Buying a rental property can be a very lucrative and sound financial investment. But it can also winding up costing you, particularly if you haven’t done your due diligence prior to making a purchase.
Here’s how to determine whether or not buying a rental property with financing makes sense.
1. Location, Location, Location
Location for the property is critical. Buyers tend to think of a rental property in terms of dollars and cents related to the transaction with less focus on location. While this isn’t necessarily a bad strategy, a rental property in a fantastic location will always have strong rents, fewer vacancies and much better appreciation over time compared to a property with better cash flow in a less desirable location.
2. Get Real About Repairs
Generally, it is a good bet when you can buy a rental property where the rent is greater than the mortgage payment, turning your cash flow positive. Still, it is a good idea to allocate at least 5% of the gross rents for the inevitable repairs that you’re going to incur as a landlord. These repairs include but are not limited to:
- New roof
- New/repaired gutter
- New paint
- New kitchen
- Various repairs
3. Return on Investment
Considering how much cash your rental property will need to earn X return is critical. Rate of return (ROI) is your net (after expenses) annual income divided by the capital investment. For example, if your net income is $1,000 per month and your cash to buy a rental is $100,000 (down payment + closing costs), then $12,000 divided by $100,000 equals a 12% return.
Each property will have a different rate of return. What’s the best return to aim for? That depends on your appetite for risks, cash on hand and rents the property in question could generate.
4. Property Type
This one is big and is by far the most important decision you’ll need to make. To give you some general rules of thumb, let’s consider single-family homes, condominiums and multi-family properties. Multi-family properties almost always generate more rental income than single-family homes. A multi-family home is essentially getting several single-family homes for one.
Here’s a reason: Buying a rental, such as a duplex, allows the landlord to have flexibility when there’s a vacancy. If one unit is vacant, the other unit makes up for the loss and vice versa. The combination of more units means more revenue-driving potential and higher returns.
Single-family homes can be solid financial investments as long as you do your homework. A single-family home in a great location can be a sound financial investment. However, if you have a vacancy, you don’t have another unit to offset loss of rent — unless you have a single-family home with a granny unit. The granny unit can help offset that negative rental impact from the vacancy.
Condominiums are at the end of the list of properties types to consider since they are the last to appreciate and the first to depreciate in economic cycles. Additionally, you’re sharing units with other owners, which makes the income potential limited compared to a single-family home or a multi-family property. Taking it a step further, the homeowner’s association payment can be anywhere between $200 and $400 per month. That’s a big chunk of your cash flow that otherwise could be used to plan for upkeep or pay a property manager.
The Big Picture
Ask yourself the following questions when evaluating whether a rental makes sense for you:
- Is the property in a good location that would command solid rents and will always be desirable?
- If it’s not in a good location, how much better is my ROI?
- Is this a property that will need minimal or manageable upkeep over the long-term?
- Is this an older property that will need more upkeep?
- How is this benefitting me financially?
A good rule of thumb when buying a rental property is to make sure you understand all the figures associated with this high-ticket investment. (Remember, this can include checking your credit, since a good credit score will generally net you lower rates on a mortgage. You can view two of your credit scores, updated every 14 days, for free on Credit.com.) The better handle you have on the numbers, the better chance you will have at purchasing a solid rental property.