Buying rental property can be a great way to generate income – but it’s not without risk. This guide will walk you through important considerations and discuss how to buy investment property. From choosing a potential property to estimating your return on investment, we’ll help you figure out if becoming a landlord is right for you.
What is a Rental Property?
A rental property is any type of dwelling (house, apartment, or building) that a property owner rents to a tenant for a specified amount of time. The property might serve as a place to live (residential) or conduct business (commercial).
Before purchasing an investment property, it’s important to understand the different types.
- Permanent rental – The owner (and any claimed dependents) never live there.
- Nonprofit rental – This is the same as a permanent rental, but the property owner is a nonprofit organization.
- Partial rental – The owner lives in one part of the property and rents another, such as a duplex.
- Vacation home – A vacation home is a property that’s rented out by different tenants at various times during the year.
When Is The Right Time To Buy a Rental Property?
You may be asking yourself, when should I buy a rental property? The answer is simple: when you’re in a good place financially. Make sure you have the resources necessary to buy a property – and you’re ready for the unexpected. Here’s how:
- Get your down payment ready – Now’s the time to save, save, and save some more. Unlike a traditional home mortgage, lenders require a down payment of at least 20 to 30 percent. Personal loans may be an option if you’re looking to finance the down payment.
- Build a cushion – Separate from the down payment, have a “cushion” of money saved in case the property doesn’t rent right away, or you have to make unexpected repairs or purchases, like a new refrigerator.
- Pay down your debts – Pay down debts such as student loans, credit cards, or medical bills as much as possible. You don’t want to choose between paying your personal debts versus your rental property mortgage. Calculate carefully to figure out what fits in your budget.
In addition to being prepared financially, think about your time availability and mental focus. For example, becoming a first-time landlord when you’re about to welcome your first child might feel overwhelming.
How To Choose An Investment Property
What types of properties should you consider as an investment rental? While it might be tempting to buy a fixer-upper, first-time buyers should look for something move-in-ready, and preferably priced under market.
With property, it’s all about location!
- Look for neighborhoods that are stable or being revitalized
- Check proximity to good schools and amenities, such as restaurants, parks, and shops
- Confirm there’s a good job market in the region
- Review criminal activity maps and choose an area with low crime rates
- Make sure the market isn’t flooded with rentals without enough renters
- Learn about future development in the area
Making yourself aware of the current and projected state of potential neighborhoods will help you narrow your search. A real estate professional can help you check out viable neighborhoods that might be right for you.
Next, consider what type of rental you’d prefer to own.
Residential Rental Properties
Residential rental properties include single-family homes, apartments, condos, or townhomes. Most first-time property investors start with residential properties like a single-family home because they’re less expensive to purchase.
However, owning a residential rental property still comes with some inherent risk. The property might sit unoccupied longer than expected, or you may have a problem tenant who causes expensive damages.
Is it worth it? To figure out a property’s potential cash flow:
- Add up set expenses – Calculate the amount of the mortgage and associated costs you’ll pay each year (property tax, homeowners association or HOA, homeowner insurance).
- Allow for maintenance – Expect to spend one to three percent of the property value each year on repairs and upkeep. Add this to your total costs.
- Estimate rental income – Look at how much rent you’ll collect for the same 12-month period. Err on the side of caution, using the lower end of the range.
- Calculate profit – Assuming you have a renter for the entire 12 months of the year, subtract your income from your expenses and divide by 12. That’s your projected monthly income from the property.
Generally, residential landlords aim for a profit of around ten percent.
Commercial Rental Properties
Properties rented with the purpose of running a business are considered commercial real estate. These include warehouses and retail, industrial, office, and apartment buildings. Commercial rental properties have a higher return on investment than residential – typically 6 to 12 percent of the purchase price.
Here are some other reasons commercial real estate may look more attractive to you.
- More likely to maintain property – Tenants of these properties are usually better about upkeep since they want their business environment to impress customers.
- Standard hours of operations – Your work as a landlord will typically fall within the workday, compared to the on-call 24/7 lifestyle of a residential landlord.
- Less legal complexity – Commercial rentals have less consumer protection laws than residential property, making it easier for you to navigate.
- Potentially less administration – With commercial tenants, you can also consider a triple net lease. You’re only responsible for paying your mortgage, while the tenant handles any property expenses – including taxes.
Important Considerations of Buying a Rental Property
There are a few more things to know before buying a rental property. To be fully prepared, we’ll talk about the implications of how you purchase the property as well as the ongoing logistics of being a landlord.
