If you’re a regular viewer of reality TV, you might think you’ve learned a thing or two about buying a rental or investment property. Many reality shows make being a landlord look glamorous, fun, and easy.
While being a landlord and owning rental properties can be financially rewarding, it’s something you want to research thoroughly before jumping in. Don’t get all your information from TV shows, which simplify things and don’t show all the ins and outs of the process. Here are a few tips you’ll want to keep in mind throughout the process.
1. Get Your Finances in Order First
If you already own a home, you’re most likely familiar with the process of getting a mortgage and the general costs of homeownership. Getting a mortgage for a rental property is similar to getting a mortgage for a primary residence, but there are distinct differences. Getting your finances sorted out and making sure you can afford the upfront and ongoing costs of being a rental property owner is one of the most critical steps to take before you buy an investment property.
Determine Your Budget
One of the first things to do before you buy an investment property is figure out how much you can afford. When deciding how much to lend you, a financial institution is likely to look at something called a front-end debt-to-income ratio. This ratio is the total amount of your monthly loan payments divided by your gross monthly income.
While many lenders like to see a front-end ratio of about 28% or less, if you add a rental property, a lender would likely allow a higher debt-to-income ratio. However, you still want to be sure you can cover your mortgage expenses on the rental property if it’s unoccupied for any length of time.
Have a Sufficient Down Payment
One of the biggest differences between a mortgage for a residential home and a mortgage for an investment property is the size of the down payment. Government-backed FHA loans let you buy a home with as little as 3.5% down. Other options include VA loans, for veterans and active-duty service members, and USDA loans, for homes in rural areas.
If you make a small down payment with a conventional loan on a home you plan on living in, your lender may require you to purchase private mortgage insurance (PMI). PMI offers the financial institution protection if you end up being unable to make your loan payments. PMI usually isn’t an option for mortgages on investment properties. If you’re going to buy a home to rent out or a vacation rental home, you’ll likely need to put at least 20% of the sale price down. The advantage is that putting more down reduces the amount of the loan.
Open a HELOC for Your Down Payment
Getting enough money for a down payment on your first home might have seemed like a big enough hurdle, even if you ended up putting just five or 10% down. How can you save up a full 20% to cover the down payment on a rental property? If you already own a primary residence and you’ve been paying on your mortgage for years, you might have another option.
As you’ve made payments on your primary mortgage over the years, you’ve built up equity in your home. Your home’s equity is the market value of your home, minus the amount you still owe on the mortgage. If your home is worth $250,000 and you have $100,000 left on the mortgage, you have equity of $150,000.
A home equity line of credit (HELOC) lets you borrow against your home’s equity. While some people use a HELOC to renovate or repair their primary residences, you can also use the funds to make a down payment on an investment property.
There is some risk worth considering when using funds from your HELOC to make a large enough down payment for a second property. You’re borrowing against your primary residence, so there’s a chance that you could lose your home if you have trouble making payments on the HELOC.
Create an Emergency Fund
Beyond the cost of a mortgage, owning a rental property will have other costs. You might need to pay for general maintenance and upkeep of the property. You may have to shell out money for major repairs or renovations, depending on the condition of the home.
It’s a good idea to have an emergency fund specifically for your rental property. Ideally, the fund will have at least 1% of the property’s value in it to cover the cost of repairs or maintenance. If your rental home costs $100,000, aim to have an emergency fund with at least $1,000 in it. The more you have set aside for any issues or “what-if’s” that come up, the better off you’ll be, as you may be able to avoid taking on additional debt to keep your property in good shape.
Along with having some cash set aside to handle repairs and upkeep, it’s also ideal to have some money available to cover the mortgage costs. If the property is vacant for a few months and not bringing in any income, you can use your reserves to cover the mortgage.
2. Perform Location and Market Research
There’s a reason people always say “location, location, location” on reality homebuying shows. The location of your rental home matters as much as, if not more than, its condition. If the property is in an out-of-the-way area or an area without much demand for rentals, it may be more challenging to find tenants. Some things to consider when researching the property’s location and market include:
- Nearby universities. If there are colleges or universities near the property you’re considering purchasing, it might be a good investment, as students are often in need of a place to live. You might have a higher turnover in a college area, though, because students tend to live in a place for the academic year, then move on.
- The mix of rented properties and owned properties. It’s a good idea to get a sense of the mixture of rented and owned properties in a neighborhood. If you buy a rental in an area where many people own, that can make the property more attractive to potential tenants, as homeowners are generally more invested in maintaining their properties and in making the area they live in welcoming and comfortable.
- The average rental price in the area. Another thing to consider is the average price of rentals in the area and how that average price compares to the cost of your investment property. If the market rate is lower than what you’d pay on your mortgage, it’ll be challenging to get a return on your investment.
- Safety and crime rates. How safe is the area you’re considering? It’s a good idea to learn about crime rates and other potential concerns, as tenants will also be looking at that information and using it to determine whether or not a home or apartment is right for them.
- Area amenities. Just as a high crime rate or other safety concerns can deter people from an area or property, a lot of amenities and conveniences can increase the appeal of a property. When researching homes to buy as rentals, take a look at what’s nearby. Are there local parks or recreation centers within a short walk or drive of the home? Where is the nearest grocery store? Will a person be able to take public transit if they live in the home, or will they need to rely on a car? How is parking in the area?
- Price history for the area. To heighten your chances of getting a good return on your rental property, examine the price history for the neighborhood. Have home values climbed or fallen recently? Are rent prices up compared to what they were a year or two ago? While the past doesn’t guarantee the future, it can give you a relatively accurate idea of what you can expect if you buy in a particular area.
