Maybe you’ve heard about the benefits of diversifying your investment portfolio. That means investing in a variety of products so that if one type of investment doesn’t work out, you may have other types that provide a financial cushion that may even out your investments.
In addition to investing in products like stocks, bonds and mutual funds, many investors choose to purchase property as an investment.
According to a 2021 survey by Bankrate, real estate is the top choice for Americans when choosing an investment asset for long-term investing for 10 years or more. More than a quarter—28% of Americans preferred it. Real estate investments have been the top choice for five of the last seven years.
But buying a rental property also requires time, knowledge and management skills. It can also require significant financial investment and carry some risk.
Use this guide to investing in rental property for beginners to see if purchasing property might make sense for you as an investment. Learn about annual expenses you can expect, how to determine if your investment is successful and how you can finance your investment property.
What Is An Investment Property?
An investment property is a form of real estate someone purchases to make money in the short or long term. Investment properties may be in the form of a house, apartment, condo or detached home.
The owner of an investment property chooses how to use it and the methods they’ll use to potentially make money. Some people purchase vacation homes that they both use and rent out to others throughout the year. Others lease a home to a single tenant on annual lease terms.
If you purchase a home with a homeowners association (HOA), such as a condo or townhouse, the HOA may stipulate how the home can be used. For example, some HOAs may not allow short-term rentals, like a home-sharing arrangement. They may require that any rental property has tenants in the property for at least a couple of months at a time.
Before you purchase an investment property, you should think about what you envision for it, and who you want to live there. You may be happy buying a second home you can visit whenever you want and leaving it vacant at other times since the home could still bring you long-term gains over decades of homeownership.
If you’re hesitant about purchasing a home all your own, you might consider investing in a real estate investment trust (REIT). REITs are publicly traded securities that make investments in real estate like office buildings and hotels. You don’t have to manage the property, but you may be able to get a percentage of the earnings back in the form of dividends.
Another way to dip your toe into real estate investing is to rent out a room in a home you live in. You can do this through a property-sharing site, like Airbnb. As a host on a site like this, you typically get protections for things like property damage. Plus, the “renters” go through a prescreening or review process so that you can vet your renters.
Is Buying Rental Property A Smart Investment?
The simplest definition of a smart investment is one that results in more money than you put in. With investments, you’ll also want to factor in inflation. Just because your home is worth more in five years than what you bought it for doesn’t necessarily mean you’ve achieved a return on investment (ROI). But if home values go up, taking inflation into account, your investment may be worth it.
There are potential advantages to investing in real estate, some that go beyond monetary value. Consider benefits like:
- A potentially solid long-term ROI
- Tax deductions
- A potential second home. If you choose to rent out the property sporadically, like on a home-sharing site
- Source of cash flow
When you purchase a rental property, you’re also diversifying your investment portfolio. Say your retirement account funds plummet due to a stock market crash. You’ll still have a property to live in or rent out. Over time, the home value may rise, as well, giving you a potential source of additional retirement income.
While many people choose to purchase rental properties as an investment, there are potential risks like any investment. You should also factor in your annual costs to understand if you’re up for the responsibility of owning an investment property.
What are the annual expenses associated with investment properties?
Similarly to purchasing a first home, you may find that you need a home loan (mortgage) to finance an investment property. That will require a down payment and closing costs, in addition to monthly mortgage payments that require interest.
In addition to up-front costs to purchase an investment property, you’ll also need to factor in annual costs to maintain your investment. These include:
- Homeowners insurance
- Property taxes
- Utilities
- Maintenance costs
- Advertising the property for rent
- HOA fees
- Travel expenses for traveling to and from the property
- Legal and management fees
It helps to overestimate your expenses so that you have enough cash available to cover whatever comes up. Anticipate you’ll need to save around 20% to 30% of your rental income to go toward upkeep, maintenance and emergencies.
Another expense that’s harder to quantify? The value of your time. Depending on how involved you want to manage your investment property, you may find that property management becomes like a part-time job.
Landlords need to communicate with tenants, coordinate maintenance, collect rent and do other management tasks. You can outsource these to a property manager, but that will result in additional annual expenses.
