Are you considering buying an investment property? Many of the world’s wealthiest people have come from real estate, so there are lots of reasons to believe it is a good investment. Experts agree, however, that before investing hundreds of thousands of dollars, it’s best to be well-versed in the field. Before you acquire your first rental property, examine the following issues and challenges.
Do you know how to navigate a toolbox? How well do you repair drywall and unclog a toilet? You could employ a property manager or hire someone to handle it for you, but it will eat into your profits. To save money, property owners with one or two homes frequently conduct their own repairs.
Of course, when you add more properties to your portfolio, this changes. Lawrence Pereira, head of Redondo Beach, Calif.-based King Harbor Wealth Management, lives on the West Coast but has residences on the East Coast. He makes things work despite the fact that he claims he isn’t particularly handy. How? Pereira adds, “I put together a competent team of cleaners, handymen, and contractors.”
Being a tulum mexico houses for sale landlord may not be ideal for you if you’re not the handy kind and don’t have a lot of extra cash.
Personal Debt Reduction
Debt may be part of a savvy investor’s portfolio investing strategy, but the average person should avoid it. Purchasing a rental property may not be the best option right now if you have student loans, overdue medical costs, or children who will be attending college shortly.
Pereira thinks that caution is essential, noting, “If the return on your real estate is larger than the expense of debt, paying off debt isn’t necessary. This is the calculation you must perform.” Pereira advises keeping a cash reserve. “Don’t put yourself in a situation where you can’t pay your debts because you don’t have enough money. Always keep a safety margin in mind.”
Obtain a 20% (or more) down payment.
Investment properties typically require a bigger down payment and have more strict approval criteria than owner-occupied properties. The 3% down payment you made on your present home will not work for an investment property. Because mortgage insurance is not available on rental properties, you’ll need at least a 20% down payment. However, you might be able to finance the down payment through bank financing, such as a personal loan.
Locate the Ideal Location
The last thing you want is to be trapped with a rental property in a deteriorating neighborhood rather than one that is steady or growing. A city or location with a booming population and a revitalization plan in the works could be a good place to invest.
Look for a location with reasonable property taxes, a good school district, and plenty of facilities like restaurants, coffee shops, shopping, trails, and parks when looking for a successful rental property. Furthermore, a low-crime neighborhood with easy access to public transit and an expanding job market may attract a wider pool of renters.
Should you buy or take out a loan?
Is it better to pay cash for your investment property or to take out a loan? That is dependent on your investment objectives. Paying cash can help you have a positive cash flow month after month. Take, for example, a $100,000 rental property. With rental revenue, taxes, depreciation, and income tax, the cash buyer may earn $9,500 per year on a $100,000 investment, or a 9.5 percent annual return.
Financing, on the other hand, can yield a higher profit. For example, suppose an investor puts down 20% on a home and the mortgage compoundes at 4% per year. After running expenses and additional interest are deducted, the earnings total $5,580 per year. The investor’s cash flow is lower, but the 27.9% annual return on the $20,000 investment is significantly larger than the 9.5 percent gained by the cash buyer.
How to Get a Rental Property Mortgage
A rental property mortgage is similar to a principal residence mortgage in many ways, but there are a few important differences. For starters, rental property loans have higher default rates since borrowers who are having financial difficulties prioritize their primary residence’s mortgage. Because of the increased risk, lenders demand higher loan rates on rental homes.
Then there are the underwriting guidelines, which are usually more stringent in the case of rental homes. Lenders look at the borrower’s credit score, down payment, and debt-to-income ratio in general. The same principles apply to rental property mortgages, but the borrower will almost certainly be subjected to stricter credit score and DTI requirements, as well as a greater required down payment. In addition, the lender may scrutinize the borrower’s employment history and income, as well as prior landlording experience.
In general, lenders demand the following information from borrowers in order to accept a rental property mortgage:
A minimum credit score of 620 is required, with higher credit scores resulting in better rates and terms.
Down payment: Borrowers can put as little as 3% down on a traditional mortgage for a principal house, but if the down payment is less than 20%, they must pay private mortgage insurance (PMI). Because PMI does not apply to rental property mortgages, applicants must typically put down at least 15% to 20%.
DTI (debt-to-income ratio): DTI is the percentage of a borrower’s monthly income that is used to pay off debt. To qualify for a rental property mortgage, borrowers should have a DTI of 36 percent to 45 percent, while the restrictions are more flexible for principal residence mortgages.
