Here’s What You Need to Know Before You Buy a Rental Property

Estimated reading time: 4 mins

Did you know that real estate is the most popular investment vehicle in America right now? A rental property can generate a steady stream of income, and the longer you hold onto it, the more income it will generate and the more value it will gain thanks to appreciation. But you shouldn’t rush into buying a rental property just because you can.

You need to know what you’re getting into with becoming a landlord, because owning a rental property can be a lot of work and you can even lose money on the investment, especially if you don’t manage it right. You need to have the time and skills to keep your rental property in good condition, or the willingness to pay a property management company to manage it for you. You need real estate savvy to choose a property in a good location and one that can command enough rent to be profitable for you. 

Being a Landlord Is a Lot of Work

When people daydream about owning rental property, they typically fantasize about collecting rent checks on the side from their regular paycheck. They don’t think about all the work that goes into being someone’s landlord. You’re responsible for repairing things when they break, fielding calls from your tenants at all hours of the day and night, taking care of the landscaping, finding tenants, updating the property between tenants, collecting rent, and starting eviction proceedings. Managing a rental property can be a full-time job. Even if you’re not doing repairs and maintenance on the property yourself, you’re going to need connections among local contractors so you know who to call and can have them show up reliably.

However, if you can’t handle all of that responsibility, there is another option. For 10 to 20 percent of the rent you earn each money, you can hire a property management company to take care of your property for you. They’ll do everything from find tenants to maintain the property to perform evictions as needed. It can be expensive to hire a property management company, but it can be worth it to not have to worry about your rental property – and then you really can sit back and collect rent checks every month.

An Investment in Rental Property Has Its Risks

Just like any investment, an investment in rental property has its risks. You run the risk of a tenant not paying rent and taking months to evict, during which time you’ll have to cover the expenses on the property. You run the risk of a tenant doing costly damage to the property, especially if they become disgruntled. You run the risk of the property depreciating, or losing value, so you need to know, how does rental property depreciation work? If the location becomes less desirable over time, or you can’t afford to maintain the property and it deteriorates, that could cause depreciation, for example. And, of course, if you have trouble finding tenants and your rental property sits empty, that will cost you money too.

You Will Need to Get Your Finances in Order to Get a Mortgage to Buy a Rental Property

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Getting a mortgage to buy a rental property isn’t typically as easy as getting a mortgage to buy a primary residence, because you don’t qualify for government-backed loan programs like Federal Housing Administration (FHA) loan or the Department of Veterans Affairs (VA) loan. Of course, that’s not the case if you plan to live in the property yourself, whether you’re house hacking or buying a multi-family unit. You can buy up to a four-unit property and still qualify for a primary residence loan as long as you live in one of the units yourself.

Otherwise, you’re going to need to save up 15 to 25 percent for a down payment. You’ll need a credit score of at least 620 (if not higher). You’ll need a debt-to-income ratio (DTI) of no more than 45 percent. You’ll need at least six months of mortgage payments saved up. And you’ll need 3 to 6 percent of the purchase price to cover closing costs on the loan.

You’ll Have Expenses as Well as Returns

Expenses on a rental property include taxes, insurance, upkeep, and repairs. Payments toward mortgage principal aren’t considered an expense because they build equity, which increases your investment returns. Most landlords use the one percent rule, which states that rent should be at least one percent of the purchase price of the home, and the 50 percent rule, which states that expenses should never be more than 50 percent of the rent. As far as returns go, you can expect a return of about six percent in the first year, going up to about 10 percent in subsequent years.

You shouldn’t buy rental property on a whim. Take your time to consider whether it’s a good investment in your area and with your financial situation, so you don’t end up making an investment you’ll regret.

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