Thinking about purchasing an investment property? Real estate has produced many of the world's wealthiest people, so there are plenty of reasons to think that it is a sound investment. Experts agree, however, that as with any investment, it's better to be well-versed before diving in with hundreds of thousands of dollars. Here are the things you should consider and investigate.
Do you know your way around a toolbox? How are you at repairing drywall or unclogging a toilet? Sure, you could call somebody to do it for you or your could hire a property manager, but that will eat into your profits. Property owners who have one or two homes often do their own repairs to save money.
Of course, that changes as you add more properties to your portfolio. Lawrence Pereira, president of King Harbor Wealth Management in Redondo Beach, Calif., lives on the West Coast but owns properties on the East Coast. As someone who says he's not at all handy, he makes it work. How? "I put together a solid team of cleaners, handymen, and contractors," says Pereira.1 This isn't advisable for new investors, but as you get the hang of real estate investing you don't need to remain local.
Savvy investors might carry debt as part of their portfolio investment strategy, but the average person should avoid it. If you have student loans, unpaid medical bills, or children who will attend college soon, then purchasing a rental property may not be the right move. Pereira agrees that being cautious is key, saying, "It's not necessary to pay down debt if your return from your real estate is greater than the cost of debt. That is the calculation you need to make." Pereira suggests having a cash cushion. "Don't put yourself in a position where you lack the cash to make payments on your debt. Always have a margin of safety."
Investment properties generally require a larger downpayment than do owner-occupied properties; they have more stringent approval requirements. The 3% you may have put down on the home where you currently live isn't going to work for an investment property. You will need at least a 20% downpayment, given that mortgage insurance isn't available on rental properties. You may be able to obtain the downpayment through bank financing, such as a personal loan.
The last thing you want is to be stuck with a rental property in an area that is declining rather than stable or picking up steam. A city or locale where the population is growing and a revitalization plan is underway represents a potential investment opportunity.
When choosing a profitable rental property, look for a location with low property taxes, a decent school district, and plenty of amenities, such as parks, malls, restaurants, and movie theaters. In addition, a neighborhood with low crime rates, access to public transportation, and a growing job market may mean a larger pool of potential renters.
Is it better to buy with cash or to finance your investment property? That depends on your investing goals. Paying cash can help generate positive monthly cash flow. Take a rental property that costs $100,000 to buy. With rental income, taxes, depreciation, and income tax, the cash buyer could see $9,500 in annual earnings, or a 9.5% annual return on the $100,000 investment..
On the other hand, financing can give you a greater return. For an investor who puts down 20% on a house, with compounding at 4% on the mortgage, after taking out operating expenses and additional interest, the earnings add up to roughly $5,580 per year. Cash flow is lower for the investor, but a 27.9% annual return on the $20,000 investment is much higher than the 9.5% earned by the cash buyer.