Savings: Borrowers should have enough money in the bank to cover three to six months’ worth of mortgage payments, including principle, interest, taxes, and insurance, in addition to demonstrating a positive debt-to-income ratio.
High Interest Rates Should Be Avoided
Although the cost of borrowing money may be low in 2021, the interest rate on an investment property is typically higher than that of a standard mortgage. If you do opt to finance your purchase, you’ll need a moderate mortgage payment that won’t take up too much of your monthly earnings.
Discrimination in mortgage lending is against the law. There are actions you can take if you believe you’ve been discriminated against because of your color, religion, sex, marital status, use of public assistance, national origin, disability, or age. A report to the Consumer Financial Protection Bureau or the US Department of Housing and Urban Development is one such process (HUD). 12
Determine Your Margin
Because, among other things, they must pay workers, Wall Street businesses that buy distressed homes aim for returns of 5% to 7%. Individuals should aim for a 10% return on investment. Annual maintenance costs should be estimated at 1% of the property value. Homeowners insurance, prospective homeowners association fees, property taxes, monthly expenses such as pest treatment and gardening, as well as regular maintenance expenses for repairs, are all factors to consider.
Purchase Landlord Insurance.
Protect your new purchase: Rental property owners should always acquire landlord insurance in addition to homeowners insurance. This sort of insurance typically covers property damage, loss rental income, and liability protection in the event that a tenant or visitor is injured due to a lack of property care. 3
Keep in mind that normal homeowner’s insurance may not cover losses suffered while the house is being rented out.
4 Make sure you’re properly insured by contacting your insurance agent.
Investigate whether you may save money by bundling your landlord and homeowners insurance policies.
Consider Unforeseen Expenses
Maintenance and upkeep aren’t the only expenses that will eat into your rental income. There’s always the possibility of an emergency arising, such as roof damage from a hurricane or broken pipes destroying a kitchen floor. Plan to set aside 20% to 30% of your rental income for these types of expenses so that you have a fund to pay for repairs on schedule.
Fixer-Uppers should be avoided at all costs.
It’s tempting to look for a house that you can buy for a low price and turn into a rental. If this is your first property, though, this is probably not a good idea. You’d be paying too much to renovate unless you have a contractor that does good job for a low price—or you’re an expert at large-scale home upgrades. Instead, look for a home that is undervalued and simply need minimal repairs.
Calculate your operating costs.
Your new property’s operational expenses will be between 35 and 80 percent of its total operating income. If you charge $1,500 for rent and your operating expenses are $600 per month, your operating expenses are 40%. Use the 50 percent rule to make things even easier. Expect to pay $1,000 in total expenses if your rent is $2,000 per month.
Calculate Your Refund
What is your return on investment for every dollar you put in? Stocks may yield a cash-on-cash return of 7.5 percent, while bonds may pay 4.5 percent. A 6% return in your first year as a landlord is regarded healthy, especially since it is expected to increase over time.
Purchase a Low-Cost House
The higher the price of your property, the higher your monthly expenses will be. Start with a $150,000 to $200,000 property in a desirable community, according to several experts. Furthermore, experts advise against buying the nicest house on the block—or the ugliest house on the block.
Is purchasing a condominium a wise investment?
Condos are a fantastic alternative for rental property buyers because they are typically less expensive than comparable single-family homes and are frequently located in desirable areas (think: at the beach or a ski resort). Condos also have lower upkeep requirements because the owners aren’t liable for the grounds or the building’s façade.
Financing a condo, however, is more difficult than financing a single-family home. Most lenders, for example, demand that at least 50% of the units be owner-occupied and that the homeowners association be in good standing. It’s also crucial to think about any prospective particular assessments. You may be able to pay the monthly dues without difficulty, but if the building requires a special one-time expenditure, such as a new roof, you may be responsible for thousands (or tens of thousands) of dollars.
Understand Your Legal Responsibilities
Landlord-tenant regulations in their state and area should be familiar to rental owners.
5 To avoid legal wranglings, it’s critical to understand your tenants’ rights and obligations regarding security deposits, lease requirements, eviction procedures, fair housing, and other issues.
When is it appropriate to hire a property manager?
Owners of rental properties have the option of managing the property themselves or hiring a property manager. It can be a difficult option to make because property managers often charge between 8% and 12% of collected rents, which can significantly reduce profits.
