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Updated on Wednesday, January 23, 2019
Buying and renting out property is a time-honored way to grow wealth. It’s a popular strategy for people in all stages of life, from younger ones buying their first property to retirees looking for a solid source of retirement income.
Why real estate is an attractive investment
In today’s uncertain market, real estate looks especially attractive.
- Real estate prices continue to rise.
- Demand for rental properties outpaces supply in many areas, which allows landlords to raise prices.
- Real estate provides some protection against inflation. As the costs of other goods rise, a landlord can nearly always raise the rent.
Don’t ignore the risks
Yes, there are risks, and in order to be successful you have to figure out how to avoid them. Here are three things to look out for:
- Location, location, location is a real estate mantra that is particularly true when you buy real estate for investment. Buy in the wrong place and you risk not being able to make enough from the property to pay your costs — let alone make a profit.
- Don’t pay too much. Even a great property in a terrific location is risky if paying the mortgage eats up all your profits.
- Who is going to manage the property? Managing rental property is hard work. If you know what you are doing, you may be able to do it yourself. Or you may find it smarter and more profitable to hire someone else. But the bottom line is, good management is critical.
The “secrets” to success
The internet is full of advice for becoming a real estate mogul, but a lot of it is useless. The secret to successfully buying real estate for rental is not especially glamorous. Here are the basics:
- Decent credit score. Being able to get in the game by borrowing requires at least an average credit score, and you have more negotiating room if you have excellent credit.
- Cash in the bank. The bigger the down payment, the better the deal. If you can do the deal in all cash, you are truly on your way to success.
- Willingness to work hard. It is hard to over-emphasize how important this is. Finding good tenants, maintaining the property, managing the finances and keeping on top of market trends are all both necessary and challenging.
- Ability to pay even when you don’t have a tenant. Rental dry spells, maintenance emergencies and other unforeseen circumstances happen to every landlord. Even if you don’t have a paying tenant, you still will have to pay the costs of ownership. Having a fat emergency fund is key.
Ideas for financing your real estate investment adventure
Be an owner-occupant. The cheapest way for a novice investor to buy a first property is to purchase a small multi-family property, live in one unit and rent the rest. Most of the federal programs that assist first-time or non-recent homebuyers will consider lending to someone who wants to buy a four- or fewer-unit property, as long as the borrower lives in one of the units. These programs include conventional Fannie Mae loans, loans backed by the Federal Housing Administration (FHA), the U.S. Department of Veterans Affairs (VA) and the U.S. Department of Agriculture (USDA) rural home loan program. In all these cases, a portion of the anticipated income will be considered as part of the borrower’s income, which increases the amount you can borrow.
Use a conventional or an investment-only lender. If you are buying an investment property and this will be a second mortgage, expect the lender to make getting approval more difficult than it was the first time around. The lender will want to know what the property’s rental history has been. If it doesn’t have a rental history, the lender will probably ask for a rental appraisal. Expect to provide a 20% down payment, but don’t be surprised if the lender asks for 25% down. It is smart to shop around. Some lenders won’t even lend on investment properties, but others have programs for lending on both single-family and small multi-unit properties for both immediate rental and fix-and-flip.
Friends and family. Getting a loan from Mom and Dad or your brother-in-law may be cheaper, but it also can be painful. Make it a documented transaction — not a casual “I’ll pay you when I can” deal. Not only will the IRS approve, but also a formal agreement can preserve your relationship.
Cash. You inherit money from a family member, you get a nice, big bonus at work or maybe you win the lottery. Or you just save steadily and aggressively. Buying a property with cash gives you the most opportunity to get a great property at a good price. Before you do it, talk with your accountant and tax adviser. Even buying with cash can be surprisingly complicated.
Home equity loan or home equity line of credit (HELOC). That’s when you take cash out of another property you own and use it to buy the second property. The tax rules on these have changed recently, so understand the implications before you leap. Plus, remember that should things go badly, you can easily lose both properties.
Hard money lenders. These are private lenders that will lend without asking the same questions that conventional lenders ask. Interest rates are often high and repayment periods short. Be cautious.
Good reasons to take the leap and buy a rental property
- Buy smart and manage the property well and you have tax-deferred growth on your money and tax-sheltered cash flow. You are likely able to convert some personal expenses to business expenses, which can be a big tax advantage. But before you count on these, talk to your accountant. Don’t get into a fight with the IRS.
- Rental property can be a good retirement savings plan. Buy smartly and by the time you are ready to retire, you may be able to sell it for a nice gain that will help finance your leisure years.
- In the meantime, rental income will offer some cash flow that you can use to pay for some of the bonuses in life.
- If you already have other types of investments like retirement savings or a brokerage account, it is a way to diversify your investments, says Tendayi Kapfidze, chief economist for LendingTree, which owns MagnifyMoney.
Good reasons to run in the other direction
- Being a landlord is tough and the real estate industry is fickle. Circumstances beyond your control can turn a fabulous rental property into a dog you can’t rent or unload.
- All the pre-purchase inspections in the world won’t uncover all the potential money-sucking problems. Repairs can eat you alive.
- Tenants from hell. The seemingly nicest people in the world can turn out to be the worst kind of tenant — tenants who can cost you a fortune in both money and energy.
Buying a rental property — especially with financing — can be a nerve-racking risk, but for many, it turns out to be a rewarding investment. If you are determined to do it, get good advice, shop wisely for the best property you can afford and find financing that will give you enough leeway to manage the ups and downs of real estate investment.
“You have to have the capability to manage business — it isn’t easy or everybody would be doing it,” says LendingTree’s Kapfidze.
This article contains links to LendingTree, our parent company.