Rental properties can be a great source of income that appreciates over time. According to data from the Census Bureau, there are about 48.2 million rental units in the United States. Individual investors own about a third of those units, including a large number of single-family and duplex rentals.
Before you dive into rental property investing, there are several items, costs and expenses, such as how much home insurance do you need or if you need renters insurance, to consider
Understanding Rental Properties as a Real Estate Investor
As home values rise, many Americans are turning to the rental market. Rental properties are more profitable than ever, but they also involve a steep commitment from buyers. It’s important to consider the pros and cons before making a purchase.
Benefits and Drawbacks of Rental Properties
Rental properties have financial implications which make it essential to understand the associated risks and rewards. Below are a few reasons why rental properties are a great investment — along with a few things to be wary of.
Benefits & Drawbacks
BENEFITS
- Lucrative source of income. Rentals generate two sources of income: monthly rent and property value growth.
- Tax deductions. As an owner, you stand to benefit from tax deductions from property insurance, mortgage interests, maintenance costs and other necessary expenses.
- Inflation protection. Real estate can serve as a hedge against inflation. Despite the ups and downs of the economy, assets like single-family homes tend to appreciate.
- Asset buildup. By purchasing a residential property and renting it out, you may only end up footing 10 to 15 percent of a mortgage.
- Income predictability. Rental properties have predictable expenses and returns. As you determine your rental rate, you can accurately budget.
DRAWBACKS
- Difficult tenants. Difficult tenants can destroy property or fall behind on rent.
- Neighborhood decline. The value of properties in a neighborhood can decline due to external factors like local politics or failed redevelopment projects.
- Regular upkeep. Regular maintenance can be difficult for those preoccupied with a full-time job or may not have extra funds to set aside.
- Active involvement. Owning a property often involves talking to tenants regularly, repairing the property when needed and filing necessary documents.
- Vacancies. High vacancy rates can hamper rental income, and many properties remain vacant for at least a portion of the year.
Common Challenges
Investing in a rental property is a hands-on process. From facing problems with tenants to maintaining your property, you are bound to face obstacles that can impact your livelihood. Below are a few common challenges.
Type of Challenges | What It Entails |
|---|---|
Property upkeep | Property ownership requires upkeep related to construction, landscaping and even housekeeping. When a problem occurs, you must be available to solve them as your rental contract entails. |
Tenant risks | A poor tenant can lead to missed rent, destroyed property or even legal conflict. |
Long vacancy periods | Finding a tenant requires an owner to do advertising, background checks and other extensive administrative work. |
Property tax hikes | Property taxes can increase unexpectedly, which can be problematic if a tenant’s rental rate isn’t enough to cover expenses. As a result, you might end up breaking even or shelling out more. |
Determining Your Involvement
Depending on your commitment level, investing in a property or owning a rental can feel like having another part-time or full-time job. Before purchasing a property, determine your investment style and if you want to be a hands-on landlord or leave the work to someone else.
Types of Investors: Which One Are You?
Involved investors may be well-suited for overseeing short-term rental units that require steady upkeep. Passive investors may decide to invest in REITs or even rid themselves of the hassle by paying for the services of a property manager. Knowing what type of investor you are can help determine what real estate strategy suits you best.
Type of Investor | Characteristics |
|---|---|
The Involved Investor | Involved investors may not mind short-term rentals and wholesale properties that require a high level of energy and commitment. Such properties can be profitable but demanding. |
The Passive Investor | The passive investor is hands-off and may opt to pay for the services of a property manager or invest in real estate investment trusts (REITs). By investing in REITs, you earn income from a company that owns and operates real estate. |
The Inquisitive Investor | Young professionals may be juggling the demands of a full-time job or family. One way to entry: renting out an extra room at home or turning a garage into an additional apartment. |
The Full-Time Investor | Full-time investors may spend a significant amount of time choosing houses and fixing them up just enough to sell or rent for the highest reasonable price. |
5 Ways to Make Money from Real Estate
There are multiple ways you can make money from real estate beyond just buying and renting a property. By recognizing and understanding other opportunities, you can build a portfolio of diverse assets to help you achieve your financial goals.
Fix-and-Flip
Flipping houses involves purchasing a house for a below-the-market rate, making necessary repairs and then reselling it at the highest amount to earn a return. Making the most of this highly involved process requires looking at key factors like affordable materials and labor.
Real Estate Investment Trusts (REITs)
REITs are a passive form of income which involve investing in companies that own income-producing properties. These can be purchased through popular stock exchanges and can also eliminate the hassle of buying and managing a property on your own.
