Tips on buying rental property before deciding to invest
If you’ve been watching reruns of HGTV’s “Income Property” and wondering if it’s time to buy an investment property and become a landlord, you’re not alone.
Between a recent jump in inflation, historically low interest rates, and the mood of millennials to rent instead of own, buying rental property has been on an uptick in recent years.
In fact, real estate is now Americans’ favorite long-term investment, according to a recent Bankrate study. Real estate investing has consistently ranked as one of the top choices since Bankrate started the survey in 2012.
Here are a few things to consider before diving into an investment property.
1. Determine if buying an investment rental property is right for you
Forget the TV sitcom stereotypes of clueless landlords. To make the most of income property requires an accountant’s eye for detail, a lawyer’s grasp of landlord-tenant laws, a fortune teller’s foresight and, should you choose to manage your rental property yourself, a landlord’s firm-but-friendly disposition.
“Where people who want to become landlords fall short is, they don’t realize how much work goes into it,” said Diana George, founder of DG Design Group.
So before you leap in, you’ll want to consider whether you have the time, willingness and skill to put into managing a rental. While rental property is considered a passive investment, that doesn’t mean you’re fully passive in managing it.
Over the long-term, real estate investments may compare favorably to other long-term investments such as stocks, but the results can vary significantly depending on the circumstances of the region and specific property. You’ll want to consider whether you think you can increase rent payments over time and why the economy surrounding the property would support that, among other issues. Whether or not you finance the property and the terms of any financing can have a significant impact on the return you ultimately earn.
2. Buy or finance? Analyze which is better for you
While some financial pundits insist you should never buy a rental unless you can pay cash for it, Jeremy Kisner, a senior wealth adviser at Surevest Wealth Management in Phoenix, begs to differ.
“Leverage (that is, a mortgage) typically magnifies returns, on both the upside and downside,” says Kisner, who owns two rental properties in Las Vegas.
For example, imagine a rental property purchased for $100,000 in cash. The house yields a rent of $12,000 annually after all expenses, such as maintenance and insurance, and is taxed at $1,000. With a depreciation schedule of 27.5 years and an income tax rate of 20 percent, an investor would earn just over $9,500 in cash annually. So the investor’s annual cash return is about 9.5 percent. Not bad.
Here’s how the investor using leverage performed, assuming the same house. This investor has a mortgage for 80 percent of the house, which compounds at 4 percent. After subtracting the operating expenses as well as additional interest expenses, this investor earns almost $5,580 in cash annually. With $20,000 invested, the investor’s annual cash return is about 27.9 percent.
In fact, the situation for the leveraged owner is actually a little bit better than these numbers suggest. That’s because part of the rent goes to pay down the mortgage’s principal. So while the investor couldn’t pocket the cash flow because it was used to pay the loan, the investor still profited (and paid tax) on that money.
3. Find the right location That old realtor mantra about the importance of location takes an interesting turn when applied to income property.
“The best locations with the most appreciation are where you’ll potentially have the worst cash flow with a rental,” Kisner said.
Why? Investors can earn a return in two ways: cash flow and appreciation. In some areas investors may want higher cash flow in order to compensate them for slower appreciation. But if investors expect an area to appreciate substantially, they may be willing to forgo some of the cash flow in order to enjoy that appreci ation. The result: house appreciation outstrips the growth in rents, and houses appreciate while yielding relatively low cash flow.
“As a result, the property has to appreciate more in order to compete as an investment with properties in less desirable areas,” Kisner said.
4. Success requires a longterm outlook
“The way that people get in trouble with almost all investments is, they just don’t hold onto things long enough,” Kisner said. “With rentals, if you break even on a cash-flow basis, that’s actually not too bad because you’re paying down the principal and building equity that way. Then, you hopefully also see some appreciation.”
So if you’re looking to make money in real estate, you’ll want to think long term. As you pay down or eliminate principal over the years, you should be able to grow your cash flow.
5. Make sure you’re landlord material
If you purchase a rental property, should you be your own landlord or fork over 6-10 percent of your rental income to a management service? While there’s no right answer for everyone,
George and Kisner prefer to subcontract the work.
“They do the background check on your tenant, make sure they sign the lease and pay their rent on time,” George said. “That frees you up to manage your money, not your property and tenants.”
Kathy Hertzog, former president of Erie, Pennsylvania-based LandlordAssociation.org, said there’s a potentially steep downside to being your own landlord.
“If you get too close to your tenants and the tenants have financial problems, you can find yourself stuck because you don’t want to evict them,” she said. “You have to be very professional about it, because if somebody doesn’t pay their rent, they’re stealing from you.”