How to Invest in Rental Property

Thinking about purchasing an investment property? Purchasing rental real estate requires knowledge of leasing practices, mortgage loans, tenant and landlord relationships, and property management.

Buying real estate to rent can be lucrative but, like any investment, should be undertaken only after some solid research.

So You Want to Be a Landlord?

Buying investment property and renting it out can be a good way to earn income, but it requires a commitment of time and money. After choosing the right property, prepping the unit, and finding reliable tenants, ongoing maintenance is required.

Maintenance and upkeep costs can decrease your rental income. There's always the potential for an emergency such as roof damage. Investors should plan to set aside 1% of their property's value for repairs.

Rental property owners can manage the property personally or hire a property manager, who typically charges between 8% and 12% of collected rents. Although costly, a property manager can provide a wide range of services including arranging maintenance and repair work, screening new tenants, and handling late rent payments.

Rental property owners need to know the landlord-tenant laws in their state and locale. Both tenants and landlords have rights and obligations regarding security deposits, lease requirements, eviction rules, and fair housing laws.

It is important to protect a real estate investment. In addition to homeowners insurance, rental property owners can purchase landlord insurance, which covers property damage, lost rental income, and liability protection in case a tenant or a visitor suffers an injury as a result of property maintenance issues.

Buying a Rental Property

In order to get started, you'll need to identify the right property and prepare to get financing to buy it.

Location, Location, Location

When choosing a profitable rental property, look for a location with low property taxes, a good school district, and walkable amenities such as restaurants, coffee shops, and parks.

A neighborhood that has a low crime rate, easy access to public transportation, and a growing job market signals a larger pool of renters.

An area that has a growing population or a revitalization plan underway represents a potential investment opportunity.

Online real estate property sites like Zillow.com provide information for investors including home rental rates and current investment property values. Airbnb.com listings can indicate the going rates for short-term vacation homes or condos in any neighborhood. Other sites like Trulia and Realtor.com list long-term rentals.

Financing Your Rental Property

The process for obtaining a rental property loan is similar to that for a primary residence mortgage, with key differences. Lenders typically charge higher interest rates on rental properties due to a higher rate of default.

Like a home buyer, an investor may choose a traditional mortgage loan or may qualify for an FHA loan or a VA loan.

Underwriting standards can be stricter for rental property applicants. Mortgage lenders focus on credit score, down payment, and debt-to-income ratio. These are the same factors that apply to rental property mortgages, but the investor may be held to a more stringent credit history and a higher down payment.

Typical requirements for a rental property mortgage:

• Credit score: A minimum score of 620, with better rates and terms for scores of 740 and higher.
• Down payment: For government-backed mortgages, 0% to 3% may be acceptable on a mortgage for a primary residence but borrowers for investment real estate generally have to put 15% to 25% down.
• Debt-to-income ratio (DTI): DTI represents the percentage of the borrower's monthly income that goes toward debt. Lenders will generally allow you to count up to 75% of your expected rental income toward your DTI.
• Savings: Borrowers should have cash available to cover three to six months of mortgage payments, including principal, interest, taxes, and insurance.

Is it better to buy with cash or to finance an investment property? That depends on the investor's goals and savings. Paying cash for an investment property can generate positive monthly cash flow immediately, but it's not an option for many.

Making Money in Rentals

Operating expenses on a new rental property will be between 35% and 80% of your gross operating income.

If the monthly rent charged is $1,500 and expenses are $600 per month, that's 40% for operating expenses.

Many investors use the 50% rule. If the rent is $2,000 per month, expect to pay $1,000 in total expenses.

Wall Street firms that buy distressed properties aim for returns of 5% to 7%. Individuals should set a goal of a 10% return.

Estimate maintenance costs at 1% of the property value annually.

Other costs include homeowners insurance, homeowners association fees (HOA), property taxes, and monthly expenses such as pest control, landscaping, and maintenance.

While stocks may offer a 7.5% cash-on-cash return, or bonds may pay 4.5%, a 6% return in the first year as a landlord on an investment property is considered healthy and that number should rise over time.

Some real estate investors choose to flip houses by purchasing a house at a below-market price, making repairs, and then reselling it for a high return. There may or may not be tenants during a "flip" and investors must consider key factors like affordable materials and labor.

Risks and Rewards of Rental Property

The Bottom Line

A rental property can be a lucrative investment, providing a passive, steady income for the investor.

As always, do your research in advance. Investing in rental property requires knowledge about tenant and landlord laws, leasing practices, mortgage policies, and property management issues.