Short-Term Rentals or House-Hacking
Short-term rentals provide greater flexibility but still generate a steady form of income. Popular platforms like AirBnb can provide a gateway into this niche, but you can also pick up extra income by renting out a spare room or turning a garage into an additional apartment. By creating rentable space, you can reduce your total housing costs while learning how to be a landlord.
Wholesaling
This strategy involves being the “go-between” for investors and sellers. The wholesaler finds good deals on the market and then finds a buyer who can purchase the property for a small markup. Think of wholesaling as an investment form that requires good sales and marketing skills.
Buying and Holding
This long-term investment strategy involves purchasing and holding a property with the intent to sell it after an extended period of time to reap the benefits of appreciation. The property is typically leased during the “holding” period in order to help with financing.
Finding a Good Rental Property
Not all properties suit all investors. Aside from finding a property that fits your budget, a real estate investment should be something you are willing to mostly manage on your own. Taking time to learn about different types of properties can help you determine how to proceed with the purchasing process.
Type of Property | Description |
|---|---|
Single-family homes | A single-family home is the most common type of property. It is typically detached from neighboring properties and can be one of the most reliable investments in inflationary periods. |
Vacation homes | Vacation homes are located in popular tourist spots and typically serve tenants for short-term stays. With sites like AirBnb, it’s also easy to make a listing and find takers. |
Multi-family buildings | Multi-family properties usually include several rentable units, such as a duplex, triplex, condominium group or even an entire apartment building. These investments provide multiple streams of revenue and adhere to the economies of scale principle. |
Luxury homes | Luxury homes target high-end renters and typically come with cutting-edge technology, a modern design and several utilities. Such properties can be lucrative, but entry is steep. |
The Basics of Evaluating a Property
Geography and demographics play a significant role in determining the value of a rental property and making a profit in the long term. Knowing how to evaluate a property can make the difference between a successful investment or filing for bankruptcy.
Examine the neighborhood
In real estate, neighborhoods are broken down into three classes, with Class A being a neighborhood that would have the lowest turnover rates, Class B having a moderate turnover rate and Class C having high turnover. Neighborhoods can determine the long-term income potential of a property, so ask yourself: Is it safe? Are there any redevelopment projects going on? What are the vacancy rates?
Find the nearest establishments
Key establishments and institutions, such as a clinic or hospital, pharmacy, school, police station and mall, can boost the value of a rental and make it a more viable option for tenants.
Check the demographic
Demographics can impact your earning potential as a landlord. For example, is the area full of students or families? If it’s full of students, you may have a steady stream of tenants, but you may also deal with a higher vacancy rate. If there are predominantly families, you might want to opt for properties with multiple bedrooms.
Look at the interior and exterior
Carefully evaluate the interior and exterior for work that is needed immediately and further down the line. Unless you’re squarely focused on the fix-and-flip strategy, avoid properties that need noticeable repairs or completely renovated kitchens or bathrooms.
Making a Financial Plan
You can ensure you’re making a solid real estate investment by making a financial plan. Factors such as the cost of a down payment, financing and miscellaneous expenses such as insurance and repairs should all be considered prior to making a buy.
Steps for Buying a Rental Property
Once you’ve chosen the right rental property, ownership comes down to the purchasing process. Buying a property includes more than the ability to make a mortgage payment. Knowing the ins and outs of what to expect can help you prepare.
Pay off debts
To qualify for financing, you should have a minimum amount of debt in your name. Hold off on buying a rental property until you’ve paid off medical debt, student loans, credit cards and car payments.
Save for a down payment
Many mortgage programs require less than 5% down, but investment properties may have conditions that require up to 20% of the purchase price. Determine what you can afford before you commit.
Determine if you will buy or finance
Depending on your investment goals, you can buy a rental property outright or finance it through investment loans. Paying with cash means interest rates won’t burden you. On the other hand, a mortgage won’t tie up a large amount of money in one spot.
Evaluate interest rates
Interest rates for investment properties are typically higher than your traditional mortgage rate because lenders believe it’s more likely you’ll pay off debt on your principal residence. Factor this in and shop around to see what your options are.
Calculating Your Return on Investment
Your ROI can tell you whether you’re looking at a profitable property with the potential for long-term appreciation. A number of factors can affect your ROI, including mortgage rates, financing, property taxes and more. The following steps can help you get a ballpark estimate of much you should expect to earn.
Determine your annual rental income
Look at the average rental price for a property like yours and use that as a baseline. Typically, rents should be about 1% of a home’s value. If you already have a monthly rate in mind, take that number and multiply it by a year to calculate your annual income.
