Rhonda L. Jensen

NMLS # 261050

801-272-0600

rhonda@advancedfunding.com

Rhonda L. Jensen Mortgage Loan Advisor
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INVESTMENT PROPERTIES

INVESTMENT PROPERTY Loans




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, it's better to be well-versed before diving in with hundreds of thousands of dollars. Here are the factors and challenges you should consider before buying your first rental property.

 
 

Key Takeaways

Decide If You're Cut Out to Be a Landlord

Being a landlord can be a good way to earn real estate income, but it's not easy or glamorous. In addition to choosing the right property, prepping the unit, and finding reliable tenants, there are always maintenance hassles and headaches.

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 you 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.

⭐TIP: If you're not the handy type and don't have much spare cash, being a landlord may not be right for you.

Secure a 20% (or Larger) Down Payment

Investment properties generally require a larger down payment than owner-occupied properties do; they have more stringent approval requirements. The 3% you may have put down on the home where you are going to live isn't going to work for an investment property. You will need at least a 20% down payment, given that mortgage insurance isn't generally available on rental properties. You may, however, be able to refinance your owner-occupied property to obtain the down payment.

Find the Right Location

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 restaurants, coffee shops, shopping, trails, and parks. In addition, a neighborhood with a low crime rate, easy access to public transportation, and a growing job market may mean a larger pool of potential renters.

Should You Pay Cash or Finance?

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 get you a greater return. For example, say an investor puts down 20% on a house, with an interest rate of 4% on the mortgage. After taking out operating expenses, 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.

How to Get a Mortgage for Rental Property

Though a rental property mortgage is basically the same as a primary residence mortgage, there are some key differences. For starters, there are higher rates of default on rental property loans because borrowers facing financial troubles tend to focus on a primary home's mortgage first. The added risk means lenders typically charge higher interest rates on rental properties.

Then there are the underwriting standards, which tend to be stricter for rental properties. In general, mortgage lenders focus on the borrower's credit score, down payment, and debt-to-income ratio. The same factors apply to rental property mortgages, but the borrower will likely be held to more stringent credit score and DTI thresholds—and a higher minimum down payment. Additionally, the lender may take a closer look at the borrower's employment history and income and want to see prior experience as a landlord.

In general, here's what lenders require from borrowers to approve a rental property mortgage:

Beware of Higher Interest Rates

The cost of borrowing money might be relatively cheap in today, but the interest rate on an investment property is generally higher than it is for a traditional mortgage. If you do decide to finance your purchase, you need a low mortgage payment that won't eat into your monthly profits too much.

Calculate Your Margins

Wall Street firms that buy distressed properties aim for returns of 5% to 7% because, among other expenses, they need to pay staff. Individuals should set a goal of a 10% return. Estimate maintenance costs at 1% of the property value annually. Other costs include homeowners insurance, possible homeowners association fees, property taxes, monthly expenses such as pest control, and landscaping, along with regular maintenance expenses for repairs.

Invest in Landlord Insurance

Protect your new investment: In addition to homeowners insurance, rental property owners should always purchase landlord insurance. This type of insurance generally covers property damage, lost rental income, and liability protection—in case a tenant or a visitor suffers an injury because of property maintenance issues.

Keep in mind that standard homeowners insurance policies may not cover losses incurred while the home is rented out. Contact your insurance agent to make sure you are adequately insured.

Factor in Unexpected Costs

It's not just maintenance and upkeep costs that will eat into your rental income. There's always the potential for an emergency to crop up—roof damage from a hurricane, for instance, or burst pipes that destroy a kitchen floor. Plan to set aside 20% to 30% of your rental income for these types of costs so you have a fund to pay for timely repairs.

Calculate Operating Expenses

Operating expenses on your new property will be between 35% and 80% of your gross operating income. If you charge $1,500 for rent and your expenses come in at $600 per month, you're at 40% for operating expenses. For an even easier calculation, use the 50% rule. If the rent you charge is $2,000 per month, expect to pay $1,000 in total expenses.

Determine Your Return

For every dollar that you invest, what is your return on that dollar? Stocks may offer a 7.5% cash-on-cash return, while bonds may pay 4.5%. A 6% return in your first year as a landlord is considered healthy, especially because that number should rise over time.

Know Your Legal Obligations

Rental owners need to be familiar with the landlord-tenant laws in their state and locale. It's important to understand, for example, your tenants' rights and your obligations regarding security deposits, lease requirements, eviction rules, fair housing, and more in order to avoid legal hassles.

When to Hire a Property Manager

Rental property owners can manage the property themselves or hire a property manager. It can be a hard decision to make because property managers typically charge between 8% and 12% of collected rents, which can really eat into profits.

Still, hiring an experienced property manager can be well worth the cost. After all, it means less work and fewer headaches for you, as you take advantage of their industry expertise. In general, a property manager will:

To decide if hiring a property manager makes financial sense for you, ask yourself these questions:

WARNING: Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

Weigh the Risks vs the Rewards

In every financial decision, you must determine if the payoff is worth the potential risks involved. Does investing in real estate make sense for you?

✔ Rewards

✖ Risks

The Bottom Line

Be realistic in your expectations. As with any investment, rental property isn't going to produce a large monthly paycheck right away, and picking the wrong property could be a catastrophic mistake. Still, rental properties can be a lucrative way to invest in real estate. For your first rental property, consider working with an experienced partner. Or, rent out your own home for a period to test your proclivity for being a landlord.

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