Financing vs. Buying a Rental Property
What are some reasons to pay cash for a rental property versus obtaining investment property loans? Let’s take a look at the pros and cons of each option. As you’ll see, the way you finance your rental property will affect your return on investment.
Pros of Paying Cash
If you pay cash, you’ll see a greater monthly income. The rent you collect will go to you instead of the bank, minus any property repairs or maintenance. Many sellers will accept a lower asking price if you’re paying cash, and you’ll avoid the costs associated with a mortgage, like interest and closing fees.
Cons of Paying Cash
When you pay cash for a house, you decrease the diversity of your investment portfolio by putting a large sum into one asset. Real estate isn’t a liquid asset – meaning it’s not easy to sell quickly for cash.
Pros of Financing
If you take out investment property loans, your monthly cash flow may be lower because you have a mortgage to pay, but you won’t have thousands of dollars tied to just one investment. Since you’ll only have to put down 20-30 percent for a down payment, you’ll have more flexibility to put the money elsewhere, like your 401K. Plus, mortgage interest rates are typically lower than other types of loans, and saving to purchase an entire house takes more time than saving a down payment.
Cons of Financing
Unlike cash, you’ll have to qualify for a mortgage and pay interest, which can be costly if you don’t lock in a good rate. You won’t own the property outright and while it’s an investment, the loan means you’re in debt for the life of the mortgage – which could be 30 years.
Budgeting For The Unexpected
Rental property expenses can add up, so budgeting is essential.
Set aside 50 percent of the property’s gross annual income for operating expenses. For example, if your property generates a profit of $10,000 per year, expect to spend half ($5,000) on yearly expenses. You’ll need to budget for things like damage caused by renters, general repairs, vacancy costs, legal fees, etc.
Some ideas to save cash quickly:
- Pay off debts – Then, pocket those payments. Send them straight to your savings account.
- Find a second job – Even if it’s temporary, a second job on the weekends or evenings can help you save quickly.
- Tighten your belt at home – Drastically reduce unnecessary living purchases, such as dining out or expensive vacations.
Prepare for Property Taxes
When it comes to tax on rental income, it’s important to know how to report your income and what deductions are available. As the property owner, you’re responsible for property taxes – not your tenants.
Taxed as income, rental income can potentially push you into a higher tax bracket, but taking deductions should help. According to the IRS, rental income can also include security deposits you keep, bills the tenant pays and deducts from the rent, and payments for services in exchange for discounted rent (like painting the house in exchange for $100 off rent).
The good news is that you can deduct property expenses from your income – including mortgage interest, HOA fees, utilities you pay, insurance, and cleaning and maintenance costs, to name a few. There’s also a depreciation deduction you can calculate each year minus the cost of your land.
Rely on an experienced tax professional to learn more about potential deductions for landlords.
Security Deposits, Leases, and the Law
Learning what to include in a rental agreement is essential. Be sure you’re operating within the law. The lease or rental agreement is a legally binding document that lays out both tenant and landlord responsibilities. It should list some of these important points:
- Rental price – List the amount you’ll receive each month, the due date, and acceptable methods of payment. For example, the tenant pays $1,000 in a check made payable to you on the first of every month. Include any charges for bounced checks.
- Security Deposit – Most landlords ask for an additional sum of money (usually a month’s worth of rent) to help pay for damages or future unpaid rent. Your lease should include details on how you will and won’t use this money. For example, you may want to outline that you won’t accept the deposit as last month’s rent. Check out each state’s laws that govern how long you can keep tenants’ deposits.
- Late fees – If your lease doesn’t outline charging late fees, you won’t be able to collect them for late payments. Typically you’ll need to offer a three-day grace period before charging a percentage of the rent as a fee.
Become knowledgeable in your state’s landlord-tenant laws to make sure you’re in compliance.
As you’ve learned from this blog, being a landlord has its risks. For example, you could lose money on the property, sinking more into it than the revenue you earn. This can happen if your monthly payments are too high, you have a tenant destroy your property, or a market downturn causes your property to decrease in value.
To better protect yourself, you may want to consider landlord insurance. It covers property damage, loss of rental income, and liability protection. Check with your homeowner’s insurance to see if they offer a way to bundle landlord insurance into your existing policy.
Are You Ready To Be a Landlord?
Buying an investment property can be a great way to boost your financial portfolio and generate passive monthly income, especially when you save a nest egg for operating and unexpected expenses. Wondering if an investment property is right for you? Contact a BHHS Fox & Roach real estate professional to discuss researching and buying a rental property.