Figure out your cash flow
Subtract your annual expenses from your annual rental income, which includes maintenance costs and your monthly principal and interest payment. This will be your annual cash flow or return.
Calculate your out-of-pocket expenses
Whether you’re buying or financing, out-of-pocket expenses include how much you spent upfront to get the house, closing costs and remodeling costs, among many other things.
Compute your ROI
Divide your annual cash flow by your out-of-pocket expenses and multiply it by 100 to get your ROI. One caveat: Factors like time cannot always be quantified. If you choose a steep fixer-upper, be sure to analyze your earning potential.
Costs to Consider
There are many costs associated with rental properties, including homeowners insurance and landlord insurance in case of property damage or loss of income. You should also consider marketing expenses, repairs, appraisal fees and homeowner’s association expenses, among other things.
- Tax implications: Your location will dictate your property taxes. A high property tax can significantly add to your costs, so be sure to factor that in ahead of time. Contact the municipality assessment’s office where your property is located and ask for the latest property tax information, and if tax increases are likely to happen in the near future.
- Mortgages and interest rates: Compared to traditional mortgages, the interest rate for investment properties is higher. Generally, borrowers can expect a 1% to 3% increase in interest for property rental mortgages. This can add up over time, so it’s important to find a low mortgage rate that won’t significantly affect your annual rental income.
- Additional expenses: Out-of-pocket expenses arise regardless of whether you’re buying or financing. In addition to maintenance and repairs, you may have to deal with remodeling costs, utilities, property management fees, homeowners association fees. Unexpected expenses can also occur if your property is vacant for a significant period, as you will be shouldering the principal interest and other monthly fees until you get a tenant.
MoneyGeek’s mortgage calculator can help you factor in costs like HOA costs, insurance and taxes to learn how much your monthly mortgages may be.
Financing Your Rental Property
You may have enough saved up to purchase your rental directly — but this isn’t a viable solution for everyone. For those who can’t afford to buy a property outright, seeking financing through a mortgage loan can help. Remember that loans for rental properties are typically more expensive and have much tighter restrictions, such as needing a higher down payment or a better credit score. Below are additional avenues you can take to finance your property.
- Blanket mortgage: A blanket mortgage allows you to finance multiple properties at once through cross-collateralization. This can be helpful for real estate developers trying to finance multiple properties at once.
- FHA loans: You can get an FHA loan for a multi-family and rent out a property after living in it for at least one year. Financing offered by lenders approved by the U.S. Department of Housing and Urban Development FHA can help with construction, rehabilitation and acquisition and refinancing of apartments and health care facilities.
- Veterans Affairs (VA) loan: VA loans are backed by the U.S. Department of Veterans Affairs. Although they are only available for active-duty service members, veterans and eligible spouses, these loans require no minimum down payment or credit score and let you purchase up to seven units. One of the units must be your primary residence. U.S. Department of Veterans Affairs's Regional Loan Center Contact finder to help you. You may also have remaining entitlement for your VA loan. Learn more about your loan limits.
Insuring Your Rental
Lending institutions will typically require homeowners’ insurance to give you a loan. The required amount of coverage will depend on the kind of property and where it is located, in addition to other factors. You can find great homeowners insurance at an affordable rate. Consider asking your insurance provider about available discounts.
Homeowners’ insurance is sufficient for some rental scenarios, but landlords’ insurance can be a better bet for investors looking at a long-term property. Landlords’ insurance is a more extensive add-on and can cover additional costs associated with owning a property.
Some owners may also ask their tenants to purchase renters’ insurance for their own protection and to avoid potential disputes.
Expert Insight for Beginner Rental Property Investors
MoneyGeek spoke with several financial experts on the best times to start managing rental properties and what beginner investors need to be successful.
- In your experience, when is the best time in your life to start managing rental properties? And how many properties would you say investors should start with?
- Are there factors and circumstances investors should be aware of? If so, how would they overcome those factors? What advice can you give beginner investors to be successful?
