Owning a rental property can be a lucrative way to earn passive income, but it isn’t for everyone. Use these tips on buying rental property and becoming a landlord to determine if it's the right decision for you.
Research the rental market.
Before you invest in real estate, make sure to do thorough research. Savvy investors don’t just search for the most affordable property they can find. They get to know the neighborhoods, demographics, and housing trends. Spend some time figuring out what type of rental property you want, and make sure you target your search where it makes the most sense. For example, if you’re looking to rent a condo to students, it may not be best to buy a property that’s far from campus and public transportation. You’ll also need to evaluate the market rate. Determine whether or not you’ll be able to charge enough in rent to cover your mortgage, routine and unexpected maintenance costs, and turn a profit.
Decide what you can afford.
Although you can sometimes put down as little as 3 percent for a property that will be your own primary residence, buying rental property usually requires a minimum of 20 percent down. This is because private mortgage insurance (PMI), which protects the lender if you default on your loan, is not available for investment properties. But a down payment of 20 percent—or more—supports your investment strategy: The less you borrow, the less you pay in mortgage, leaving more room for you to profit from whatever you charge in rent.
If you’re unable to put down at least 20 percent, consider buying the property as a residential property first. Depending on the terms of your mortgage, you generally only need to live in the home for one or two years. After that, you’re free to use it as a rental property, as long as there are no city or homeowners association restrictions. If you already own a home, you could potentially rent it out and move into the new property for a couple of years. However taking on two mortgages can be risky, especially if you run into any difficulty maintaining a renter.
Keep extra costs in mind.
One of the most important factors in the lifetime cost of your loan is the interest rate on your mortgage. The interest rate for investment properties is generally higher than it is for a traditional mortgage—be careful not to bite off more than you can chew. Before you make any commitments, factor in risks—such as a recession—so that you’re prepared to pay even when the economy isn’t at its best.
Finally, when choosing the property itself, avoid buying anything that’s in total disrepair. Home renovation shows are fun to watch, but buying a fixer upper as a rental property can be a big risk. You end up not only sinking more money into the property, but also forgoing rental income during the renovation process. Buying a property that requires few or no repairs means you can rent it out right away. Instead, consider simple renovations such as new paint and updated appliances. A little refresh allows you to charge more for rent without eating into your profits.
Weigh the pros and cons of being a landlord.
Becoming a landlord also means taking on a lot of responsibility. You can hire a property manager to interview potential tenants and take care of late-night maintenance calls for you, but that will eat into your profit. When you’re starting out, consider investing in a single-family home so that you can handle maintenance projects and tenant interviews on your own.
Of course, if you’re becoming a landlord, you also need to protect yourself and your investment with insurance. Depending on the coverage you select, landlord insurance may reimburse you for losses such as dry rot, other repairs, and even lost rental income if the property becomes uninhabitable. Make sure you’re familiar with both landlord and tenant rights, which vary by state. Understanding the laws that affect your investment can help you protect yourself from potential lawsuits.
Owning a rental property can offer many rewards, including passive income that is free of social security taxes—in fact, you can even deduct the interest you pay on your loan. A rental property is also often a more stable investment than toying with the stock market. This is because owning stock leaves you vulnerable to whatever the company decides to do while a rental property is a physical asset under your control. Plus, with stocks, you don’t get your hands on any cash until you sell your investment. A rental property provides income as long as you own it and you’re free to sell whenever you choose.
However, there are also potential cons to owning a rental property. For example, you can’t instantly sell your investment as you would with stock. Depending on local state law, you’ll need to provide advanced notice to tenants with a month-to-month lease (typically 30 to 60 days). But, if your tenants are still under an active long term lease, things get a bit trickier. Your first option is to wait until the lease ends. Your second option is to try to find a buyer who will continue the lease—as you can imagine, this route can be quite difficult. Your last option is to try to buy your tenants out of their lease, though this can be costly.
To reduce risk and make the best investment possible, don’t rush into anything. Take your time researching properties, and consult a financial adviser before you purchase anything. If you do decide on owning a rental property, let AAA help you find the best possible protection for your new investment.