We often hear about diversifying our investment portfolio, and one of the ways of accomplishing this is by owning real estate. Investing in real estate can be done in several ways, such as investing in REITs purchased like stocks or actually owning physical properties.
Whether you are a seasoned real estate professional, interested investor, or simply want an extra stream of income, buying property and renting it out could certainly be an income booster. Of course, actually going through the process and understanding the ins and outs of real estate can be a challenge that can quickly shut down aspirations of purchasing and managing properties. For all the first-timers out there looking to be a landlord, here are six essentials to know before you purchase rental property.
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1. First Time Being a Landlord?
First things first, if you are considering an investment property, you will officially be responsible for potential repairs and maintenance. Have you ever heard stories of tenants calling their landlords at 1 a.m. for help? It may not hurt to get acquainted with your dusty toolbox from the garage and learn how to change leaky pipes or repair drywall.
Some landlords get by without being an expert in construction, development or repairs. If your income source is large enough, it may make sense to hire a well-incorporated group of maintenance and property management experts to help you handle the building’s maintenance requests.
As a landlord, you should carefully screen your prospective tenants. Perform comprehensive due diligence early so you save yourself and headaches later on. It may be a good protocol to ask for items like references, employment status and monthly income, a recent credit report, a credit score and a bank account that shows enough savings to cover rent for the duration of the lease if there’s a sudden job loss. They don’t have to give you everything you ask, just like you don’t have to rent them your property.
2. Location is Key
Just like purchasing a home or renting an apartment for yourself, location plays a major factor in looking for your rental property. In order to attract the ideal tenant, location can be a deciding factor. Are you looking for your tenant to be a family with children? Properties nearby schools, easy transportation access, and short distance to corporate offices and jobs could help.
It’s important to carefully research various trends in counties and cities. Rather than purchasing a rental property in a declining area, investing in a property in an area with growth potential can be a good investment in the long haul.
A few important factors to keep in mind when looking for a rental property include a location with low property taxes, a variety of amenities such as parks, restaurants, public transportation, low rates of crime, and public health guidelines that fit your lifestyle as we try to get through the COVID-19 pandemic.
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3. Observe Comparable Properties in the Area
When looking at your finances and the potential income that could be generated, you should also make sure to research other properties to get a thorough understanding on how similar properties to the one you are interested in are priced.
Going hand in hand with the previous point on location, doing your thorough research on multiple locations and neighboring properties will also help you get a feel for information such as the own versus rent ratio in the neighborhood.
4. Paying Down Debt
Paying down debt is also an important action item if you are aspiring to own your own rental property. Like investing in the market and in yourself, paying down your debt is an important part in setting yourself up for financial success down the road. If you have debt, whether it be credit card, student loans, medical bills, or even planning to take a loan for your child’s college education, then you may want to seek professional advice from a real estate expert or financial advisor to see if buying a rental property is the right choice.
5. How Much Should I Finance?
Choosing the right level of financing depends on your financial position. First, make sure you have enough cash to comfortably cover emergencies in both your personal life and the property. Then, decide what level of mortgage payment is acceptable based on the rents you think you’ll be receiving and accounting for other associated costs like HOA, insurance, and taxes.
When you take out a mortgage, you’re using leverage. Leverage magnifies the annual return or loss when you sell, and the more leverage is used, the greater the effect. If you plan to hold for a long time and are convinced the property will rise in value more than the after-tax interest cost of the loan, then leverage can increase returns if you sell at a profit. Leverage works both ways though, and a big price decline that leaves you underwater is always a possibility, so don’t spread yourself too thin.
If you are looking to secure a downpayment and finance your rental property, it is likely you will need to save up at least 20% for the downpayment since mortgage insurance is not available on investment properties. Keep an eye on the interest rates, since overly high rates could eat into your potential profits.
6. Beware of Expected and Unexpected Costs
As a landlord, you should always be wary of potential property related costs that can arise at any point in time. When you consider purchasing a rental property, one rule of thumb you can follow is the 50% rule: You prepare your finances assuming that the overall expenses will equal roughly 50% of your gross annual income.
For a clearer representation of potential costs, expenses can be grouped into recurring and non-recurring categories. Recurring expenses can include taxes, property insurance, routine maintenance and updates, and property management costs. Non-recurring expenses can be larger items such as water damage, air conditioning and heating repairs, and roofing. Don’t forget to include expensive but uncommon repairs such as a new air conditioning unit or furnace which will come into play if you own the property for a long time.
Is a Rental Property Worth the Investment?
Owning a rental property for the first time can be a learning experience, so do your research ahead of time to make sure it’s a good one. Investors and property owners should be patient and manage their expectations, understanding that rents need to rise to keep pace with other associated costs or returns could be eroded over time.
Depending on your overall financial situation, owning a rental property may add to your annual income. Of course, like everything else in investing, there are risks involved, and high quality properties are not easy to find. Consider the many factors and options with your financial advisor before putting in an offer and getting your own rental property.