How to acquire and establish a rental property
Purchasing a second home to rent out can be a great passive investment idea: You buy a house, your renters pay off your second mortgage and you’ll have supplemental income from your tenants’ rent payments. An investment property is real estate that you buy with the intention of earning investment returns through rental income, flipping the home and/or through resale in the future.
Data released by the U.S. Census Bureau in 2017 shows that 47 percent of rentals were owned by individual investors, and rental properties can generate 31 percent of the average landlord’s annual income.
Purchasing a second house deserves some serious thought. After all, owning a rental property is more complex than plumbing in the occasional sink faucet or fixing the air conditioning when it collapses on the hottest day of the year. Here are a few considerations you might want to weigh before you take the plunge.
Initial considerations when purchasing a second property
Here are a few questions to ask yourself before you get serious about buying a second property.
Remember, it’s easier to look in on a property across town rather than one that’s two or more hours away. True, you can always use a local manager to keep the home in tip-top shape but that’ll eat away at your monthly rental income.
Consider the full financial impact
How much money do you have on hand to make a down payment or even pay for the home in full? Don’t forget to calculate your approximate return on investment (ROI) before you purchase a property. Estimate how much income you’ll get from the property and what your expenses will be. Subtract your expenses from your income to find your net operating income.
There are also other fees to consider, including:
- Homeowners association fees
- Travel expenses to and from the property
- Cleaning, maintenance and repairs
- Professional fees (legal and management fees)
- Mortgage interest
Know the laws
Do you know the laws when your tenants won’t pay up? For example, certain states require a grace period when your tenant is behind on rent. In other words, you can’t evict a tenant until the grace period is over but you can still charge late fees.
Know the laws in your state before you rent out your space and check out a few other things before you decide to rent out your home, according to NOLO:
- Don’t use outdated rental lease forms or lease forms that don’t comply with the laws in your state.
- Know about discrimination laws so you don’t inadvertently deny a family the rental home and possibly get slapped with a discrimination suit.
- Act on what you promise your tenants, otherwise, they could sue you or withhold rent for not delivering on what you said you’d do.
- Don’t violate tenants’ right to privacy.
- Know the security deposit laws, particularly when you are allowed to keep the security deposit.
- Resolve any dangerous situations in and around your rental property, such as a crumbling foundation or faulty steps.
Determine what you’ll do if you can’t rent it out
You’re not always going to be able to rent out your home. You might have trouble finding renters, you might have to rip up carpet and patch drywall. A family member might need a rent-free place to stay for three months, etc. In other words, there could be any number of reasons why income from your home may dry up. How will that impact your financial situation? Carefully consider what the implications will be if you really rely on that constant money flow.
Taxes on investment and vacation homes
The IRS considers a rental property differently than it does a primary residence and you’re required by law to report all rental income that you make. Talk to your accountant or tax attorney to find out how a rental property could impact your tax situation.
“Income taxes must be paid for all money made on the property. Of course, everyone thinks of the monthly rent. However, income also includes any other money you collect, such as late fees, pet fees or even work by the tenant in lieu of rent,” says Trent Ellingford of the Real Estate Knowledge Institute.
He says property taxes can include city, county and/or state taxes. On the flip side, you can take deductions that can reduce your income and offset other costs. Keep your receipts for advertising, traveling to and from the property, cleaning, repairs, insurance, utilities, etc.
Investment property for supplemental income
Think you’re ready to pull the trigger on an investment property? Here are the steps you can take.
Know how mortgages differ for second homes and investment properties
Thought you might scoop up a USDA, FHA or VA loan for the mortgage on your investment property? Unfortunately, you can’t use these government-backed loans to purchase an investment property because you can only get one of these loans if you’re purchasing a primary residence.
This leaves the following options for an investment home purchase:
- Conventional loan
- Jumbo loan
- Home equity loan
- Home equity line of credit
- Cash-out refinance
Your interest rate might also be higher for a rental property mortgage than for your primary residence because it’s an additional risk to the lender. In other words, it’s riskier for a lender because in most cases, you’ll pay your primary mortgage, but if money gets tight, you’re more likely to stop paying on your investment property first.
Kathy Fettke, CEO of Real Wealth Network, host of the Real Wealth Show podcast and author of Retire Rich with Rentals, says it’s exciting to think of the opportunities available for anyone considering a rental property. “Fannie and Freddie allow you go get up to 10 conventional loans for rental properties. For many people in high-priced markets like San Francisco or New York, it is much easier to qualify for investment property in more affordable metros than to qualify for a primary residence in your hometown,” says Fettke.