3. Work With a Real Estate Agent
Buying an investment property isn’t a DIY project. The more people you have on your team, working with and for you, the better. Hiring a real estate agent is an excellent idea when you’re looking to buy a rental property, especially if you’re considering buying in an area that’s unfamiliar to you. Working with a licensed real estate agent offers several advantages:
- They work for you. When you sign a contract with a real estate agent, they have a fiduciary duty to you. That means they need to work for you and in your best interests. They’re not supposed to recommend properties to you that would mean a higher commission for them if those properties aren’t appropriate for you.
- They have connections. Sure, you can find properties online pretty easily or can scope out properties by driving around a neighborhood. But a real estate agent is likely to have their fingers on the pulse of the local market. They might get information on soon-to-be-listed homes or be able to arrange showings of properties that aren’t yet online.
- They can point out any red flags. A good real estate agent doesn’t just know about local markets and property value. They also understand what potential concerns or red flags in a home might be. For example, you might visit a property that seems perfect. Your agent might then note that the furnace is broken or that there’s considerable water damage in the basement.
- They can give you the scoop on a neighborhood. Your agent can provide you with details about the neighborhoods or areas you’re considering buying in. They can give you information on the public schools in the area, zoning laws and requirements, and other issues that might influence your decision in the buying process.
- They can help you determine if a home is worth its price. A real estate agent can pull comparables (comps), which are similar homes that have sold recently, to give you an idea of whether the place you’re considering is priced well for the area. You might find that you’re getting a great deal or that the price is considerably higher than the cost of similar homes nearby.
- They can help you negotiate. Since a real estate agent knows the market and can pull comps, they can help you make an offer that will get the seller’s attention. Your agent will work with you through the negotiating process, both when you’re making an offer and after the home inspection, when you might have to go back and forth with the seller to request repairs.
4. Determine the Return on Investment (ROI) of Your Property
One considerable difference between buying a home to live in and buying an investment property is that with an investment property, you’re likely to be reasonably concerned with its ROI. You don’t want to lose money on a rental property, nor do you want to barely break even.
Getting to know the property before you buy it can help you better understand if it’ll deliver a positive ROI. If the property is currently a rental or has been rented in the past, what’s been the average rental price? Another thing to consider is if the property has been consistently rented out or if past sellers have struggled to find tenants for it.
After learning about the rental history of the home, take a look at the rental price. Ideally, the monthly rent will be enough to cover any costs associated with owning the property, with some money left over for you.
You might follow the 1% rule when evaluating the potential ROI of a property. Ideally, the monthly rent you can charge will be equal to or more than 1% of the purchase price plus the cost of any repairs. If your property costs $100,000, you should be able to charge $1,000 per month for rent. If the average rent in the area is less than $1,000, the property might not be worth it.
It’s also a good move to look at the price and sales history of the rental home. When it was listed previously, did the property linger on the market for months, or did someone snap it up quickly? A house that sells quickly is one that’s in demand. In terms of the price, did the previous buyer pay more or less for the property than they’re selling it for? If less, how much less, and how long ago was the sale? If more, that can be a sign that the real estate market in the area isn’t doing so well.
5. Buy a Low-Cost Home
The last thing you want to do when buying an investment property is to purchase an overpriced home. Since your goal is to make money, you most likely want to look for a property that’s priced on the low side. In a perfect world, you’ll buy a property for about 10% less than its market value.
There are a few reasons to look for a low-cost home as an investment property. You don’t want to overextend yourself financially, nor do you want to run the risk of purchasing a home that could be challenging to rent out. If you buy a $250,000 home, you’ll need to charge at least $2,500 per month in rent to follow the 1% rule. If most homes in the area don’t rent for anywhere near $2,500, you’ll be pricing yourself out of the market from the start.
Buying a low-cost home also means less risk for you. If a $250,000 home is at the top of your budget, you run a higher risk of falling behind on mortgage payments if you can’t rent the place quickly. Instead, if you buy a $100,000 home, your mortgage would be considerably lower, and you could safely charge less rent without hurting your bottom line.
When figuring out how much to spend on a home, it’s a good idea to include the cost of renovations or repairs in with the total price. If the house is $100,000 and you estimate it will need $25,000 in updates and repairs to make it rentable, then you’re spending $125,000 on it. To follow the 1% rule, you’ll need to rent it for at least $1,250 per month.
Calculating the cost of repairs, updates, and renovations, and completing them before you put the rental on the market will help you price the home right and get the best ROI.
6. Consider a Property Manager
Another item to consider before buying a rental property is how much effort it will take to manage the property. Will you be able to manage it yourself, or would you rather hire someone else to do the job?
Although the IRS considers rental income as “passive” income, being a landlord can be a pretty hands-on, demanding job. You need to be there for your tenants at any time of day, and any day of the week, in case there’s a problem at the property, such as a broken pipe or a lack of hot water.
Even with excellent tenant screening processes, you might find yourself having to deal with problem renters or tenants who make a lot of demands. In short, being a landlord can mean a lot of headache and hassle.
For that reason, it might be worthwhile to hire a property manager or property management company to handle emergency calls, general maintenance requests, and tenant screening. Usually, property management companies charge about 10% of the monthly rental cost for their services. It’s up to you to decide if what a management company offers is worth the added cost.
PSECU Can Help You Navigate Our Mortgage Options
If you’re looking to purchase a rental property in PA, PSECU can help. We have a variety of mortgage options available, including those for rental or investment properties, and experts on staff you can talk to. We also offer HELOCs if you need cash for a down payment on your investment property. Contact us today to learn more and to become a member.
Check out our WalletWorks page for more personal finance advice for every stage of your life.