If you’ve never owned rentals before, you must understand four basic principles if you want to be successful:
These quick tips will get you started and help you decide if you’re ready to make money with investment property.
Buying your own residence involves your head and your heart because a home is more than a roof over your head. But leave your heart out of the decision when buying a rental. Features you love, such as a swimming pool or intricate garden, might become maintenance nightmares or big fat liabilities once tenants move in.
Buying the top-of-the-line home you’ve wanted all your life also might not be the best decision. Renters can be hard on a home, and expensive, delicate fixtures may be early casualties. Understand that almost no one rents their dream home, and people expect to compromise. Most renters, according to Apartment Guide, choose for location above other considerations. It’s smart to buy a rental with durable finishes even if they are less attractive than what you’d want in your own home.
And speaking of location, you need to understand who you want your tenant to be before choosing a neighborhood. If you buy near a university, expect to rent to students. In a resort, you may cater to vacationers, and you’ll have older tenants in a retirement community. You’ll likely get families in good school districts near parks. Research your location to see what home prices and rents are, then run the numbers and decide what price you can pay and still make a profit. One-third of respondents to Apartment Guide’s survey moved to be closer to their jobs, so proximity to large employers should probably be another consideration for you.
The property is beautiful, the price seems right, and you want to pull the trigger and make an offer. Or do you? One of the biggest mistakes new landlords make is buying property that loses them money every month. Don’t make that error. First, decide how much you need a property to earn to make it worth buying. Then, calculate your return on investment.
Estimate the annual rental income of the home. That’s easy if it’s already rented. Otherwise, look for online rental estimates (many real estate sites have them) or check nearby listings for similar homes. In popular resort areas, your highest income might come from short-term rentals, while in other communities, you might prefer long-term tenants.
Next, get the figures for operating costs — landlord insurance, estimated maintenance and repair, property taxes, etc. There are many calculators online that can help you with these figures and determine if a property will make you money.
Don’t forget to include a vacancy factor — many beginning investors make the mistake of assuming their property will be rented all the time. Make sure you have enough reserves to cover your mortgage and other costs when you don’t have tenants.
Finally, don’t forget to estimate property appreciation, resale value, and selling costs including real estate commissions. Before buying, research property price trends in areas you’re considering. Is the area improving or declining? Are there new developments? Zoning changes? How is the local economy? A good real estate agent can be invaluable in providing important local information for investors.
Financing investment property can be complicated. (Many experienced investors pay cash for houses, but newbies don’t often have that luxury.) Most mainstream residential lenders won’t approve loans for investment property to landlords with less than one year of property management experience or they won’t allow new landlords to use rental income from the subject property to qualify for the mortgage.
There are a couple of ways to get around this requirement: You can finance a duplex, triplex or fourplex as a primary residence if you live in one unit and rent the others out, or you can finance with an “investor cash flow” loan. Investor cash flow loans use the income from the property to qualify you for financing, and many don’t require landlord experience.
Investment property financing is riskier for lenders, so you’ll need a larger down payment — at least 20%. And you’ll pay a higher interest rate than you would for a traditional residential mortgage. If your rental property has more than four units, you’ll need to apply for commercial residential financing.
Finally, don't forget about 1031 exchanges. Legal in every state — from Florida to Alaska — 1031 exchanges let you defer capital gains taxes from the sale of an investment property by using the proceeds to purchase another investment property.
Most mistakes are the result of ignorance. Fortunately, you don’t have to learn the hard way. You can protect yourself from most legal missteps by hiring a professional property manager, a real estate attorney, or whatever you need to fill in the gaps of your knowledge and experience. Experts can keep you out of trouble until you learn the ropes.
Another way to gain knowledge without mishaps is to invest with an experienced partner. You divide the income, but you also have someone to share costs with. The right partner will be willing to provide education in exchange for you taking on more of the legwork, a bigger share of the costs, or some other compensation.