How to determine if the investment is successful
Ideally, you’ll want to make an ROI that justifies the time and energy you put into your rental property. When you’re searching for properties to invest in, you’ll ideally want to purchase one where you can make more money in rent than you’ll be charged in expenses. But if you plan on using the property for yourself, like as a vacation rental, the enjoyment you get out of the property may also play a role in your decision.
A simple ROI calculation for an investment property is:
Money made divided by expenses x 100 = ROI%
For a more accurate calculation regarding ROI for rental investment properties, follow these steps.
- Estimate your annual income from your rental property. Say you’re renting your property for $2,000 a month. That would be $24,000 a year.
- Estimate your annual costs for maintaining your rental property. These include mortgage payments with interest, taxes, insurance, maintenance, HOA fees and repairs. Let’s say your costs are $1,500 a month, at $18,000 a year.
- Calculate your net operating income (NOI) by subtracting your annual rental income from annual costs. Using the above figures, that’d be $6,000 per year.
- Calculate your total cash investment. This figure includes your down payment, closing costs and any up-front repair or renovation costs. Let’s say this figure was $50,000.
- Divide your NOI by your total cash investment. $6,000 divided by $50,000 would be 12%.
Whether or not 12% is a good ROI depends on a variety of factors. One to consider is how that ROI compares to your other investment accounts, like a retirement account. Another is how that figure compares to other rental properties in the area.
Keep in mind, with rental property investments, you’re able to write off rental property expenses on your federal tax return, like maintenance and upkeep. That can help you lower your income tax payments, which could be another benefit.
Another consideration for having a rental property is that you’ll need to be aware of rental property laws around eviction, regulatory requirements and fair housing. Your time is valuable, so you’ll want to consider how much your time investment in managing the property is worth.
How To Buy An Investment Property
You may have already purchased the home you live in, but buying rental property has other considerations. Here are the key steps to buying rental property and what you may need to begin the process.
1. Determine how you’ll pay for it
Even if you can purchase a rental property in all-cash, some investors prefer to get a mortgage. That’s because when mortgage rates are low, you may be able to make more money by investing your other funds elsewhere and paying off the low-interest rates your mortgage has. For some, the peace of mind of purchasing a property outright is valuable.
The choice is yours, but know that when you’re purchasing an investment property, you’ll typically need at least 15%, if not higher, to put toward a down payment when you’re applying for an investment property mortgage.
2. Prequalify for a mortgage
If you are getting a mortgage for your investment property, get prequalified first. This gives home sellers confidence you have the funds to purchase the property. You’ll also learn exactly how much home you can afford, making the home shopping experience with your real estate agent easier.
3. Think about how you want to use the home
Do you want to rent out your property to a single tenant for a year or longer? Do you want to turn your home into a home-sharing property? Do you plan on spending lots of time in your second home?
You’ll want to envision what you want to do with your investment property, so your real estate agent can show you homes that meet your needs. Since some HOAs will have strict rules on who you can rent to, you’ll want to tour homes that fit your criteria.
4. Find a real estate agent
It’s helpful to work with a real estate agent who has experience in rental properties as you shop for homes. They’ll be able to help you navigate average rent prices and help you find a property that’s more likely to provide you with a higher ROI. Location is typically an important factor that influences home value. A real estate agent can guide you to properties that match your goals.
5. Consider turnkey versus repairs needed
Some rental property owners love putting a personal touch into their properties through repairs and renovations. Others want a turnkey property that’s ready to rent immediately. You might be able to get an investment property for cheaper when it’s a fixer-upper, but think about how much time and money you’re willing to invest in repairs before you rent.
The closing process for an investment property is similar to when you purchase your primary home. Once the home is yours, you’ll need to follow HOA regulations and local laws when finding renters and signing them to leases. Ask your real estate agent for guidance. Connecting with a lawyer can also help you as you become a landlord.
Consider Financing Options
An investment property can be an exciting purchase that helps you grow your wealth over time and make money in the short term. It can also be a lot of work, but many rental property owners find investment property ownership rewarding for a variety of reasons.
Get more tips and tricks for real estate investments with our guide to the BRRRR Method.
If you’re exploring the possibility of becoming an investment property owner, Arizona Central Credit Union can help you navigate financing options. Contact us online for investment property financing information or call (866) 264-6421.
