Real estate has produced many of the world’s wealthy people, so there are plenty of reasons to think that property is a sound investment. But like any investment, it’s better to be well-versed before diving in with your hundreds of thousands of dollars. Arm yourself with the information below before starting a new career as a real estate tycoon. (See also: Tips for the Prospective Landlord.)
1. Make Sure it’s for You
Do you know your way around a toolbox? How are you at repairing drywall? Or unclogging a toilet? Sure, you could call somebody to do it for you, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money. If you’re not the handy type and you don't have lots of spare cash, being a landlord may not be right for you. (See also: Becoming a Landlord: More Trouble Than It's Worth?)
Your first property will consumer lot of your time as you learn the ins and outs of being a landlord. Think of it as another part-time job. Do you have the time?
2. Pay Down Debt First
Savvy investors might carry debt as part of their investment portfolio, but the average person should avoid debt. If you have student loans, unpaid medical bills or have children who will soon attend college, purchasing a rental property may not be the right move at this time.
3. Get the Down Payment
Investment properties generally require a larger down payment than owner-occupied properties, so they have more stringent approval requirements. The 3 percent you put down on the home you currently live in isn’t going to work for an investment property. You will need at least 20 percent, given that mortgage insurance isn’t available on rental properties.
4. Beware of Higher Interest Rates
The cost of borrowing money might be cheap right now, but the interest rate on an investment property will be higher than traditional mortgage interest rates. Remember, you need a mortgage payment that’s low enough so that it won’t eat into your monthly profits too significantly.
5. Calculate Your Margins
Wall Street firms that buy distressed properties aim for 5 percent to 7 percent returns because they have to pay a staff. Individuals should set a goal of 10 percent. Estimate maintenance costs at 1 percent of the property value annually. Other costs include insurance, possible HOA fees, property taxes and monthly expenses such as pest control and landscaping. (See also: A Quick Guide To Landlord Insurance)
6. Don’t Buy a Fixer-Upper
It’s tempting to look for the house that you can get at a bargain and flip it into a rental property. But if this is your first property, that’s probably a bad idea. Unless you have a contractor who does quality work on the cheap – or you’re skilled at large-scale home improvements – you’re likely to pay too much to renovate. Instead, look to buy a home that is priced below the market and that needs mostly minor repairs.
7. Calculate Operating Expenses
Overall, operating expenses on your new property will be between 35 percent and 80 percent of your gross operating income. If you charge $1,500 for rent and your expenses come in at $600 per month, you’re at 40 percent. For an even easier calculation, use the 50 percent rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total expenses.
8. Determine Your Return
For every dollar you invest, what is your return on that dollar? Stocks may offer a 7.5 percent cash-on-cash return while bonds may pay 4.5 percent. A 6 percent return in your first year as a landlord is considered healthy, especially given that number should rise over time.
9. Get a Low-Cost Home
The more expensive the home, the higher your ongoing expenses will be. Some experts recommend starting with a $150,000 home.
10. Find the Right Location
Look for low property taxes, a decent school district, a neighborhood with low crime rates, an area with a growing job market and plenty of amenities like parks, malls, restaurants and movie theaters. (See also: Top 10 Features of a Profitable Rental Property)
The Bottom Line
Keep your expectations realistic. Like any investment, a rental property isn’t going to produce a large monthly paycheck for a while and picking the wrong property could be a catastrophic mistake. Consider working with an experienced partner on your first property or rent out your own home to test your landlord abilities.