Are you looking to purchase a residential rental property? The idea can be daunting for a first-time investor. Real estate is a tough business and the field is peppered with land mines that can obliterate your returns. Here are the most important things to consider while shopping for an income property.
Starting Your Search
You may want a real estate agent to help you complete the purchase, but you should start searching for a property on your own. An agent can bring unnecessary pressure on you to buy before you have found an investment that suits you best. And finding that investment is going to take some sleuthing skills and some shoe leather.
- Thoroughly check out the neighborhood. Its liveability and amenities are key.
- Is the neighborhood vacancy rate high? That's not a good sign.
- Check out local selling prices to get a sense of local market value.
- Find out the average rent in the area and work from there to determine if it's financially feasible.
Your 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 don't want a property that's too far from where you live. If you are going to get a property management company to look after it, proximity is 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 neighborhood in which you buy will determine the types of tenants you attract and your vacancy rate. If you buy near a university, the chances are that students will dominate your pool of potential tenants and you will struggle to fill vacancies every summer. Also be aware that some towns attempt to discourage rental conversions by imposing exorbitant permit fees and piling on the red tape.
2. Property Taxes. Property taxes are likely to vary widely across your target area, and you want to be aware of how much you will be losing to them. High property taxes are not always a bad thing in a great neighborhood that attracts long-term tenants, but there are lousy places with high taxes, too. The municipality's assessment office will have all the tax information on file, or you can talk to homeowners in the community. It is also wise to find out if property tax increases are likely in the near future. 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 homes, consider the quality of the local schools. Although you will be mostly concerned about the monthly cash flow, the overall value of your rental property comes into play when you eventually sell it. If there are no good schools nearby, it can affect the value of your investment.
4. Crime. No one wants to live next door to a hot spot for criminal activity. The local police or public library should have accurate crime statistics for neighborhoods. Check the rates for vandalism, serious crimes, and petty crimes, and note if criminal activity is moving 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 attract more tenants. To find out how an area rates for job availability, check with the U.S. Bureau of Labor Statistics or go to a local library. If you see an announcement about a major company moving to the area, you can be sure that workers in search of a place to live will flock to the area. This may cause house prices to go up or down, depending on the type of business moving in. You can assume that if you would like that company in your backyard, your renters will as well.
6. Amenities. Tour the neighborhood and check out the parks, restaurants, gyms, movie theaters, public transportation links, and all the other perks that attract renters. City Hall may have 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 new development that is coming or has been zoned into the area. If there is a lot of construction going on, it is probably a good growth area. Watch out for new developments that could hurt the price of surrounding properties. Additional new housing could also compete with your property.
8. Number of Listings and Vacancies. If a neighborhood has an unusually high number of listings, it can either signal a seasonal cycle or a neighborhood in decline. You need to find out which it is. In either case, high vacancy rates force landlords to lower rents to attract tenants. Low vacancy rates allow landlords to raise rental rates.
9. Average Rents. Rental income will be your bread-and-butter, so you need to know what the average rent in the area is. Make sure any property you consider will bear enough rent to cover your mortgage payment, taxes, and other expenses. Research the area well enough to gauge where it will be headed in the next five years. If you can afford the area now but taxes are expected to increase, an affordable property today may mean bankruptcy later.
10. Natural Disasters. Insurance is another expense that you will have to subtract from your returns, so you need to know just how much it's going to cost you. If an area is prone to earthquakes or flooding, coverage costs can eat away at your rental income.
Official sources are great, but talk to the neighbors to get the real scoop. Talk to renters as well as homeowners. Renters will be far more honest about the negative aspects because they have no investment in it. Visit the area at different times on different days of the week to see your future neighbors in action.
Choosing a 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 takes care of external repairs, leaving you to worry only about the interior. Condos, however, 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.
When you have the neighborhood narrowed down, look for a property that has the potential for appreciation and good projected cash flow. Check out properties that are more expensive than you can afford as well as those within your reach. Real estate often sells 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 raise 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 pay no more than 12 times the annual rent you expect to get.
Setting the Rent
So how is the potential rent determined? You are going to have to make an informed guess. Don't get carried away with overly optimistic assumptions. Setting the rent too high and ending up with an empty unit for months chips away at the overall profit in a hurry.
Start with the average rent for the neighborhood and work from there. Consider whether your place is worth a bit more or a bit less, and why.
To figure out if the rent number works for you as an investor, figure out what the place will actually cost you. Subtract your expected monthly mortgage payment, property taxes divided by 12 months, insurance costs divided by 12, and a generous allowance for maintenance and repairs.
Don't underestimate the cost of maintenance and repairs. These costs depend on the age of the property and how much you plan to do yourself. A newer building probably will require less than an older one. An apartment in a complex for seniors is unlikely to be subjected to the same amount of damage as off-campus college housing.
Doing your own repairs cuts costs 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. 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.
Making the Purchase
Banks have tougher demands for giving loans for investment property than for primary residences. They assume that if times get tough, people are less inclined to jeopardize their homes than a business property. Be prepared to pay at least 20% to 30% for a down payment plus closing costs. Have the property thoroughly inspected by a professional and have a lawyer review everything before signing.
Don't forget homeowners' insurance. Renter's insurance covers a tenant's belongings, but the building itself is the landlord's responsibility, and the insurance may be more expensive than 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. 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 healthy enough that you can wait for the property to start generating cash rather than needing it desperately.