Research your investment
The most important thing you can do is find a real estate agent who knows his or her stuff. “Don’t use just a real estate agent,” says Fettke. “It’s best to look for an agent who specializes in real estate investments. Ideally, look for someone who owns them nearby. Oftentimes, property managers have brokers in-office to help.”
The best agents will know how to help you do research, understand the costs and lead you through the entire buying process. They’ll also help you narrow down the type of property that’s best for you and your needs.
Types of properties
You can generally opt for three types of investment properties: single-family homes, condo units or multi-family unit properties.
- Single-family homes offer lower cash returns than unit properties that can house multiple tenants. Consider your cash flow potential over most considerations.
- You’ll need to take care of all maintenance for a single-family home but the homeowners association (HOA), which is the association that makes decisions and regulations for the members that live there.
- There isn’t conclusive evidence that single-family homes increase your investment returns, but certain neighborhoods and properties may increase your investment return potential over time.
Watch for emerging markets, evaluate the zip code and neighborhood. Determine whether existing home sales have flourished or declined, whether rent has gone up in the type of home you’re considering and check for general growth in the area. Has a new school district been built, as well as a lot of new construction? If so, you could be on the right track toward the best possible location for your rental property.
How will appreciation fit into the mix? In other words, ask yourself whether you think the eventual return on your investment will make it worth it in the long run.
Another strategy is to avoid over-inflated real estate markets, where you’ll pay a lot for a piece of real estate but won’t have much flexibility in terms of rent pricing, since the market will drive rent pricing (good examples are California and New York City). Explore real estate that’s lower in initial cost and has more potential for an increase and return on investment.
Search for the right property
Ellingford says that as you’re trying to carve out your niche in the rental market, you’re a business owner and must think like one. “The property you purchase needs to be one that will rent easily and is likely to appreciate. It won’t necessarily be the home you would buy to raise a family,” he says.
Here are several factors to consider when evaluating rental properties, according to Ellingford:
Vacancies: An area with a lot of vacancies may not make a good rental property location.
Neighborhood: The neighborhood you choose for your rental property will attract a specific type of renter. For example, you’ll wind up with student renters if you purchase a home near a college or university.
School district: This is important if you plan to rent to families. A home in a good school system will allow you to charge more rent but home prices will generally be higher.
Crime rates: Check into the crime rates in the area.
Accessibility: The property should be near major transit and employment opportunities.
Amenities: How close is the property to city parks, fitness centers and shopping?
Above all else, Ellingford recommends not getting emotionally attached to a home that won’t bring in sufficient income.
Financing your second property
Once you answer all of the questions above, you probably have a pretty good idea of how you’ll finance your second property. One of the most important things you can do is get a mortgage preapproval so you’ll know how much a bank is willing to lend you. A mortgage preapproval is like a green light when you shop for a home. You give your lender information about your income, debts and assets and the lender checks your credit. Once you’re approved, you’ll get a loan estimate that details the amount you’ll be able to borrow through that lender.
Make a sizeable down payment: You’ll need to put down at least 20 percent for a rental property, but if you want to look more attractive to a lender, you might want to put down more than 20 percent.
Be a strong borrower: You’ll also need a credit score of at least 640 and a debt-to-income (DTI) ratio of no more than 45 percent, according to Fannie Mae. DTI is your monthly debt payments divided by gross monthly income. Need to improve your credit score? Learn some tips.
Stay away from big banks: Big banks might not readily loan to you as much as a small bank or offer you desirable loan terms. Compare both big and small banks side-by-side prior to landing on a lender.
Ask for owner financing: Owner financing means that the seller agrees to accept payments directly from you instead of requiring you to get a mortgage. This can benefit both you and the seller, but there are risks involved. Think through this option before you take the plunge.
A rental property could be a sound investment, particularly if the rental income you collect offers you some extra income. However, it’s best to weigh all aspects of purchasing a second home, including financial implications, taxes you’ll have to pay, laws involved and how much extra time you have on your hands.
Ellingford says that a second property as an income stream isn’t the only way to gain wealth. “Real estate appreciates in value over time. Of course, there are downturns in the economy, during which time a property may appear to lose value,” he says. “But maintained property will typically be worth more over a period of years.”