What Is an Income Property?

The term income property refers to a property that is purchased or developed to earn income by renting or leasing it out to others or through price appreciation. Investors must take several things into consideration—such as interest rates and the housing market environment— before purchasing an income property as there is a significant risk to this kind of investment. Income properties, which are also called investment properties, may be either residential or commercial.

Key Takeaways

  • An income property is purchased or developed to earn income by renting or leasing it out to others or through price appreciation.
  • Income properties may be both commercial and residential.
  • Owners should have a financial cushion to pay for repairs, maintenance, and other costs such as property taxes in case of emergency.
  • Although they may generate income, owners should consider the risks including interest rates, housing market conditions, and disruptive tenants.

Understanding Income Properties

An income property can be a good investment for a variety of reasons. It offers an alternative to standard market investments in stock equity and bonds. It also offers the investor the security of real property with many investment diversification benefits. Investing in real estate for income requires a broad range of considerations including interest rates and the state of the housing market, among others.

A real estate property can be an excellent long-term investment that may even provide a source of income in retirement. But income properties require a great deal of analysis to ensure that steady cash flow is available throughout the life of the loan and beyond. Determining a base rate of income to rents is often important in order to determine the desired rate of return (RoR). One way to do this is by analyzing the current rental rate on similar properties in the area while factoring in the monthly payments required for the mortgage.

Because the costs to maintain an income property may be high, property owners should consider having a financial cushion on which to fall back in cases of emergency. This includes being able to pay for repairs, regular maintenance, or other costs they are liable for on the building like property taxes and utilities. Managing the cash flow and ensuring that it exceeds the cost of borrowing and expenses help increase the return on the owner's investment overall.

As mentioned above, income properties can be both commercial and residential. Income-producing commercial real estate is mainly used for business purposes such as office buildings, retail space, hotels, or mixed-use properties. Residential properties, on the other hand, are used primarily for personal use by people other than the owner. Residential income properties may be single or multifamily homes, condominiums, townhomes, apartments, or seasonal homes such as cottages.

Special Considerations

Income properties may be part of primary residences or additional properties owned by an investor. In some cases, the homeowner rents out a portion of their own home—say, their basement or the upper level of the property—in order to produce income while maintaining a residence there. This is called an owner-occupied income property, meaning both the owner/landlord and the tenant live in the same property. A non-owner-occupied property is one that isn't occupied by the owner and is purely retained for income-producing purposes. This means the property is only used by the tenants or lessees.

Mortgages

An investor typically needs to be approved for a mortgage loan in order to purchase a property used to generate income. Investors interested in income-producing real estate generally need to have high credit scores and steady incomes in order to prove they can make monthly installment payments. For many investors, the most common type of loan for a real estate property will be a conventional bank loan.

Most lenders want investors to have high credit scores and steady income before they approve an income property mortgage.

In order to qualify, the investor needs to make a formal credit application. The bank analyzes information about the borrower through its underwriting process. An underwriter provides a loan offer with a specified interest rate, principal value, and duration based on the underwriting analysis.

Flipping

Flipping is now a very common investment strategy for many real estate investors. With a fix and flip property, the income property owner believes the resale value after renovations will cover the cost of interest on the loan and renovation expenses, generating an immediate positive return when sold. This type of income property investing includes higher risks than conventional income property ownership, but it provides for a lump sum payout at the time of resale rather than over a prolonged period of time.

Several resources for fix-and-flip investors are available in the real estate market such as a fix-and-flip loan. These loans are really popular with online debt crowdfunding platforms willing to take on some of the higher risks of fix and flip investments. These loans are generally offered for shorter time periods with higher interest rates than conventional loans. With a fix-and-flip loan, the income property is used as collateral, and the owner must be prepared to buy and renovate a property to resell it within a short period of time.

Advantages and Disadvantages of Income Properties

Just like any other investment, there are distinct benefits and pitfalls to owning income properties. As mentioned above, they are great investment opportunities that can provide diversity to someone's portfolio. This helps spread the risk across different investment vehicles. Investors are also able to generate income, providing security and savings for their retirement.

But owning an income property requires a lot of time, effort, money, and patience. For instance, dealing with tenants can be difficult at times. This can lead to additional repairs, trips to the home, and court costs if the owner needs to pursue an eviction. Furthermore, if the owner isn't able to manage the property themselves, they may have to spend additional money to hire a property management company to do the work for them.