Things to consider before buying an income property
Avery Carl was looking for a way out. “I started investing in property to build a passive income stream so that I wouldn’t have to rely on a corporate gig my whole life,” she said. The former music executive bought her first investment property at age 26. Today, she owns 11 properties and operates The Short Term Shop, brokered by eXp Realty: a business aimed at helping other investors acquire short-term rentals. “I was surprised by how easy it actually is to own rentals,” she said, “and how quickly one can become five, and five can become 20.”
What is an investment property?
An investment property is real estate purchased with the goal of earning a financial return through rental income or resale. There are several options when buying an income property:
- Single family. A house, condo or apartment leased to a single person or family.
- Multi-family. Larger buildings of two or more units, including duplexes and apartment complexes. Additional units may seem daunting, but according to Logan Allec, CPA and author of Money Done Right, small investors still stand to benefit. “While firms are the sole buyers of large properties, it’s entirely possible for an average person to buy a four-unit apartment building,” he said.
- Retail. A storefront for a tenant’s commercial use.
- Storage. It may sound dull, but a warehouse could be a worthwhile buy. “Storage is the hottest investment area now,” Allec said. “If you buy a storage facility, you hope to make money by leasing a storage unit to people who pay a monthly rent for it.”
- Land. Buying a vacant lot in a fast-growing area could amount to greater returns. “Waiting for [land] to appreciate has long been a popular investment strategy,” Allec said.
- House flipping. If you don’t want to deal with tenants, house flipping could be the answer, which involves buying, renovating, and reselling property at a profit within a short time frame.
The pros and cons of buying an income property
What motivates a buyer to pursue investment property? What are the benefits and risks of adding a second (or third) home to your list of assets and debts?
Pros of buying investment property
- Cash flow. The primary benefit of buying an investment property is simple: more income. The average Airbnb host earns $924 per month in rental revenue, according to a Priceonomics study. You also have the choice of a traditional lease agreement to bring in a predictable monthly income.
- Tax benefits. Paying taxes on rental property may seem like a drawback, but there are plenty of breaks aimed to help investors. “Rental properties come with a range of tax advantages,” said Brian Davis, real estate investor and co-founder of Spark Rental. “Every single expense is deductible, plus investors can take advantage of some paper expenses as well, such as depreciation. If they hold the property for at least a year and sell it for a profit, those profits are taxed at the lower capital gains tax rate. And even that can be deferred indefinitely, by doing a 1031 exchange.”
- Leverage. Perhaps the most tempting aspect of buying an investment property is the potential, also known as financial leverage. Earning passive income could lead to greater investments and profits in the future. According to Allec, there are plenty of possibilities. “Let’s say you want to buy a $100,000 house that earns you $500 per month in rent,” he said. If you had $100,000, you could buy the house outright and make $500. Or, you could use the $100,000 and put down five different $20,000 down payments on five different houses. In that scenario, you make $2,500 a month in rent. That’s the beauty of leverage.”
Cons of buying investment property
Time management. Taking care of investment property takes time. “It takes work to find good deals, to buy and finance them, and to manage properties,” Davis said. “It also takes expertise, which of course takes time and effort to learn.” The learning curve is steep for a first-time income property buyer and tackling it may not be feasible if your schedule is already overloaded.
Lack of liquidity. Perhaps the greatest risk of investment property is lost income and flexibility. “Real estate is not a very liquid asset and can take time to sell, which is one of the primary cons of investment properties,” said Chris Mardelli, a California-based real estate broker. If your budget is already tight, sinking your savings into a real estate investment can be a bad move, especially if the homes in your area of interest have a tendency to sit on the market for an extended period.
Up-front and ongoing costs. Non owner-occupied real estate comes with higher upfront costs. The first thing to consider is your investment property mortgage. Even with perfect credit and a sizable down payment, the mortgage fees incurred for investment properties are higher than primary residences, and you’ll see the difference in the interest rate. In general, you’ll pay about one percentage point above owner-occupied residential mortgages, according to HSH, a mortgage consumer organization.
In addition to a higher mortgage interest rate, there are the typical closing costs that come with buying a home. It’s also important to think about ongoing expenses like maintenance, lawn care, and other landlord responsibilities that diminish your overall profits. If you plan to use the home as a short-term vacation rental, you’ll need to cover the usual things like utilities, but there’s also furnishing the property and paying for management and maid services after each use.
Is investing in rental properties right for me?
Profit or loss are the outcomes of buying investment property, but the decision to take the first step should extend beyond financial simplicity. According to Allec, successful investing requires dedication. “If you are the kind of person who loves open houses and scrolling through Zillow, you probably have the passion to stick with it,” he said. “It is a difficult and time-consuming industry that many beginners eventually quit because they don’t love it. If this is you, it might be best to avoid.”
If you have the motivation, all that remains is ensuring your ability to safely afford an investment property. You can help determine your readiness by taking a few first steps:
- Check your credit scores to ensure that you qualify for the best interest rates.
- Talk to a real estate broker about what it takes to qualify for an investment property mortgage, including how it will influence your debt-to-income ratio.
- Consider how a down payment on an investment property would affect your savings.
- Create a property budget and be prepared to stick to it. “Even investment properties can become emotional multi-offer situations driving the price up, so [buyers] must be sure they stress test their investment criteria and numbers and be prepared to walk away if a deal doesn’t make sense,” Mardelli said.
- Consider how you would pay for surprise income property expenses.
With the right approach, investing in rental property can be a lucrative move, but it takes skill and planning to earn a profit. Organize your finances and do your research to make the most of the opportunity.