Assistant Professor of Marketing and Professional Sales at Kennesaw State University
Sales Partner at Amalfi Estates
Professor of Real Estate at the University of North Texas
Assistant Professor of Business at Clarke University, Dubuque, IA
Professor of Economics, Southern Connecticut State University
Financial Advisor and Planner at iNNOVA Wealth Partners
Director, Center for Innovation and Professional Development at Webster University
Financial Advisor, CFP® FPQP®, at Creative Wealth Management, LLC
Senior Wealth Advisor at AlphaCore Wealth Advisory
Founder and Lead Advisor at Sona Wealth
Chief Executive Officer and Co-Founder of RiversEdge Advisors, LLC
Professor at Pratt Institute
CFP®, AIF®, Founder of Impel Wealth Management
Senior Financial Advisor with Evensky & Katz / Foldes Financial
Home Insurance Expert with USInsuranceAgents.com
SVP Commercial Real Estate Regional Manager at Johnson Financial Group
Owner of Financial Coach Seth Connell, LLC
Founding Partner and Managing Member at CFS Investment Advisory Services, LLC
Chartered Financial Consultant at The Secret Profits
Owner at Team Sztanyo and We Buy NKY Houses
Investor & Founder of Master Passive Income
Professor, Department Chair of Real Estate at El Camino College
CFP® Fee-Only Financial Planner and Founder of Harrison Financial Planning
Professor of Finance at San Diego State University
President & CIO, RockCrest Financial LLC
Associate Professor of Real Estate & Finance at Austin Community College
Owner of Habitats By Kat
Associate Professor & Director of the Financial Planning Program at Missouri State University
Chair of the Center for Real Estate and Urban Analysis at George Washington University
Founder of Ideal Wealth Grower
Alabama Association of Realtors Chair of Real Estate and Associate Professor of Finance, The University of Alabama
Founder of InterNACHI and Certified Master Inspector®
Professor of Practice & Adjunct Professor of Law at Brooklyn Law School
Department Chair, Business and Real Estate, at West Valley College
CPA and Financial Advisor at Insight Wealth Partners
Lecturer – California State University Dominguez Hills; Author and Business Consultant
Assistant Professor of Accounting at Trine University
Financial Planner at Arnold and Mote Wealth Management
Associate Dean of Graduate Business Programs and Professor of Finance at the University of Portland's Pamplin School of Business
Certified Financial Planner and Chief Executive Officer of Peak Financial Solutions
Associate Professor of Real Estate at California State University, Northridge
Lecturer at Central Washington University
Associate Dean & Investments Limited Professor at Florida Atlantic University
Professor of Practice - Freeman School of Business at Tulane University
Founder and President of Intrepid Eagle Finance
Advisor on the Gast Freeman Team at Moneta
Partner & Financial Planner, CFP® at Insight Wealth Strategies
Associate Professor Finance at The College of New Jersey
Adjunct Faculty, Rosemont College and Retired Senior Financial Advisor
CEO and Founder of Sloan Financial Group
Partner, Financial Planner CFP®, AIF at VLP Financial Advisors
Co-Founder and Financial Partner at AllStreet Wealth
Director of Financial Planning, CFP, MST at Beacon Pointe Advisors
Executive Director of Financial Planning at Heritage Investors
Writer/Blogger at FinancialPanther.com
Assistant Professor of Finance at the University of Wyoming
CFP®, Host of Hey Peoria! Let's Talk Money Podcast
Professor of Economics at Villanova University
President of Driven Wealth Management
President, Certified Financial Planner® at NextGen Wealth
Additional Resources for Rental Property Investing
There are many resources which can help potential investors conduct research and remain prudent.
- The Collegian: Resources for fresh college graduates can be a great way to learn about real estate and get started as an investor. The Collegian provides tips and more.
- U.S. Securities and Exchange Commission: Resources offered by the SEC can help explain real estate terms, such as trusts, benefits and more. For those wondering how to finance their investment, you can also learn about the basics of mortgages.
- USAGov: The U.S. government provides a wealth of information on how you can obtain mortgage refinancing and relief.
- U.S. Department of Housing and Urban Development: The U.S. Department of Housing and Urban Development outlines what FHA loans are, how they work for seniors and more.
- Federal Trade Commission: This guide by the Federal Trade Commission explains what reverse mortgages are, what types exist and how they work. It also answers a few frequently asked questions.
- Federal Reserve Board: The Federal Reserve Board provides this guide to discuss how mortgage refinancing works and what you need to do to get it. It also shares tips on how to lower your interest rate.
- U.S. Securities and Exchange Commission: This resource can help you learn about the fundamental principles of investing, including asset allocation, risk tolerance and more.
- Harvard Business School Online: HBS outlines alternative investments aside from real estate that you can consider, such as private equity, hedge funds and more.
About Nathan Paulus
sources
- Harvard University. "America’s Rental Housing." Accessed August 18, 2021.
- National Association of Realtors. "94% of Metro Areas Saw Double-Digit Price Growth in Second Quarter of 2021." Accessed August 19, 2021.
- Pew Research Center. "As national eviction ban expires, a look at who rents and who owns in the U.S." Accessed August 18, 2021.