Looking to purchase and profit from a residential rental property? From the first decision to get into the landlord biz to actually buying a building, the idea may be daunting for the first-time investor. Real estate is a tough business and the field is peppered with land mines that can obliterate your returns. Let's examine the things you should consider when shopping for an income property.
Starting Your Search
Although you may want a real estate agent to help you complete the purchase, you should start searching for a property on your own. Having an agent can bring unnecessary pressure to buy before you have found an investment that suits you. The most important thing is to take an unbiased approach to all the properties and neighborhoods within your investing range.
Your investing range will be limited by whether you intend to actively manage the property or hire someone else to manage it. If you intend to actively manage, you should not get a property that's too far away from where you live. If you are going to get a property management company to look after it for you, proximity will be less of an issue.
Let's take a look at the top 10 things you should consider when searching for the right rental property.
1. Neighborhood. The quality of the neighborhood in which you buy will influence both the types of tenants you attract and your vacancy rate. For example, if you buy in a neighborhood near a university, the chances are that your pool of potential tenants will be mainly made up of students and that you will face vacancies on a fairly regular basis (i.e., during summer). Be aware that some municipalities attempt to discourage turning homes into rentals in some 'hoods by imposing exorbitant permit fees and various bureaucratic red tape.
2. Property Taxes. Property taxes are not uniform across an area and, as an investor planning to make money from rent, you want to be aware of how much you will be losing to them. High property taxes may not always be a bad thing if the neighborhood is an excellent place for long-term tenants, but the two do not necessarily go hand in hand. The municipality's assessment office will have all the tax information on file or you can talk to homeowners within the community. It is also wise to consider the likelihood of property tax hikes in coming years. A town in financial distress may hike taxes far beyond what a landlord can realistically charge in rent.
3. Schools. If you're dealing with family-sized accommodations, you need a consider the quality of local educational facilities. If a property is good, but the nearby schools are poor or non-existent, it can affect the value of your investment. Although you will be mostly concerned about the monthly cash flow, the overall value of your rental property comes in to play when you eventually sell it.
4. Crime. No one wants to live next door to a hot spot for criminal activity. Go to the police or the public library for accurate crime statistics for various neighborhoods, rather than asking the owner who is hoping to sell the property to you. Items to look for are vandalism rates, serious crimes, petty crimes and recent activity (either up or down). You might also want to ask about the frequency of a police presence in your neighborhood.
5. Job Market. Locations with growing employment opportunities tend to attract more people – meaning more tenants. To find out how a particular area rates, go directly to the U.S. Bureau of Labor Statistics or to your local library. If you notice an announcement for a new major company moving to the area, you can rest assured that workers will flock to the area. However, this may cause house prices to react (either negatively or positively) depending on the corporation moving in. The fallback point here is that if you would like the new corporation in your backyard, your renters probably will too.
6. Amenities. Check the potential neighborhood for current or projected parks, malls, gyms, movie theaters, public transport hubs and all the other perks that attract renters. Cities, and sometimes even particular areas of a city, have loads of promotional literature that will give you an idea of where the best blend of public amenities and private property can be found.
7. Future Development. The municipal planning department will have information on all the new development that is coming or has been zoned into the area. If there are many new apartment buildings, business parks or malls going up, it is probably a good growth area. However, watch out for new developments that could hurt the price of surrounding properties by, for example, causing the loss of an activity-friendly green space. Additional new housing could also provide competition for your property.
8. Number of Listings and Vacancies. If there is an unusually high number of listings for one particular neighborhood, this can either signal a seasonal cycle or a neighborhood that has "gone bad." Make sure you figure out which it is before you buy in. You should also determine whether you can cover for any seasonal fluctuations in vacancies. Similar to listings, the vacancy rates will give you an idea of how successful you will be at attracting tenants. High vacancy rates force landlords to lower rents in order to attract tenants. Low vacancy rates allow landlords to raise rental rates.
