In a nut shell investment properties are a large asset that can generate good additional income. Rent prices rise over time, and if the value of your property increases over time as well, you have a great short-term and long-term return.
The average yield for investment properties in the US was 9.4% last year, while stocks yield an average of 4.8%. So it goes without saying that with greater risk comes more reward. In some cases it is even worth taking out a investment loan, as you will still attain a decent yield comparable to the stock market. Using an investment property loan calculator can help you determine if thats the right option for you.
Owning an investment property is a much more hands on investment then any stock or bond. Therefore it is extremely important to invest in the right area. It also means, the improvements you make can directly affect the value of the home and investment. For example: renovating the kitchen, or finishing the basement, will both increase how much you rent the property for, and your value when you are prepared to sell.
There are also tax breaks and deductions that can be taken advantage of when investing in real estate. These tax breaks will be covered very briefly at the end of this article, along with the criteria in finding a suitable investment property.
So what are the risks?
The biggest factor that can make or break an investment is the tenant.
- A tenant that doesn’t pay results in a huge headache and loss of income
- A tenant that destroys the house may require thousands of dollars in repairs
- The complete lack of a tenant for consecutive months, or even for an off month between rentals can add up quickly.
Even with a good tenant there are always carrying fees and operating costs.
Managing a rental property can be time consuming as well- if there are any problems or repairs that need to be done its the landlords job to attend to these things in a timely manner. It may even require multiple trips driving to and from the property, if you are within driving distance. If you have a full time job it can be difficult to manage the demands of being a landlord, as emergencies can happen any time of the day. As with any home, many things can happen out of our control so it’s worth getting insurance on the home incase of any floods, fires, or natural disasters.
While there is some luck involved, a diligent screening process can greatly increase your chances of landing the right tenant . That may mean having to keep the property vacant for an extra month, instead of taking the first offer. It is equally as important to work with the right real estate agent to bring in the right clients and get the property rented as quickly as possible.
My husband and I had some relative issues with our recent rental property. It’s a spacious 2-bedroom condo in a desirable downtown core. On paper its perfect, but we struggled for three months to get it rented out. We had custom closets installed- a floor to ceiling sliding shoe cabinet in the den, and a 5 unit wrap around closet in the second bedroom, as well as all renovated wood floors, and brand new appliances.
So why the problem?
Our first offer wanted us to rip out the custom closets and cabinets and repaint the place. Then the next best offer was below asking to use the place for short-term AirBnB rentals. We thought luck was not on our side, as both offers were essentially asking to destroy the place. We were barely getting any showings and we are 3000 miles away from the condo. Things were not looking good, until we hired the right agent. He had a contract signed for a one-year rental to a nice couple, within one week of giving him the listing.
The moral of the story- not all real estate agents are going to be active in the same areas, with the right focus, or right network. This agent in particular has a strong focus on leases, as his philosophy is that leases provide a good return clientele with the potential for a sale in the future. He was able to see what type of a client would fit for the rental, and was able to reach out the right people to close the deal. Not everyone will have that outlook and drive when it comes to a lease, as it doesn’t bring the revenue that a sale does.
If after that, you still think a rental is good for you, continue reading to find out what it takes to get an investment property.
As a preliminary step, If you’re unsure of how much home you can afford, using online calculators that can help you get an idea of what the monthly mortgage costs may be, and what income is required. An investment property loan calculator is a great assessment tool.
There are some basic guidelines for attaining a mortgage for a rental property, which are slightly more difficult then attaining a mortgage for a family home. You need to have:
- a good credit score (minimum score 620, though over 700 will get you better interest rates).
- a good down payment (minimum 20%). The more you put down the less your monthly payment will be.
- enough savings to carry the mortgage for approximately 6 months with at least 2 months of bank statements to prove it.
Before you start looking at properties, it is extremely important to get pre-approved.
If you don’t- you risk looking at a property you can’t afford, or you risk losing the property while waiting to get approval.
It just takes one strategic offer to close, and this could happen in a matter of hours. Having your pre-approval will allow you to move quickly and make that strategic decision.
FHA loans generally do not qualify for an investment property, but may be worth a try.
Now that you have your pre-approval, you’re ready to start looking for a property.
Finding the right property
You want to find a home that is:
- Low maintenance
- In an area with limited vacancies
- Is near good schools
- In developing areas
- Provides a good ROI (this will be discussed next)
- Doesn’t need any improvements- while you can get a great deal on a home that needs to be fixed up, you will likely be getting in way over your head. If it is your first investment property its best not to take on so much.
Some cities can offer great opportunities for investors . A recent study done by GOBankingRates.com has shown that Florida and Texas have top real estate opportunities , because of the population and infrastructure growth. Unfortunately, no Midwest states qualified as a good investment due to steady or declining populations. According to the study these are the top 15 states to make a real estate investment:
- Richmond, VA
- Charlotte, NC
- Jackson, FL
- Pheonix, AZ
- Nashville, TN
- Miami, FL
- Raleigh, NC
- Portland, OR
- Dallas, TX
- Reno, NV
- Austin, TX
- Seattle, WA
- Denver, CO
- Tampa, FL
- Orlando, FL
Determine your ROI
First , you have to establish the property’s net annual income. This is the rent money left after taxes, insurance, property fees, HOA fees, utilities not covered by rent, and possible repairs (allocate 1% of the property value to this).
Generally speaking you can ask for 1% of the home value for the rental price, however, you can check Zillow’s tool called Rent Zestimate to get a ball park range if you are still unsure. Note: this tool gives a figure on the lower end of the spectrum.
Next , take that figure and divide it by how much you want to spend on the property (down payment, closing costs, etc) to determine the ROI.
If you are left with 7000$ on a $100,000 investment, then your ROI is 7%.
Keep all your receipts for repairs, maintenance, interest payments, gas and transportation as these can be deducted
The IRS treats investment properties in the same way as a business expense, so tax rules allow you to deduct depreciation losses for much more then the deductible of a single-family home. Depreciation losses can be claimed even if the value of the property is rising; therefore it’s worth speaking to your accountant to better understand this.
You can use like-kind exchange to defer taxes and mitigate capital gains. The process is fairly complex, but the idea is simple- when you sell your property, reinvest the proceeds directly into another property of greater or equal value within the time frame and criteria.
Alternatively a section 721 exchange can help you defer taxes as well. Instead of investing into another property you can diversify interest into a real estate investment trust.
Both tax deferrals require a knowledgeable accountant, as there are many intricacies that were not discussed here.