Real estate has produced many of the world’s wealthy people, so there are plenty of reasons to think that property is a sound investment. However, as with any investment, it’s better to be well-versed before diving in with hundreds of thousands of dollars. Arm yourself with the information below before starting a new career as a real estate tycoon.
Make Sure It’s for You
Do you know your way around a toolbox? How are you at repairing drywall or unclogging a toilet? Sure, you could call somebody to do it for you, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money. If you’re not the handy type and don’t have lots of spare cash, being a landlord may not be right for you.
Of course, that changes as you add more properties to your portfolio. Lawrence Pereira, president and director of investments at King Harbor Wealth Managementin Redondo Beach, Calif., owns properties on the East Coast while living on the West Coast. As somebody who says he’s not at all handy, he makes it work. How? “I put together a solid team of cleaners, handymen and contractors,” says Pereira. This isn’t recommended for new investors, but as you get the hang of real estate investing you don’t have to remain local.
Pay Down Debt First
Savvy investors might carry debt as part of their investment portfolio, but the average person should avoid it. If you have student loans, unpaid medical bills or children who will soon attend college, purchasing a rental property may not be the right move. Pereira agrees that being cautious is key, saying, “It’s not necessary to pay down debt if your return from your real estate is greater than the cost of debt. That is the calculation you need to make. However, don’t put yourself in a position where you lack the cash to make payments on your debt. Always have a margin of safety.”
Get the Down Payment
Investment properties generally require a larger down payment than owner-occupied properties, so they have more-stringent approval requirements. The 3% you may have put down on the home you currently live in isn’t going to work for an investment property. You will need at least 20%, given that mortgage insurance isn’t available on rental properties.
Beware of Higher Interest Rates
The cost of borrowing money might be relatively cheap right now, but the interest rate on an investment property will be higher than traditional mortgage interest rates. Remember, you need a low mortgage payment that won’t eat into your monthly profits too significantly.
Calculate Your Margins
Wall Street firms that buy distressed properties aim for returns of 5% to 7%, because they have to pay a staff. Individuals should set a goal of 10%. Estimate maintenance costs at 1% of the property value annually. Other costs include insurance, possible homeowners’ association fees, property taxes and monthly expenses such as pest control and landscaping. And then there’s landlord insurance.
Don’t Buy a Fixer-Upper
It’s tempting to look for the house that you can get at a bargain and flip into a rental property. However, if this is your first property, that’s probably a bad idea. Unless you have a contractor who does quality work on the cheap – or you’re skilled at large-scale home improvements – you’re likely to pay too much to renovate. Instead, look to buy a home that is priced below the market and needs only minor repairs.
Matt Holmes, Founder/CEO of Holmes Real Estate Group, says that the best type of home to purchase is one where you can add a bedroom right away or in the near future. “Adding a bedroom not only increases resell value but often pays for itself in the first month if you are renting out the property by room. Plus, adding a bedroom costs about 10% of a kitchen remodel, and it can be argued that in many markets also has a more meaningful resell value impact,” says Holmes.
Calculate Operating Expenses
Operating expenses on your new property will be between 35% and 80% of your gross operating income. If you charge $1,500 for rent and your expenses come in at $600 per month, you’re at 40%. For an even easier calculation, use the 50% rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total expenses.
Determine Your Return
For every dollar you invest, what is your return on that dollar? Stocks may offer a 7.5% cash-on-cash return, while bonds may pay 4.5%. A 6% return in your first year as a landlord is considered healthy, especially given that number should rise over time.
Get a Low-Cost Home
The more expensive the home, the higher your ongoing expenses will be. Some experts recommend starting with a $150,000 home.
Find the Right Location
When choosing a profitable rental property, look for low property taxes, a decent school district, a neighborhood with low crime rates and an area with a growing job market and plenty of amenities, such as parks, malls, restaurants and movie theaters.
Risk vs. Reward
Every financial decision is about weighing the rewards, determining payoff against potential risk. Does investing in real estate make sense for you?
- Your income is passive. Aside from the initial investment and upkeep costs, you can earn money while putting most of your time and energy into your regular job.
- Your income should grow. You don’t just earn rental income; as real estate values increase, your investment rises in value.
- You can put real estate into a self-directed IRA.
- Rental income isn't included as part of your income subject to Social Security tax.
- Interest you pay on an investment property loan is tax deductible.
- Short of another crisis, real estate values are more stable than the stock market.
- Real estate is a physical asset. Investing in stocks or Wall Street products isn’t anything you can see or touch.
- Although rental income is passive, tenants can be a pain to deal with unless you use a property management company.
- If your adjusted gross income is above $200,000 (single) or $250,000 (married filing jointly), you may be subject to a 3.8% surtax on net investment income, including rental income.
- Rental income may not cover the total mortgage payment.
- Unlike stocks, you can’t instantly sell real estate if the markets goes sour.
- Unlike stocks, in most cases you can’t sell a portion of your real estate. It’s all or nothing.
- Entry and exit costs are high.
- If you don’t have a tenant, you have to pay all expenses.
The Bottom Line
Keep your expectations realistic. As with any investment, a rental property isn’t going to produce a large monthly paycheck for a while and picking the wrong property could be a catastrophic mistake. Consider working with an experienced partner on your first property or rent out your own home to test your landlord abilities.