9. Rents. Rental income will be the bread-and-butter of your rental property, so you need to know what the average rent in the area is. If charging the average rent is not going to be enough to cover your mortgage payment, taxes and other expenses, then you have to keep looking. Be sure to research the area well enough to gauge where the area will be headed in the next five years. If you can afford the area now, but major improvements are in store and property taxes are expected to increase, then what could be affordable today may mean bankruptcy later.
10. Natural Disasters. Insurance is another expense that you will have to subtract from your returns, so it is good to know just how much you will need to carry. If an area is prone to earthquakes or flooding, paying for the extra coverage can eat away at your rental income.
Talk to renters as well as homeowners in the neighborhood. Renters will be far more honest about the negative aspects of the area because they have no investment in it. If you are set on a particular neighborhood, try to visit it at different times on different days of the week to see your future neighbors in action.
The Physical Property
In general, the best investment property for beginners is a single-family dwelling or a condominium. Condos are low maintenance because the condo association is there to help with many of the external repairs, leaving you to worry only about the interior. Because condos are not truly independent living units, however, they tend to garner lower rents and appreciate more slowly than single-family homes.
Single-family homes tend to attract longer-term renters. Families or couples are generally better tenants than singles because they are more likely to be financially stable and pay the rent regularly. As a landlord, you want to find a property and a neighborhood that is going to attract that type of demographic.
When you have the neighborhood narrowed down, look for a property that has appreciation potential and a good projected cash flow. Check out properties that are more expensive than you can afford as well as those within your reach – real estate can often sell below its listing price. Watch the listing prices of other properties and ask buyers about the final selling price to get an idea of what the market value really is in the neighborhood. For appreciation potential, you are looking for a property that, with a few cosmetic changes and some renovations, will attract tenants who are willing to pay higher rents. This will also serve you well by raising the value of the property if you choose to sell it after a few years.
Of course, a key step in ensuring a profitable endeavor is to buy a reasonably priced property. The recommendation for rental property is to not pay more than 12 times the annual rent you can expect to get. So how is the potential rent determined? You are going to have to make an informed guess. Take the average rent for the neighborhood and subtract your expected monthly mortgage payment, property taxes (divided by 12 months), insurance costs (also divided by 12) and a generous allowance for maintenance and repairs. Don't get carried away with overly optimistic assumptions; setting the rent too high and ending up with an empty unit for several months chips away at the overall profit in a hurry.
In contrast, don't underestimate the cost of maintenance and repairs. These costs depend on the age of the property, the tenants and how much you plan to do yourself. A newer building probably will require less than an older one. An apartment located in a complex for seniors is unlikely to be subjected to the same amount of damage as a residence-turned-frat house.
Doing your own repairs cuts down the cost considerably, but it also means being on call 24/7 for emergencies. Another option is to hire a property management firm. The firm handles everything from broken toilets to collecting rent each month but it comes at a price; expect to pay about 10% of the gross rental income for this service.
If all these figures come out even or, better yet, with a little left over, you can now get your real estate agent to submit an offer and, if everything goes well, order business cards with Landlord emblazoned across the top.
Making the Purchase
Banks have considerably tougher demands for giving loans for investment property than for primary residences. They figure that, if times get tough, people are less inclined to sell and leave their homes, whereas they'd have much less emotional attachment to a business property. Be prepared to pay at least 20% to 30% for a down payment plus the usual closing costs. It is also important to have the property thoroughly inspected by a professional and to have a lawyer review everything before signing.
Make sure you get the best mortgage rate if you're going to have to finance your purchase. And don't forget homeowners' insurance: Renter's insurance only covers a tenant's belongings; the building itself is the landlord's responsibility, and that insurance may be more expensive for a similar owner-occupied home. The property's mortgage, insurance and depreciation are all tax-deductible (up to a certain amount).
The Bottom Line
Every state has good cities, every city has good neighborhoods and every neighborhood has good properties, but it takes a lot of footwork and research to line up all three. When you do find your ideal rental property, keep your expectations realistic and make sure that your own finances are in a healthy enough state that you can wait for the property to start generating cash, rather than needing it desperately. Real estate investing doesn't start with buying a rental property – it begins with creating the financial situation that makes it feasible buy one.