Are you thinking about investing in real estate to rent out or use as a vacation home for travelers? If so, it can turn into a reliable source of income. But how do you know if you’re ready to become a landlord?
Before you invest in real estate, it’s crucial to understand what an investment property is, explore different types of property investments and learn how to secure financing for your investment property.
An investment property is real estate purchased to generate passive income. In other words, the property can earn a return on investment through rental income, resale or both.
Investment properties are typically purchased by individual investors or groups of real estate investors. Investors can generate profits in the short term by fixing and flipping properties or renting them for a longer-term investment.
Investors can buy several types of investment properties to earn passive income. Common property investment options include residential and commercial real estate and raw land.
The most common type of investment property is residential real estate. Residential properties – single-family homes, condominiums, apartments, etc. – are intended for living.
Real estate investors tend to prefer residential real estate because once you secure a high-value property and long-term tenants live there, it can generate reliable income. However, the start-up costs are high, and you may need to wait before cash starts flowing in.
If you want to sell the property with tenants in the building, that can slow the sale while property prices rise.
Properties you can live in aren’t the only ones available as investment properties. People need offices to work from, hotels to stay in, retail stores to shop in and restaurants to eat at. Like a residential real estate investment, a commercial real estate investment earns income by renting out space to tenants or selling the property once its value appreciates.
As with residential properties, selling a property with tenants can slow a sale while property prices rise.
Raw land is an undeveloped property with nothing on it – not even buildings or crops. Savvy investors use land loans to purchase raw land to lease to farmers or keep it until a developer buys it at a profit.
Raw land is typically less expensive than developed land, making it an attractive option for many investors. However, it’s also a riskier investment because you must wait for the land to appreciate in value or find a buyer to lease it for agriculture.
Investing in a property differs from buying a primary residence. Before you purchase an investment property, make sure you meet the requirements.
Financing for investment properties requires a healthier financial profile than for primary residences, particularly if you plan to rent the property to tenants. Here are some costs you’ll need to cover when buying an investment property:
Before taking out a mortgage to finance your investment property, make sure you can afford the monthly mortgage payments. If you’re renting, you should aim to make at least enough rental income to cover your monthly mortgage payment. If the property is vacant or you can’t rent it for as much as you wanted, you’ll need cash reserves to cover the cash shortfall and make your monthly mortgage payments.
Most mortgage lenders require borrowers to make at least a 15% down payment for investment properties. What you put down will depend on your lender and the loan type. For instance, if you take out a conventional mortgage, you’ll likely make a 15% – 25% down payment.
Before purchasing an investment property, make sure there’s enough money in your budget to cover the initial purchase costs, such as a home inspection and closing costs. In many states, investment property owners are legally required to inspect and clean their properties.
As a landlord or rental property owner, you must complete essential repairs – like emergency plumbing or HVAC issues – which can cost a lot of money. Check your local government’s building codes to ensure your repairs meet their standards.
It may be wise to budget more money than you think you need for routine and emergency repairs.
Investment property expenses don’t begin when tenants move in or when you purchase a property with tenants. You’ll need to budget money to advertise the property and run credit and background checks on potential tenants. Great tenants are an asset. Difficult tenants are challenging to deal with and can dramatically increase your expenses.
In today’s market, real estate investors often see positive cash flow with their investment properties, and the savviest investors calculate their approximate return on investment (ROI) before purchasing a property.
To calculate your ROI on a potential property investment, follow the steps outlined below.
Look up similar rental properties in your area. Find the average monthly rent for the type of property you’re interested in and multiply it by 12 to calculate income for 1 year.
After estimating your annual rental income, calculate your net operating income (NOI). Your NOI is your estimated annual rental income minus your annual operating expenses. Operating expenses are the total amount you pay to own the property each year.
Your expenses can include:
Subtract your operating expenses from your estimated annual rental income to find your NOI.
Divide your NOI by the total value of your mortgage to calculate your total ROI. Your ROI can help you determine whether you should invest in a property. It can also give you an idea of a real estate investment’s profitability.
Suppose you buy a $200,000 property that you rent out for $1,000 a month. Your total potential annual income is $1,000 multiplied by 12 months, which equals $12,000. Let’s also assume you pay about $500 a month in maintenance fees and taxes. To calculate your estimated operating expenses, use the following formula:
$500 ✕ 12 = $6,000
Next, subtract your operating expenses from your total potential rental income to get your net operating income.
$12,000 − $6,000 = $6,000
Finally, divide your NOI by the total value of your mortgage to calculate the property’s return on investment.
$6,000 ∕ $200,000 = 0.03, or 3% ROI
A 3% ROI is excellent if you can buy a property in a promising area and know you can rent to reliable tenants. If the area is known for having short-term tenants, a 3% ROI may not be worth the time and effort.
Investment property management can take up a lot of time. Here are a few tasks you may be responsible for when you purchase an investment property:
You must maintain the home while maintaining your tenant’s right to privacy. In most states, landlords must give tenants at least 24 hours' notice before they drop by.
Before buying an investment property, make sure you have plenty of time to maintain and supervise the property.