For what seems like forever, there has been a shortage of properties for sale. A 6-month supply of homes is generally considered to be a balanced market – meaning there is equilibrium between buyers and sellers. But for the past few years, fewer homes on the market are being chased by many buyers resulting in multiple offers, pushing up prices, and thus limiting choices. This is a seller’s market.
This shortage is a challenge for everyone in the market to buy a home, including investors who want to buy rental property. For investment property buyers, this poses the additional challenge of making it harder to find a property with positive cash flow. A long time ago I heard an adage – that “you make money when you buy real estate, not when you sell it.” To me, that means that if you overpay, you will be less likely to make a profit – and I think that is especially true with investment property.
Here are a dozen considerations to make if you are thinking about buying rental property:
- Get Preapproved. When considering any real estate purchase, you should get preapproved, and find out exactly how you will be viewed by underwriters. And you can find out exactly how the financing of the property will look. You may be able to take steps to make yourself a stronger borrower – we may find mistakes in your credit report, or find strategies for improving your credit score that can lower your interest rate.
- Plan for a larger down payment. Mortgage insurance is only available in certain situations, and always requires a minimum down payment of 15%. Putting down 20% avoids the expense of mortgage insurance. And putting down 25% will get you a significantly better rate vs. a 20% down payment.
- Look for ways to get creative. I have worked with many investors over the years and have strategies that can help. For example, if you have plenty of equity in your primary residence, a HELOC can be a good source for your down payment. Just plan to pay the HELOC down quickly – to limit your exposure to future interest rate hikes.
- Gift funds are NOT allowed. Gift funds are not allowed for investment property purchases – all funds for your down payment, closing costs, and reserves must be your own, although to a limited extent, sellers may pay some of your closing costs.
- Make sure you have “reserves”. You will be required to have reserves in place after closing – typically 6-months.
- Consider using a property management company. As a landlord you will be responsible for repairs and maintenance. Be sure to have savings available for unexpected repairs. And while you may enjoy being handy, you may not want an emergency plumbing phone call at 2am. For a well-earned fee, property managers will find tenants, collect rent, and handle emergencies.
- You are responsible for the mortgage payment, even if you don’t have tenants right away. You may want to project a vacancy factor of as much as 25% – because over time tenants will come and go. It may take a while to rent out a just-vacated unit – especially if it needs substantial repairs or rehabbing, thus reducing your income.
- It is a good idea to start small. Purchasing a modestly priced 1-unit property can help you determine if owning rental property is for you. Repairs and maintenance can present a challenge, but tenants present their own challenges.
- Research the rental market. You want to make sure that you can rent the property at a competitive rent that works for the local market.
- Unless you are a contractor, beware of fixer-uppers. Unless you have serious handyman skills and a lot of free time, I’d suggest you avoid a property that needs much work. Repairs and renovations cost money, and will make it harder to make a profit on your investment. Look for properties that need modest repairs that are priced at below-market rates.
- Work with a financial advisor to determine the best approach to including rental property in your financial portfolio. For example, the interest rate will be lower with a 15 year fixed rate loan – but the payment is larger, and the loan is paid down much more quickly – and thus the interest expense on your Schedule C will go away more quickly than with a 30 year fixed. Which is the better choice? That is a question for your financial adviser.
- Consider the annual expenses.
- Fixed Expenses – these include recurring, annual expenses for property taxes, property insurance, routine maintenance and repair items, and the cost of property management services.
- Variable Expenses– you will also have unplanned expenses – for replacing the water heater, air conditioner, furnace, roof, fencing, flooring, plumbing, etc.
- Vacancy Expense – there will be time between tenants where you have no income.