Whether it’s due to all the HGTV binge watchers out there or because Americans seem to have mentally recovered from the 2008 housing-market crash, one thing seems to be clear: The real-estate itch is alive and well.
But we’re not just talking families looking for their next home. Over the past few years, an increasing number of buyers have become interested in purchasing real estate specifically as a way to help make money. Last year, investment-home sales reached an estimated 1.09 million, a 7% jump over 2014 figures, according to a survey from the National Association of Realtors. Overall, about one in five homes bought in 2015 was an investment property.
For Katherine Dayton, 42, of Bozeman, Montana, being a real estate investor has been a steady side gig since the age of 28.
After a few work colleagues gave her a primer on how mortgages work, Dayton realized that buying a home and taking in roommates would actually cost her less than renting a place by herself—plus, she’d be building equity. “I went into it with a financial approach of it being a good investment,” recalls Dayton.
But she didn’t stop there. After a few years, she sold her first property to buy and fix up another house closer to the center of town, eventually turning it “into a rental that more than covered the mortgage,” she says. This was followed by another rental home she invested in with a friend—and now, 14 years later, she owns several rental properties in the college town of Bozeman.
But Dayton is quick to point out that not all of her investments have been equally successful. For example, while smaller, more basic units fare well with the college crowd in her town, her investments in nicer, high-end buildings and vacation rentals haven’t done as well. “The few places that haven’t been so modest have been a little more of a test,” she says. “I know that other people have done better at those [markets] than I have, so it was just a lesson in sticking with what you know.”
Dayton’s experiences show that being a landlord can be a lot tougher than it sounds. Investing in real estate can be a risky and headache-inducing endeavor, especially if you aren’t mentally and financially prepared to play landlord and take on multiple mortgages. Below, we’ve lined up six things you need to think about before dipping your toes into real estate investing.
1. Your Financial House Should Be In Order First
First things first: Can your finances handle this type of commitment? In other words, do you have a steady income and a well-stocked emergency fund? Are your high-interest debts paid off? Are you on track to meet your retirement-savings goals? (And no, real estate investing isn’t a replacement for retirement savings, in case you were wondering.) If you have a financial planner, does he or she support a decision to put your hard-earned money into this type of investment?
“From an advisor standpoint, the client needs to evaluate if it makes sense to own rental property as part of their overall portfolio, given their current financial position,” says Tim Sullivan, a Certified Financial Planner™ (CFP®) and founder of Clarity Financial in Columbia, Missouri. “‘Does the purchase make sense financially?’ is certainly one question, but ‘Does owning rental property align with the goals the client has expressed?’ is also equally important.”
After careful consideration of your overall financial picture, you’ll want to map out the costs up front. “Not just any deal is going to make sense—it has to pencil out first,” says Brandon Turner, vice president of growth at the real estate investing social network BiggerPockets.com, and author of “The Book on Rental Property Investing.”
Yes, you’ll have to factor in the down payment and monthly mortgage bill, but that’s just the tip of the financial iceberg. “Learn how to calculate all of the expenses you might face, including the ones that are only once-in-a-decade, like new appliances, a new roof and new carpet and paint,” Turner says. You should also plan to set aside money for repairs and maintenance. The exact amount will vary by property, but Turner recommends budgeting $100 to $200 per month for a single-family home or 10% to 15% of the rent for a multifamily property.
And here’s one more public service announcement: If you’re thinking of tapping your 401(k) to help cover some of these costs, consider rethinking that option. By doing that, you miss out on the benefits of compound growth and you are potentially sacrificing your future retirement fund.
RELATED: Ask a CFP: ‘Is It Ever a Good Idea to Borrow From a 401(k) for a Home Down Payment?’
2. Real Estate Isn’t Without Risk, So Calculate Your ROI Before You Buy
Just the way you likely wouldn’t put money into a mutual fund or ETF without first checking its performance, neither should you jump on an investment property without checking what your potential return might be.
“Rental property is not a low-risk investment, so investors should look for something with returns much higher than what a diversified portfolio would return,” Sullivan suggests. That’s why he personally recommends looking for properties with a potential return on investment of at least 14% to start.
To get an estimate of your first year ROI, subtract the annual principle and interest you’d pay from your total estimated net income from the property (which includes potential rental income, estimated tax savings, projected property appreciation and any estimated additional equity from renovations). Then, divide that number by your down payment, assuming that closing costs and taxes are already rolled into your mortgage, and rehab costs.
