be higher than traditional mortgage interest rates. Remember, you need a low mortgage payment that won't eat into your monthly profits too significantly.
Calculate Your Margins
Wall Street firms that buy distressed properties aim for returns of 5% to 7% because they have to pay staff. Individuals should set a goal of 10%. Estimate maintenance costs at 1% of the property value annually. Other costs include insurance, possible homeowners’ association fees, property taxes and monthly expenses such as pest control and landscaping. And then there's landlord insurance.
Avoid a Fixer-Upper
It’s tempting to look for the house that you can get at a bargain and flip into a rental property. However, 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 improvements—you're likely to pay too much to renovate. Instead, look to buy a home that is priced below the market and needs only minor repairs.
Calculate Operating Expenses
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.
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% return in your first year as a landlord is considered healthy, especially given that number should rise over time.
Buy 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 in an up-and-coming neighborhood. In addition, experts say to never buy the nicest house for sale on the block, ditto for the worst house on the block.
Find the Right Location
When choosing a profitable rental property you should look for a location with low property taxes, a decent school district, and plenty of amenities, such as parks, malls, restaurants and movie theaters nearby. In addition, a neighborhood with low crime rates and a growing job market may mean a larger pool of potential renters.
5 Simple Ways To Invest In Real Estate
Risk vs. Reward
Every financial decision is about weighing the rewards, determining payoff against potential risks. Does investing in real estate make sense for you?
- Your income is passive. Aside from the initial investment and upkeep costs, you can earn money while putting most of your time and energy into your regular job.
- Your income should grow. You don't just earn rental income; as real estate values increase, your investment rises in value.
- You can put real estate into a self-directed IRA.
- Rental income isn't included as part of your income 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 more stable than the stock market.
- Real estate is a physical asset. Investing in stocks or Wall Street products isn’t anything you can see or touch.
- Although rental income is passive, tenants can be a pain to deal with unless you use a property management company.
- If your adjusted gross income is above $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 the total mortgage payment.
- Unlike stocks, you can't instantly sell real estate if the markets go sour.
- Entry and exit costs can be high.
- If you don’t have a tenant, you have to pay for all the expenses.
The Bottom Line
Keep your expectations realistic. As with any investment, 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 test your landlord abilities.