Nonetheless, employing a seasoned property manager may be well worth the investment. After all, taking use of their industry expertise equals less labor and less worries for you. A property manager will, in general, do the following:
- Understand how to market the house.
- Understand the local rental market and make sure your rental is priced appropriately.
- Show potential tenants the property (so you don’t have to)
- Tenants should be screened (for example, conduct credit checks and verify references)
- Rent is collected on your behalf and deposited into your bank account.
- Take care of late rents and the eviction process.
- Take care of tenant grievances
- Make plans for maintenance and repairs.
Property-related bills, such as taxes, utilities, and insurance, must be paid.
Ask yourself the following questions to see if employing a property management makes financial sense for you:
Is it feasible for me to manage the property on my own? You won’t have the time or energy to manage a property on your own if you have another full-time job. This is especially true if you own several homes.
What is the distance between my home and the rental property? Being far away from the property takes more time out of your day and makes managing ordinary and critical issues more challenging.
Is it possible for me to interact with tenants? Even if you screen well, you’ll almost certainly have to deal with difficult tenants, late rents, and evictions at some point. Is that something you’d be interested in doing?
Is my rental property intended for short- or long-term renters? If you’re searching for long-term renters, it might be better to self-manage. However, if it’s a short-term rental (such as an Airbnb), you’ll be dealing with a variety of tenants, as well as potential complaints and maintenance difficulties.
Do you feel the need to be in command? If you have trouble delegating activities like tenant selection and maintenance, you might be better off managing the property yourself.
Calculate the Benefits vs. the Risks.
Every financial decision must be made with the goal of determining whether the benefit is worth the potential hazards. Do you think it’s a good idea to invest in real estate?
You may generate money while spending the majority of your time and energy into your normal job because your revenue is passive, despite the initial investment and upkeep expenditures.
If the value of real estate rises, so will the value of your investment.
Real estate can be invested in a self-directed IRA (SDIRA).
Rental income is not counted as part of your taxable income for Social Security purposes.
You can deduct the interest you pay on a loan for an investment property.
Real estate values are often more stable than stock market values, barring another crisis.
Real estate, unlike stocks and other financial products, is a tangible physical asset that you can see and touch.
Unless you utilize a property management company, tenants can be a nightmare to deal with, despite the fact that rental income is passive.
You may be liable to a 3.8 percent surtax on net investment income, including rental income, if your adjusted gross income (AGI) is higher than $200,000 (single) or $250,000 (married filing jointly).
Your rental income may not be enough to meet your entire mortgage payment.
If the markets turn bad or you need cash, you won’t be able to sell real estate right away, unlike stocks.
The costs of entry and leave can be substantial.
Even if you don’t have a tenant, you must cover all costs.
Is It Necessary for Me to Find a Real Estate Investing Partner?
If you want to invest in a rental property but don’t have the funds (or knowledge) to do it, a real estate partnership can be a good option. In layman’s terms, an investing partner contributes to the deal’s financing in exchange for a cut of the profits.
Keep in mind that forming a partnership isn’t a “easy button,” and it won’t relieve you of any responsibilities. You must still conduct your homework, practice your pitch, and be prepared to demonstrate to potential investors that the investment is profitable.
What Is the Best Way to Find a Real Estate Investing Partner?
To partner with a real estate investor, you don’t need a Wall Street connection. Instead, ask your own network of family and friends, join a local real estate investment club, look into real estate crowdfunding, or look for real estate-focused social media groups.
How Much Money Do You Need for a Down Payment on an Investment Property?
When it comes to rental homes, lenders usually have higher limits. Although you can buy a personal residence with as little as 3% down, most borrowers will need to put down 15% to 20% on a rental property. Because borrowers in financial distress prioritize their primary residence’s mortgage, rental property mortgages have a higher default rate.
Should I Purchase a Condo?
Condos are frequently less expensive than comparable single-family residences, and they require less care. However, financing a condo can be more complicated, since you must factor in continuous association dues as well as the possibility of costly special assessments. When contemplating a condo as an investment, make sure to look into the homeowners association’s financial health as well as the overall state of the building, not just the particular unit.
Keep your expectations in check. Rental property, like any other investment, will not provide a significant monthly salary right away, and choosing the wrong property could be disastrous. Rental properties, on the other hand, can be a profitable option to invest in real estate. Consider partnering with an experienced partner for your first rental property. Alternatively, rent out your own home for a period of time to see if you have the potential to be a landlord.