Q. I’m thinking of buying a house down the block from me and then renting it out. How can I decide if it’s worth it as an investment?
— Maybe a landlord
A. This isn’t just a financial decision. You also have to decide if you’re ready to become a landlord.
First, the finances.
“Buying rental property can be an excellent investment strategy; it offers opportunities for both cash flow and equity creation,” Bill Connington of Connington Wealth Management in Paramus, N.J. said. “It can also help to shelter some or all of your gains from both federal and state income tax.”
Connington said you should look at the property values in the community.
If you can find an undervalued property in the neighborhood, it will only help to increase your appreciation which would be one way to value the property, he said.
While you can buy properties for appreciation alone, you can also look for cash flow. This would be the money left over from your rent after paying off your operating expenses, he said.
Real estate also offers different tax advantages.
“While you own property, it builds equity without having to pay tax on it and provides a number of expenses including depreciation,” Connington said.
Then, you need to look at the property’s debt service coverage ratio, or DSCR. To calculate that ratio, divide a year’s worth of mortgage payments into the property’s net operating income, or NOI. You are looking to have a DSCR above one, which means positive cash flow, Connington said.
Connington said being a real estate investor is neither a simple nor a passive process. Mistakes during the acquisition process can cause more than its fair share of headaches.
“When you buy a rental property make sure that you inspect it, hiring a professional inspector to go through the property with a fine tooth comb will be worth the cost,” he said. “Carefully survey the marketplace and make sure it can collect the rent you will be asking for, or need to have for a positive cash flow.”
Also research the market occupancy rates to see if rentals are needed in the area.
Connington said one of the keys to investing in a property is to know how and when to get out of it and move on to your next investment property.
He said you should have both a long- and short-term strategy. If you are buying a property to flip, you will want to rehabilitate it to get it back on the market quickly. This strategy is for areas where housing sales and property values are increasing.
If you are looking to hold onto property long-term, then you may look to take out an adjustable rate mortgage to increase cash flow, but make sure you have an exit strategy before you have to refinance, he said.
“You want to make sure your house is nice, that you rent to good, employed tenants and have a large cash cushion so you can cover expenses of items that you may need to replace,” Connington said. “Do your homework before buying.”
No matter what type of home you’re buying, it helps to check your credit before you start shopping for a mortgage. A good credit score generally qualifies you for the best terms and conditions. You can view your two free credit scores each month on Credit.com.
More on Mortgages & Homebuying:
- Why You Should Check Your Credit Before Buying a Home
- How to Find & Choose a Mortgage Lender
- How to Refinance Your Home Loan With Bad Credit