Investing in real estate can provide a reliable source of additional income if you take your time to select a great property that aligns with your goals, abilities, and budget. Investment properties can yield significant dividends, like tax breaks and equity gains, in addition to the monthly income. If you choose a property that falls outside of what you can handle, though, you might wind up looking at a potential disaster.
Here is an overview of some of the things that you should look for when choosing an investment property and what to expect if you plan to finance its purchase. Together, this guide should help you define what seek in a new investment property and help you to ascertain whether buying and renting it out is viable or not.
How to choose a property
Location
Location is everything. But really, it is. The location you choose has a significant bearing on many areas of your investment experience. For instance, think about your ideal tenants. If you ideally want to rent to a family, you'll have to look near top schools with nearby family-friendly amenities such as parks. If you’re considering a commercial property, make sure it has sufficient traffic.
To make sure your property is occupied at all times, consider purchasing something near a college campus where you might rent to a different student every year. If you’re planning to buy a vacation rental, make sure that it’s close to major attractions. You won’t get premium rates if you’re not in a prime location.
Beyond attracting the type of renter that you’d like to deal with, consider the neighborhood. Are property values in this area appreciating? Even though the goal is to earn a monthly income, you still want your property to maintain or increase its value if you decide to sell in the future. Are crime rates rising or falling? Typically, properties that are in low-quality areas will have higher turnover rates and generally require more work to manage and maintain.
And if you plan to manage the property yourself, how far will you have to travel to maintain it? The context of the neighborhood will help you determine whether the property is worth the risk now and for the long-term.
Condition of the property
Consider what you’re looking for in terms of property condition before you begin your search. If the potential to flip or rehab the house at a substantial gain is there, cautiously consider it. If you’re a handyman or woman or know a trustworthy contractor who will do quality work for a bargain price, then a fixer-upper might be a good place to start. Otherwise, keep it simple. If you’ll have difficulty financing or completing the renovations yourself, then stick to buying a property that’s already in decent shape.
As you pinpoint potential investment locations, make sure to look at them through the eyes of a future tenant rather than those of a home buyer. You don’t need the emotional component of the home buying experience, so put form and function at the top of your list. Make sure that the type of tenant you want to rent your unit will want to rent it.
Also, invest in a home or building inspection for your prospective property so you know in advance precisely what condition your property is in. If you choose to renovate, prepare for the time and expense of those improvements and build in a healthy contingency fund. As you repair properties, you’ll often uncover other problems you’ll need to fix. You have to provide a safe environment, so it’s imperative to fix all the major issues before you lease your property to a tenant.
As you consider a fixer-upper, make sure to implement practical designs that will appeal to a wide range of potential renters. Opt for durable materials that will stand the test of time and perhaps survive multiple renters. This renovation isn’t the time to coordinate a flashy custom paint palette or to waste money on touches that your target rental audience won’t necessarily enjoy. Save the custom renovation for your own house.
Bear in mind that each day that you need to work on the property is one that it won’t be generating income for you. Include the time before your property hits the market as an expense and make sure that you can handle that before you take the fixer-upper plunge.
How to Run the Numbers
Return on Investment
Once you've settled on a location, there are a few quick calculations that you can do to assess the viability of an investment. These will all give you a picture of how sound the investment is. Look at how much you have to invest. Consider how long you plan to own the property and what your potential income needs to be to justify this purchase.
A good rule of thumb as you evaluate the profitability of a property is the 1% rule. Ideally, you want to be able to secure at least 1% of the value of your total investment in fair market rental income each month. If you buy a $150,000 home, then you’ll want to make sure that you can roughly command at least $1,500 in rent each month.
The actual figure will depend on several variables. Though it's challenging to predict maintenance expenses, an older property is likely to require more work while you own it than a brand-new place. If you do not plan to maintain the property yourself, then include the anticipated management costs as one of your expenses to make sure that you still come out ahead. If your property requires HOA fees or other maintenance costs, make sure to include those too.
