6 Things to Consider Before Investing in a Rental Property
Before jumping in headfirst, ask yourself whether you're ready to be a landlord and if you'll actually make money.
Investing in rental property has long been a popular option for people who want to diversify their investments beyond stocks and mutual funds. But, unlike those more mainstream investments, rental properties can require significant hands-on work, including dealing with tenants and keeping up with maintenance. You have to be smart to make rental investment pay.
"The idea of investing in real estate being easy money is nonsense," says Casey Fleming, author of "The Loan Guide: How to Get the Best Possible Mortgage" and a mortgage professional in the San Francisco Bay Area who owns rental properties.
While investing in real estate is often referred to as "passive income," there is nothing passive about it. You should expect to put in plenty of effort if you hope to bring in a return.
"I think the key question is do you want to be a landlord," says Tiffany Alexy, a broker with Lucky Penny Realty Team in Raleigh, North Carolina, and the owner of several rental properties. "Yes, it's passive income, but if you're managing the property yourself, you're potentially giving yourself a second job."
Mutual funds don't call when the toilet is stopped up, they don't write on the walls and they don't refuse to pay rent, all issues you're likely to face with tenants.
"People need to do some deep soul searching before they walk into this," says Ray Rodriguez, regional mortgage sales manager for TD Bank. "Being a landlord is hard work."
The other myth you need to dispel before starting out is that you can invest in real estate with no money. "That's not going to happen," Rodriguez says. "If you're struggling just to get by … it's probably not a good idea right now."
In most cases, not only will you seed a sizeable down payment, you'll need to show additional savings and enough income to make payments.
If you invest in a duplex, triplex or quadraplex – and you're going to live in one of the units – you can get a conventional mortgage with a down payment as low as 5 percent if you show enough income to make the payments.
You can get a conventional loan on properties of four or fewer units with 20 percent down with solid credit. But, says Fleming, lenders will want to see at least three months of reserves, plus proof that you can afford all your current expenses as well as the mortgage on the new property. Investing in properties with more than four units requires commercial financing, which is usually more expensive.
If you don't have experience as a landlord, demonstrated by a Schedule E filed with your recent tax returns, the lender usually will not let you count income from the rentals toward your mortgage qualification. If you do have experience, the lender will use the appraiser's estimate of the rent (taking 75 percent of that) and subtract mortgage costs, property tax and insurance to get the net income that will be counted.
Even after you surmount all those financial hurdles, you still need to make sure the specific rental property will provide a positive cash flow once all the expenses are paid. Sellers and real estate agents will often provide figures that show the property is profitable, but it's up to you to make sure those figures truly reflect all the expenses and take into account maintenance costs, home repairs and vacancies.
"You have to do some very good due diligence," Rodriguez says. Fleming suggests you ask to see the current owner's Schedule E from the last few years or make an offer on the property that is subject to review of those documents. "A negative cash flow is not an asset," he says. "It's a liability."
Finding rental property that yields a positive cash flow may take some searching. Fleming recommends looking for a building that's a little rundown but in a good neighborhood, provided you have the money to improve the property. "If you get a great deal, you could probably find something for 25 percent down that cash flows," he says.
Here are six things to do before you buy rental property:
Gather as much information as you can. Talk to other investors, mortgage brokers and real estate agents who have worked with income property about what owning a rental property is really like, in addition to reading books and articles on the topic. "It's all about obtaining knowledge," Rodriguez says.
Decide if you're ready to be a landlord. Buying and managing property yourself provides the greatest return but also the greatest headaches. "Do you have the stomach for being a landlord?" Fleming says. "Stuff's going to happen that just really ticks you off." Other, less active options include becoming a partner in a limited liability company that owns properties or buying into a real estate investment trust.
Crunch the numbers carefully. A rental property is only a worthwhile investment if it makes money. Yes, the property may rise in value and yield a profit when you sell, but it also may lose value depending on which way the market goes. "If you're banking on just appreciation, it's really hit or miss," Alexy says.
Make sure you have enough cash. Getting rich on real estate with no money down is a great dream, but it's almost impossible to accomplish. Expect to need a sizeable down payment, reserves to pay for repairs and maintenance and a good income before you start investing.
Consider a live-in property. If you're buying a home for yourself, buying one with up to three additional units can be a good way to get started with investing. "We see a lot of younger people going this route," Rodriguez says. "I think it's a good way for a first-time homeowner to begin homeownership."
Plan for hands-on management. In the long run, you may decide to pay someone to do the day-to-day management of your property, including dealing with tenants and arranging for repairs. Costs vary, but you should estimate paying about 10 percent of the rents collected for this sort of service. But you will still need to be there at the beginning to make sure the building is in tiptop shape and the tenants are dependable.