I’ve spoken recently with a good number of clients that are thinking of buying rental property. Many find owning such homes to be an excellent investment and can really help improve their financial (and retirement) position.
But here’s the thing I tell them…..don’t necessarily expect an easy ride in getting it done – especially the first time.
For the best return on that investment, they really need to develop a new mindset and skill set – and it only comes from doing the research.
Owning investment property just isn’t like the buy-and-forget model of stock ownership.
I’m linking to a comprehensive guide that was put together by The Mortgage Reports’ Peter Warden. For the complete article, do click on this link – otherwise, continue on for some highlights that I’ve condensed.
Not only does this outline how to invest in real estate successfully, it warns you of some common pitfalls and suggests ways to avoid them – and I’ll take a look at the investment property loans that are available and I can help decide which one might be best for you.
Rental Property is a Good Investment
If done correctly, investing in rental property can be a great way to make your money work hard for you.
Of course, you’ll likely need some savings (or a business partner for down payments – more on that below). But what other investment can you fund with ultra-low interest rates and fixed monthly payments?
Secondly, your borrowing is secured by an asset that’s likely to appreciate handsomely over time. Sure, we all know home prices can go down as well as up – but in the long run, most markets see a long-term upward curve.
Essentially, there’s a good chance you’ll see the value of your asset rising as your mortgage balance gently falls away.
Just how tax-efficient your rental property investment will be depends on your personal circumstances. How you put together your investment vehicle has an effect – so you need to solicit advice from your tax adviser.
Interestingly, your property will most likely appreciate over time, but the IRS allows you to deduct depreciation, as though its value falls like that of other assets. This is good news for the investor.
All investments carry some risk, as it’s the nature of the game. But buying rental property can deliver good and relatively safe gains, providing you do your homework first.
To start with, your mortgage will probably have a fixed rate….but your rents will certainly not be fixed. In most market conditions, they’re likely to rise, year after year.
Finally, of course, once your tenants finish paying down your mortgages, all that lovely rental revenue is yours — after some ongoing expenses. Time your investment right, and you could find your retirement delightfully comfortable.
Arguably the biggest mistake made by first-timers buying rental property is to forget that they are not buying a home in which to live. They’re still admiring the counter tops, solid wood floors and open-plan concept, instead of focusing on the numbers.
In reality, those numbers are everything. It doesn’t matter how nice a rental home is – you don’t want to own it unless it’s going to make you a profit.
At the same time, you need to buy an attractive, pleasant place that plenty of people in the area will want to rent. You need to deliver that at a price they can afford – but most importantly, you must make a profit.
There are some numbers you know or can estimate with very good accuracy. For example, the purchase price of the property, your down payment, your mortgage interest rate (which may be different from that for a home for owner occupation — more on that below) and your monthly payments.
With that said, others will have to be based on assumptions – and don’t be scared of those. Every business plan in the world is based on assumptions.
Here’s where Warden’s article really shines:
“The aim of your research is to help you make realistic assumptions about things that could affect the profitability of your investment, including these 12:
- How much revenue the home’s going to generate from month 1 — The initial rental value of the property
- How quickly rents are rising (or falling) in the neighborhood — How much revenue it’s likely to generate in future
- How often and for how long the home’s likely to be vacant between tenancies (your “vacancy rate”) — Supply and demand in the local rental market
- How high your management, maintenance and repair bills are likely to be (see “Your role,” below), remembering to account for inflation in future years
- How quickly home prices are rising (or falling) in the neighborhood — Your capital appreciation
- How much (if anything) it will cost you initially to get the home into a marketable condition for rental purposes
- How likely it is you’ll end up with a bad tenant who saddles you with big repair bills or stiffs you over rental payments
- How much you’ll pay in property taxes and home insurance premiums — Sometimes these are higher (or much, much higher) on rental properties than owner-occupied ones. So investigate
- How much, where applicable, you’ll pay in homeowners’ association fees and what your HOA’s rules are — Make sure these aren’t onerous. And check that the HOA’s finances are sound
- How much, if anything, you’ll pay for utilities
- How much, if anything, you might pay to occasionally advertise for new tenants
- How great the risk factors are for the area — for example, whether local employment is dependent on a single employer and how likely that is to close”
Lending on the numbers
There are several formulas you can use to evaluate rental property and if you can afford it.
Your lender, per Fannie and Freddie regulations, will take 75 percent of the rent (or appraised rent if the property is not currently leased), and add that to your income. Then, it will hit you with the mortgage payment, property taxes, homeowners insurance, and HOA dues, if applicable.
You’ll know if after paying the mortgage and other regular monthly expenses whether you will have extra cash or not. But that number depends on so many other factors — the size of your down payment, for one — and may ignore things like tax deductions, maintenance and property management fees.
Investment property loans
When you’re buying rental property, you may have to choose between different types of mortgages. Those include:
- Conventional (non-government)
- Federal Housing Administration (FHA loans)
- Veterans Administration (VA loans)
You’ll find more information about each of those below – and I’d recommend that you reach out to a knowledgeable mortgage professional to coach you through this process.
Down payment requirements for investment properties
When purchasing rental property, you’ll usually need a larger down payment than you would for a primary residence. There are a few exceptions, which are described in the next section.
Typically, borrowers need a 20 percent down payment — sometimes even more. (Fannie Mae and Freddie Mac do allow you to buy with 15 percent down, but you have to pay for mortgage insurance.) That’s because lenders know that rentals are more likely to go into default than owner-occupied homes.
How do you come up with that much? Younger entrepreneurs tend to use savings and inheritances. But older ones often access the equity in their own home through a home equity loan or home equity line of credit (HELOC).
Find out more here on The New Refinance Movement that discusses how homeowners are tapping into that equity.
Because the latter is a bit more flexible (you pay interest only on outstanding balances, and can borrow and repay up to your limit as frequently as you wish), HELOCs can be especially helpful if you need to refurbish the home after purchase.
The conventional mortgage
Interestingly, borrowers must to be better-qualified to finance a rental than you do to buy your own home. That means higher credit scores, more cash reserves in the bank, and lower debt-to-income ratios.
Borrowers also need to have sufficient existing income to comfortably afford both mortgage payments.
Investment property and FHA and VA loans
Both VA and FHA loans are only available on the property where you’re going to live. However, that doesn’t mean that they block you from getting rental income.
Suppose you buy a building with two, three or four residential units. Providing you live in one of those units, you can rent out the other(s).
VA home loans are often the best mortgages any borrower can get. They don’t require any down payment at all, and they generally offer highly competitive rates. But they’re only available to those who qualify, including those on active service, veterans, certain surviving spouses and other closely defined categories.
Again, these can be very good loans when buying rental property. They require a minimum 3.5 percent down payment. Rates generally aren’t bad but you’ll have to pay more to insure your loan.
Also, providing you live in one unit, you can buy a residential building with up to four. But, as with VA loans, you may eventually be able to rent out a home with an FHA mortgage and move to a different property that you buy with a conventional loan.
In researching this guide, one piece of advice stood out in the many sources consulted. A successful real estate investor recalled the hardest thing about becoming a landlord was signing the first purchase offer.
Please let me know if I can be of service, as I’ve helped a good number of investors finance rental properties with all different types of loans, ranging from the standard conventional loan, to VA loans, to investor specific loans (where only expected rents were utilized in qualification).