Other metrics that you can use are the cap rate, which compares the price of the property to the anticipated earnings against the rest of the neighborhood. Another standard metric is the price per square foot, also compared to other homes in the area. These will give you a snapshot of how valuable your property is before you decide to do any further in-depth analysis, like calculating the actual ROI or Return on Investment. At the end of the day, if you can’t take care of the expenses associated with owning and maintaining your investment profit and clear a profit, then you’d be wasting your time.
Down Payment
If you plan to finance any portion of your investment property, know that mortgage requirements for investment properties are different from those of buying your standard family home. The first difference is that you'll have to put down at least 15-20% of the property value as a down payment. You won't be able to get away with putting down 3-10% as you would for a primary family home mortgage loan since your investment property is considered a non-owner-occupied transaction (a house that you don’t plan to live in). Investment properties don’t qualify for mortgage insurance, either, and getting approved requires that you meet stricter approval requirements to secure financing.
Beyond that, the process is similar to obtaining your standard mortgage. The lender will consider your credit score, income, and debt-to-income ratio to make sure that you can handle the added financial pressure of an investment property. Like with your own mortgage, you’ll want to get pre-approved to make sure that it’s a viable proposition. If you can’t pay the down payment required and finance the costs of renovating the property, then you should consider another property.
Investment Mortgages
You should also expect that interest rates for your investment property mortgage might be between 0.50% to 0.75% higher than what you might get if you were seeking a primary mortgage. Just like any mortgage, you’ll want to make sure you're getting the best deal. Lenders will look at a few important considerations as they evaluate your loan. The first thing is the type of property that you're looking to buy. Multi-family properties with 2-4 units will add another 0.125%-0.25% onto the standard investment mortgage interest rate. Additionally, they'll consider your credit-worthiness and the amount of your down payment. A higher credit score and larger down payment can lead to a more favorable interest rate.
These qualifications are a little stricter than a primary mortgage because research shows that if you own an investment property and fall on hard times, you’d rather default on that loan than on the one that secures your own dwelling. Since owning an investment property is essentially owning a business, owners aren’t as attached to the property, making lending for an investment property a riskier proposition for lenders.
Make sure that you’re not carrying a lot of debt in proportion to your income and cash reserves. Your finances will be reviewed even more thoroughly when you apply for an investment mortgage than your mortgage application. Lenders just want to make sure that you have the funds to pay off their loan (and cash reserves to pay for the mortgage even if you don't have tenants) and handle any expenses, so they don't have to deal with any repercussions like default or foreclosure down the line.
If you've never owned a home or managed property, it'll be more difficult to secure an investment mortgage. If that's the case, some lenders will let you hire a property manager to shore up your application.
Property Taxes
Also, pay attention to the property tax rates and appraised values of properties that you may buy. Property taxes are a considerable expense that you need to include in your calculations when you determine if your investment is viable. Property Taxes may increase over time, so familiarize yourself with what you may need to pay on the property in the future.
Purchasing an investment property is a big decision, and choosing the right property is essential to earning a nice return on your investment. Prioritize selecting a convenient location and property that will attract the types of renters that you would like to have. Look for homes in safe neighborhoods with the potential to appreciate.
If you have the skills to brave a fixer-upper, make sure that you consider all of the costs and brace yourself for any eventualities. If renovation skills aren’t in your wheel-house, the entire experience may cost you more than you’d expect. Regardless, make sure you get a home inspection so that you know what you’re getting into.
As you consider the potential income of a given property, you can use the 1% rule to assess if the rent justifies the purchase price quickly. To calculate the return on investment, you'll need a good handle on what expenses you'll incur, like property taxes or management fees, as well as any financing charges if you plan to seek a mortgage. If you plan to finance your investment property, be prepared for stricter qualification requirements and more intense scrutiny of your finances, than you would if you were seeking a primary mortgage. Lenders consider investment mortgages to be higher risk, so anticipate a higher interest rate and larger down payment, too.
Even with all of that to consider, investment properties can bring in a substantial, steady stream of income if you choose wisely. If you are financially stable with good credit and care to invest a bit of time and attention to choosing and caring for your property, you can become a bona fide real estate investor.
For additional assistance with picking out your ideal investment property, feel free to reach out to Realty Executives by calling (866) 742-5732 or emailing us at ClientCare@RealtyExecutives.com.
