6 Questions to Consider Before You Buy a Rental Property

If you’ve got some money to invest and you’ve been watching home prices and rent rise in your area, you might be thinking about buying your first rental property.

Is becoming a landlord the right move for you? Before you make the decision, let’s take a step back and evaluate real estate investments in general. Then we’ll take a closer look at what is involved and what you should consider before buying a rental property.

1. Is real estate a good investment?

While the answer is personal, it may help to know that the potential benefits and rewards of owning real estate are high. Here are a few reasons why:

• a) Appreciation. We know a used car is worth less than a new one. But while cars and most other belongings tend to depreciate over time, real estate tends to appreciate. A home you buy for $200,000 today may be worth $250,000 in just a few years. Of course, there’s no guarantee that home values will continue to rise, but historically real estate has been a sound investment.
  You also have some control over the appreciation of your property: you can maintain it well and even make improvements and renovations, leading to increased value.
• b) Leverage. You can start to make money on real estate (through rental income) after paying only about a fifth of its value as a down payment. While you owe the bank, you own the property and can put it to use right away. You can also take out loans for improvements and additional real estate purchases using the equity in properties you own.
• c) Tax benefits. If you own a rental property, you can deduct many expenses from your taxes, including mortgage interest, maintenance expenses, insurance and utilities.
• d) Cash flow. Once you have reliable tenants, rent checks will start coming in. If all goes according to your cashflow plan and it should, you will be making more each month than you’re spending.
• e) Equity. As the rental income pays down your mortgage, you will gain equity in the property. And at the same time, the property is likely to increase in value.

When you compare real estate investments to other options, such as stocks, make sure you take all of the risks and benefits into account; if you look at expected returns alone you won’t have the full picture.

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2. What type of property will I buy?

First, you need to decide whether you will live in the property yourself. If so, a duplex or multi-unit building will be necessary.

There are some advantages to living in your own rental property (or home hacks). For one, your mortgage could be covered by the rent you receive. Also, you may be able to secure the same type of financing you would for a single-family home that is your primary residence.

If you intend to live in the home for part of the year as a vacation home, you can get financing at a slightly higher rate than for a primary residence. You may have to prove that you will occupy the home for part of the year, though.

If you don’t plan to live in the home, you have more options, including a single-family house. The only limitation is financing.

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3. How will I finance the purchase?

One of the benefits of owning a property is the ability to use leverage — sometimes known as OPM (Other People’s Money). If you take out a mortgage, you may be able to obtain full ownership and use of the property after putting down no more than 30 percent of the full cost.

Even if you have enough money to buy your property outright, it may make sense to keep that cash liquid and take out a mortgage. A fixed-rate mortgage serves as a hedge against inflation, too — your payment will remain the same even as the value of a dollar drops.

To qualify for a loan, you will need to have a solid credit history. The requirements are lower for a primary residence (and the rates are lower, too). If you don’t plan to live in the property, expect to have to meet higher standards, put more money down and pay higher rates.

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4. Where should I buy my rental property?

If you plan to handle maintenance and odd jobs yourself, you’ll need to look in or near your current community. But if you plan to outsource the day-to-day operations, you have many more options.

You will find many lists online indicating the best cities and markets to invest in, but it’s important to do some research yourself and understand what makes a community a good bet for your investment.

One factor you’ll want to consider is the appreciation rates in the community over time. As with stocks, it’s best if you can buy low and sell (or rent) high — but as with stocks, there is no guarantee that prices will continue to rise. The best you can do is look for places where prices have been increasing steadily.

It’s also important to look at what factors are driving that growth. Is the population growing in the area due to new businesses that have moved in? Are more people moving to the city? How much new development is there in the area?

One number that can be useful in choosing a community is the price-to-rent ratio. This is the median home value divided by the median annual rent. The resulting number lets you compare communities to find places where you can expect to make more in rent than you spend on your mortgage.

Another factor to consider is the tax implications of your purchase. As the owner of the property, you will be paying property taxes, and these can vary widely from place to place. All other factors being equal, you’ll end up with more money in the bank in an area with lower tax rates.

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5. Who will manage my rental property?

One of the things that makes rental properties so attractive to investors is that you can keep your net profits and you don’t have to share them. But one of the things that makes rentals unattractive is the amount of work involved in being a landlord.

If you don’t want to deal with all the hassle of managing tenants, collecting rent and doing maintenance, you might want to hire a property management company. The downside is that the management company will take a significant amount of the rent.

It’s important to find a company you can trust, so consider reviews, interview multiple companies, and talk to their references. A lower rate might be tempting, but consider whether it’s worth paying extra to avoid the headaches of a less competent company.

If you choose to manage the property yourself, one of your first tasks will be to find tenants. You’ll want to list your property so renters can find it. Make sure to screen all potential renters; some options are interviews, background checks, and credit checks.

You will need a legally binding lease for your tenants to sign, which may mean working with an attorney. You’ll also need to collect a security deposit.

You’ll be responsible for paying your mortgage and maintaining the proper insurance coverage for your rental. What will be included in the rent and what will the tenant pay separately? Make sure you account for utilities, garbage collection, snow removal, and other services.

Next, you’ll have to collect rent every month and be prepared to badger your tenants if they don’t pay.

Maintenance issues are bound to arise, perhaps at inconvenient times. If you’re handy you can save a lot of money. Otherwise, you’ll need to hire someone to take care of problems. You may also need to do walk-throughs of the unit on occasion (with proper notice to the residents).

When your tenants leave, you’ll need to find new ones. Vacancies can be unpredictable and can halt your income for months at a time.

If you do it right, though, managing your own rental can be highly profitable. Make sure the rent covers your mortgage, insurance, taxes, maintenance, and any other routine expenses that you will pay out of pocket. The rest is your profit.

6. What alternatives are there to owning a rental property?

Not everyone has the time, patience and will to handle all the potential headaches of being a landlord. Does that mean you have to miss out on the profits the real estate market has to offer?

Not at all. For the rest of us, there are ways to make passive investments in real estate. You won’t get all the benefits of owning a rental, but you can sit back and allow your investments to make money:

• a) Real Estate Investment Trusts. Essentially like stocks, REITs are a way for you to buy and sell real estate on the standard exchanges. One of the benefits of REITs is that they are highly liquid; that is, it is easy to sell them when you need to.
• b) Real Estate Investment Groups. REIGs allow you to own property without being a landlord. A company builds or buys a block of rental units, and investors can own one or more. The company takes a portion of the rent and handles all the management, and typically an additional portion is pooled among the group to help balance out any vacancies. The remainder of the rent goes to the owner.
• c) Real Estate Limited Partnerships. These partnerships operate similarly to REIGs, except that they exist for a specific number of years. The big payoff comes when the property is sold.
• d) Real estate mutual funds. Mutual funds that are focused on real estate investments are a way to diversify your holdings and maintain liquidity.

Owning a rental property is a big responsibility, but it comes with plenty of potential benefits. Once you’ve considered your answers to all of these questions, you will be in a better position to decide if it’s the right investment for you.

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