Have you ever wanted to own rental property?
It makes sense—the idea of diversifying your portfolio and creating monthly, passive income is alluring. And when done right, it can be very rewarding. But before you go running off and buying the first house listed down the street, here’s a list of questions to ask and things to consider before buying a rental property.
In this article, we will paint a realistic picture of expectations, benefits, risks, and the stuff about property ownership that’s sometimes glossed over.
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This is a more complicated question simply because the answer boils down to your situation.
All of these factors contribute to the overall amount of monthly cash flow one could expect, after expenses. Although, there are a few ways to factor whether or not an investment will be worth it.
One of which is following the 1% rule.
To calculate this, you take the upfront cost of purchasing the property (repairs/upgrades included) and multiply that number by 0.01 to find 1%. Can you charge that number for monthly rent? If the answer is no, then you might want to reconsider.
To learn more about how to determine whether or not the investment will be a good one, check out this article: How to Determine if Your Investment is a Good One
When it comes to expenses, many fly under the radar. But it’s important to keep in mind the potential–and inevitable–costs.
Again, these costs will vary depending on the property, and some–*cough* maintenance–are mostly unpredictable. Accounting for as many as you can before deciding on a property is critical to not having unexpected costs down the road.
When factoring in both projected cash flows and expenses for any property, using a pre-built, cash-flow calculator is always a helpful tool to get as close as possible to the real numbers. Access our rental property calculator here. >>
The best way to view and understand projected returns is by calculating the ROI (Return On Investment).
Two ways to calculate this amount are by using either the cost method or the out-of-pocket method.
The cost method is typically used when a property is paid in full. By adding up the initial price of the property plus rehab, revamping, etc. expenses, and subtracting that number by the estimated ARV, you get the gain value. If you want to view the number as a percentage, you can divide the gain number by the amount you spent on the property in total, and turn that decimal into a percent.
The second method is the out-of-pocket method. The math is essentially the same, the only difference is that this method is used when the property is financed and there’s a downpayment. Since the hard-cash amount that one initially invests in a mortgaged property is significantly lower than if a property is purchased in full, the ROI percentage is also higher.
There are several different options that have their own unique set of benefits and risks when considering where to buy. What is the right choice for you depends on your available capital, personal strategy, and the type of portfolio you wish to build.
Neighborhoods are ranked by class. The four different classes are A, B, C, and D.
Classes A and B tend to require less maintenance on properties, have higher income residents, and be lower-risk investments but with short-term residents and lower returns.
Classes C and D tend to have more maintenance issues, lower-income residents, and be higher-risk investments but with more affordable properties and higher returns.
Again, the “right” kind of class to buy into is the one that matches your goals. Are you looking to make higher returns and are prepared for the risks? Or are you someone who wants a lower-risk investment in a higher-class neighborhood?
Forming your strategy around a set class is crucial to your success early on in your investing career. Your initial portfolio should match your specific goals and availability. A great way to get clarity is by talking to a professional in the field, as they have more experience and can paint a hands-on picture.
If you want more in-depth details about this topic, then we suggest you read: 6 Factors to Consider When Choosing a Neighborhood to Invest In. >>
When it comes to property management, there are really two options–either managing it yourself or hiring a property manager.. Both have their own set of pros and cons, and it depends on your personal situation and goals.
By managing a property yourself, you’ll get hands-on experience and also have more say in management style. You’ll choose the resident, handle inspections, and deal with any maintenance or other issues that may arise.
It’s a great option if you want to jump into the deep end and learn about management.
You’ll also save money, at least on the front end, as property managers will typically charge between 6% and 12% of monthly rent.
On the flip side, it can be a very time-consuming and stressful job. If a resident is refusing to pay rent, or there’s an emergency plumbing leak in the middle of the night, you’re the one who will have to straighten it out.
Another thing to consider when choosing to manage yourself vs hiring a property manager is opportunity cost. When you are handling all of the issues that arise, your time is being spent on lower return tasks.
Hiring a property manager enables you to scale, focus on buying more property, and remove the emotional element of owning rentals.
With hiring a property manager, there are plenty of upsides–and especially if you are investing out-of-state, it can be huge to the overall growth of your portfolio.
For one thing, there’s a buffer between you and stressful situations–aka you won’t be the one on the phone with the resident if they stop paying rent (as mentioned in the last section).
There’s also the expertise that comes with a manager. They’ve been around the block and know the mistakes to avoid. You’ll also have an expert who checks in on the property for you, helps you deal with maintenance, and at the end of the day, saves you a lot of time.
Depending on your preference, a downside can be not having much say about management style. The company or individual will likely have its own systems and processes as well as handle situations in a manner different from you. You also won’t get to know your residents very well.
In real estate specifically, you must understand one very important concept about how you actually build wealth. These are known as the four wealth generators.
They are passive income (cash flow), tax deductions, loan pay-down, and appreciation.
These wealth generators individually are each effective method for building wealth through real estate, but when combined become a powerful means of increasing your portfolio value.
Do you think killing two birds with one stone is cool? Try four.
The first is what draws most investors to this asset class, and that’s a monthly passive income or monthly cash flow. Cash flow is the amount of funds left over after expenses are paid. So, if all goes well, you own a property, other people live in and take care of said property, and they pay you to do it. Sounds like a dream, no?
The second is another major plus, which is tax deductions. Insurance, interest on a mortgage, and maintenance expenses can all be deducted from your yearly taxes, along with other offered benefits. Though it won’t actively build wealth, it’s still a major plus and a money-saver.
Thirdly, if you choose to use a mortgage to acquire your property, then the loan pay-down is another benefit. When your resident pays rent, part of those funds will go to paying off the mortgage. With each payment made, your equity increases, meaning you own more of the property.
In essence, your resident will pay for a portion of your property on your behalf, generating more wealth for you.
The fourth and final benefit, property values generally increase over time. Neighborhoods change, inflation changes, the housing demand in cities changes, and with that change comes the possibility of property value increases and a higher-value portfolio.
Now, of course, we must balance out our pros with the reality of cons.
Unfortunately, there is no guaranteed way to vet out bad residents. They may stop paying rent, trash your property, or be inconsiderate neighbors.
While property value can increase, it can also decrease. With the change mentioned in the benefits list comes the chance that it will go in the opposite direction.
There’s also the possibility that you will spend more than you make on a property. One way this can happen is when the rehabilitation process or maintenance costs are higher than you anticipated, or if you’re unable to find a resident in a timely manner and lose money to vacancy.
There’s a lot to consider when first wandering into the world of rental property investing. At the end of the day, defining your goals is the number one priority. If you have questions, it’s always helpful to talk to an expert in the field. They have a wealth of knowledge and, if they’re local, can let you in on the intel from your city.
Are you looking to take the next step in investing in single-family rentals? If so, here are a few ways you can get started today:
Start the conversation!