It’s important to remember that truly understanding your ROI can be extremely complex, and you’ll likely have to tailor any estimates to your individual situation. That’s why James Wachob, head of investor relations at Memphis Investment Properties, suggests buyers speak with a trusted commercial real estate adviser to help them better determine what their calculation could be.
Keep in mind when estimating any potential loan amounts that the rules for investment property financing may not be the same as for primary homes. For example, many of us are familiar with the rule that recommends putting down at least 20% on a home to avoid paying private mortgage insurance (PMI). However, some homeowners still opt to put down less and pay the PMI. But with an investment-property mortgage, you may have a harder time finding a lender willing to consider you if you can’t put down 20%—or more.
“Educate yourself about lending for investors, because it changes daily,” Wachob says. “It’s not something you learn [once] and you’re done.”
In an ideal situation, your tenants would help cover the full amount of your loan and then some, while your property continues to grow in value. However, the key word here is “ideal”—keep reading below to continue weighing the pros and cons.
3. Finding the Right Real Estate Agent Is Key
Many agents may view you simply as potential commission, so it helps to find someone who’ll be on your side: a real estate agent who’s interested in establishing a relationship, owns rental property themselves and specializes in investment properties, suggests Wachob. “Make sure you’re aligned with afiduciary who has your best interests in mind,” he adds.
Finding that person becomes exponentially more important if you’re considering a neighborhood you’re not very familiar with. “[You need] somebody in town who lives and breathes investment real estate with their boots on the ground,” Wachob says. In many cities, safety and desirability can vary not just by ZIP code but from block to block. An experienced agent will be well-versed in the area and will know when a property is too good to be true.
4. Your Investment Property Doesn’t Have to Be Your Dream Home
Does your list of must-haves generally include hardwood floors, a two-car garage and double-sink bathrooms? Maybe those were right for your personal abode, but they may not be necessary in an investment property. Many people bring their own emotion into the process and wait for the perfect place—only to see an opportunity pass them by, Dayton says.
Generally speaking, one of the biggest factors you should be focused on is the cliché-sounding location, location, location. “Look for property in a location that you feel comfortable spending time in and will attract high-quality tenants,” Turner advises. Beyond that, think about what would appeal to the demographic of the renter you’re trying to attract: What may appeal to grad school students in a college town, for instance, may not be suitable for a young family starting out.
5. Expect Your Taxes to Get More Complicated
The minute the keys are handed over to you, plan to hire a CPA or Enrolled Agent, a federally authorized tax practitioner, to help you with your taxes, Sullivan suggests. In the brave new world of landlordship, you’ll need to track expenses associated with the property, understand the difference between a repair and an improvement, and report rental income and losses with an IRS form Schedule E.
Plus, your tax preparer could help you unearth all the tax benefits you could potentially be eligible for. “When you own real estate, the U.S. government is very friendly to you in terms of your taxes owed,” Turner says. You may be able to take deductions, for instance, on the property taxes you pay or what you shell out for repairs.
6. Know That Finding—and Keeping—Good Tenants Will Require Some TLC
Homing in on the right property is only step one. Then comes filling it with people who will treat it properly and pay their rent on time.
“I tell people that you aren’t getting into the property-management business so much as the tenant-screening business,” Sullivan says. “First, ask yourself if you would mind getting a phone call from a tenant on a Sunday afternoon—just as you sit down to watch some football—letting you know that their toilet is broken. If something like that ruins your day, then you better think twice about having rental property.”
The closer you live to your investment, the less likely these calls should come as a surprise. “It’s helpful to be a landlord who lives at the property because you can keep an eye out; you know what’s going on at all times,” says Jeff Lanci, 39, who renovated a property in Queens, New York, and lives on the main level while renting out an upstairs apartment.
To find high-quality tenants, don’t be shy about conducting background checks and requiring deposits. Lanci also contacts two prior landlords from each prospective tenant. “They had no qualms telling me if [the tenants] were late in rent or throw loud parties,” he says. “I found that information to be invaluable.”
The extra work upfront can be worth it in the end. “If you take the time and energy to find good tenants and treat them nicely, they will stay longer and life will be much easier,” Sullivan says.