Thinking about purchasing an investment property? Purchasing rental real estate requires knowledge of leasing, mortgage loans, tenant and landlord relationships, and property management. Buying real estate can be lucrative but, just like any investment, comes with benefits and challenges.
- Rental property investors usually need a 15-25% down payment for a rental property mortgage.
- A landlord requires a broad array of skills, from understanding basic tenant law to fixing a leaky faucet.
- A passive investor is hands-off and may opt to pay for the services of a property manager or invest in real estate investment trusts (REITs).
- Full-time investors spend a significant amount of time choosing houses and fixing them up to sell or rent.
- Investment rental properties may include vacation homes, multi-family homes, or single-family homes.
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So You Want to Be a Landlord?
Buying investment property and acting as a landlord can be a good way to earn income, but requires a commitment of time and money. After choosing the right property, prepping the unit, and finding reliable tenants, ongoing maintenance is required.
Maintenance and upkeep costs can decrease your rental income. There's always the potential for an emergency, such as roof damage. Investors should plan to set aside 1% of their property's value for repairs.
Rental property owners can manage the property themselves or hire a property manager, who typically charges between 8% and 12% of collected rents. Although costly, a property manager can provide a wide range of services including arranging maintenance and repair work, screening new tenants, and handling late rent payments.
Additionally, rental property owners need to know the landlord-tenant laws in their state and locale. Both tenants and landlords have rights and obligations regarding security deposits, lease requirements, eviction rules, and fair housing laws.
It is important to protect a real estate investment. In addition to homeowners insurance, rental property owners can purchase landlord insurance, which covers property damage, lost rental income, and liability protection in case a tenant or a visitor suffers an injury as a result of property maintenance issues.
Buying a Rental Property
Location, Location, Location
A city or locale where the population is growing and a revitalization plan is underway often represents a potential investment opportunity. A neighborhood with a low crime rate, easy access to public transportation, and a growing job market may also mean a larger pool of renters.
When choosing a profitable rental property, look for a location with low property taxes, a good school district, and a host of amenities, such as restaurants, coffee shops, shopping, trails, and parks.
Online real estate property sites like Zillow.com provide information for investors including home rental rates and current investment property values. Airbnb.com provides investors with information on the going rental rates for vacation homes or condos.
Financing Your Rental Property
The path to obtaining a rental property loan is the same as a primary residence mortgage, with key differences. With higher rates of default on rental property loans, the added risk means lenders typically charge higher interest rates on rental properties. An investor may choose a traditional mortgage loan or may qualify for an FHA loan or a VA loan.
Underwriting standards can be stricter for rental property applicants. Mortgage lenders focus on credit score, down payment, and debt-to-income ratio and though the same factors apply to rental property mortgages, the borrower will likely be held to a more stringent credit score, DTI thresholds, and a higher minimum down payment:
- Credit score: A minimum score of 620, with better rates and terms offered with scores of 740 and higher.
- Down payment: 0-3% may be acceptable on a conventional mortgage for a primary residence, but borrowers for investment real estate generally have to plan on 15% to 25% down.
- Debt-to-income ratio (DTI): DTI represents the percentage of the borrower's monthly income that goes toward debt. Lenders will generally allow you to count up to 75% of your expected rental income toward your DTI.
- Savings: Borrowers should have cash available to cover three to six months of mortgage payments, including principal, interest, taxes, and insurance.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Is it better to buy with cash or to finance an investment property? That depends on an investor's goals and savings. Paying cash for an investment property may not be an option for many investors but can generate positive monthly cash flow immediately.
Making Money in Rentals
Operating expenses on a new rental property will be between 35% and 80% of your gross operating income. If the monthly rent charged is $1,500 expenses are $600 per month, that's 40% for operating expenses. Many investors use the 50% rule. If the rent is $2,000 per month, expect to pay $1,000 in total expenses.
To lower your costs, investigate whether an insurance provider will let you bundle landlord insurance with a homeowners insurance policy.
Wall Street firms that buy distressed properties aim for returns of 5% to 7%. Individuals should set a goal of a 10% return. Estimate maintenance costs at 1% of the property value annually. Other costs include homeowners insurance, homeowners association fees (HOA), property taxes, and monthly expenses such as pest control, landscaping, and maintenance.
While stocks may offer a 7.5% cash-on-cash return, or bonds may pay 4.5%, a 6% return in the first year as a landlord on an investment property is considered healthy and that number should rise over time.
Rental property investors calculate their return on investment as ROI = (Annual Rental Income - Annual Operating Costs) ÷ Mortgage Value
Some real estate investors choose to flip houses by purchasing a house for a below-the-market rate, making repairs, and then reselling it for a high return. There may or may not be tenants during a "flip" and investors must consider key factors like affordable materials and labor.
Risks and Rewards of Rental Property
Income is passive and investors earn while working a regular job.
If real estate values increase, the investment rises too.
Rental income is not subject to Social Security tax.
The interest you pay on an investment property loan may be tax-deductible.
Real estate is a tangible physical asset.
Maintenance costs or property management expenses can decrease rental income.
Monthly rental income may not cover the total monthly mortgage loan payment.
Real estate is not a liquid asset and takes time to sell.
Entry and exit costs can be high.
If a tenant moves out, a landlord still has to pay the monthly expenses.
Should I Find a Real Estate Investing Partner?
A real estate partnership helps finance the deal in exchange for a share of the profits.
Instead, you can ask your network of family and friends, find a local real estate investment club, consider real estate crowdfunding, or search for social media groups that target real estate investors.
How Much Down Payment Do You Need to Buy Investment Property?
Lenders typically have stricter guidelines when it comes to rental properties. Though you can buy a primary home with as little as 3% down, most borrowers need to put down 15% to 20% to buy a rental property.
Should I Invest in a Condo?
Condos are often less expensive than single-family homes, and they have fewer maintenance requirements. However, ongoing association dues and the potential for expensive special assessments are a risk. It is important to investigate the financial health of the homeowners association and the current condition of the overall building and the individual unit.
Condos can be a good option for rental property buyers and they are often located in desirable locations.
The Bottom Line
As with many investments, real estate rental property is often a long-term project. Yet, rental properties can be a lucrative way to invest in real estate and provide a passive, steady income for investors. Investing in rental property requires knowledge about tenant and landlord laws, leasing, mortgages, and property management.