Thinking about purchasing 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. However, experts agree, as with any investment, it's better to be well-versed before diving in with hundreds of thousands of dollars. Here are the things you should consider and investigate.

Key Takeaways

  • Purchasing an investment property to earn rental income can be a risky venture. 
  • Similar to purchasing a home, buyers will usually need to secure at least a 20% down payment 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.

1. Consider Your Comfort Level with 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.

Of course, that changes as you add more properties to your portfolio. Lawrence Pereira, president of King Harbor Wealth Management in Redondo Beach, Calif., lives on the West Coast but owns properties on the East Coast. As someone 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 advisable for new investors, but as you get the hang of real estate investing you don't have to remain local.

If you're not the handy type and don't have lots of spare cash, being a landlord may not be right for you.

2. Pay Down Personal Debt

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."

3. Secure a Down Payment

Investment properties generally require a larger down payment than owner-occupied properties; they have more stringent approval requirements. The 3% you may have put down on the home where you currently 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 available on rental properties. You may be able to obtain the down payment through bank financing, such as a personal loan.

4. Find the Right Location

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 potentially represents an investment opportunity.

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. In addition, a neighborhood with low crime rates and a growing job market may mean a larger pool of potential renters.

5. Compare Buying with Financing

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.

On the other hand, financing can give you a greater return. For an investor who puts down 20% on a house, with compounding at 4% on the mortgage, after taking out operating expenses and additional interest, the earnings add up to roughly $5,580 per year. Cash flow is lower for the investor, but their annual return on investment is 27.9% versus 9.5% for the cash buyer.

6. Beware of High Interest Rates

The cost of borrowing money might be relatively cheap in 2020, but the interest rate on an investment property will be higher than traditional mortgage interest rates. If you do decide to finance your purchase, you need a low mortgage payment that won't eat into your monthly profits too significantly.

7. 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 homeowners insurance, possible homeowners' association fees, property taxes, and monthly expenses such as pest control and landscaping.

8. Invest in Landlord Insurance

Protect your new investment: In addition to homeowners insurance, consider purchasing landlord insurance. This type of insurance generally covers property damage, lost rental income, and liability protection, in case a tenant or a visitor suffers injury due to a property maintenance issue.

To lower your costs, investigate whether an insurance provider will let you bundle landlord insurance with a homeowners insurance policy.

9. Factor In Unexpected Costs

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 due to a hurricane, for instance, or burst pipes that destroy a kitchen floor. Plan to set aside 20% to 30% of your rental income for all of these costs so you have a fund to pay for timely repairs.

10. 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.

11. 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.

12. 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.

13. 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 advise never to buy the nicest house for sale on the block, ditto for the worst house on the block.

14. Know Your Legal Obligations

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.

15. Weigh the Risks vs. the Rewards

Every financial decision is about weighing the rewards, determining the payoff against potential risks. Does investing in real estate make sense for you?

Rewards:

  • 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; if 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.

Risks:

  • 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 (AGI) 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 or you need cash.
  • Entry and exit costs can be high.
  • If you don’t have a tenant, you have to pay 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.