Investing in a rental property (or more than one) can be a great long-term way to grow your wealth. It provides some amount of passive income, and property can appreciate over time in the right market conditions.
However, do your research before deciding if you want to pursue this path. If you think you want to go for it, here are 14 things to consider as you look at rental property options.
How To Invest in Rental Properties
Investing in a rental property isn’t necessarily a walk in the park, but it can be a great choice for investors who are savvy and understand the process.
Here are 13 things you need to know before investing in a rental property:
- Calculate ROI on Rental Property
- Identify Your Operating Expenses
- Conduct A Risk Assessment
- Pay Down Other Debts
- Choose the Best Rental Location
- Check the HVAC System
- Inspect the Plumbing
- Look for Roof Leaks
- Evaluate the Entire Property
- Check for Insulation
- Look for Any Needed Repairs
- Prepare for Ongoing Maintenance
- Hire a Property Manager if Needed
The Finances of Rental Property Investing
First things first: you need to know if making an investment in a rental property is a financially sound choice at this point in your life.
1. Calculate The ROI For The Rental Property
To figure out what you can expect for a return on investment, start by collecting information about average rents in the area. You may think you can charge higher rent due to certain features, but it’s better to rely on the going market rates than what you hope you’ll get.
Then get familiar with the 1% rule, which states that the gross monthly income on the property should be at least 1% of the price of the property to sufficiently cover potential rental property expenses. If you’re not confident this will be the case, pass on the property.
To calculate ROI, you only need two numbers: gain on investment and cost of investment. Subtract the cost from the gain, then divide by cost. The key is to make sure you’ve accounted for all costs, from maintenance expenses to loan interest rates to property taxes, and more.
While you’ll want to measure this each year to make sure your investment is worthwhile and adjust as needed, projecting the potential ROI is also a good way to decide if you want to invest in real estate. Industry standards generally say that an 8 to 12% return is reasonable.
2. Identify Your Operating Expenses
It’s easy to oversimplify the realities of owning a rental property. Make sure you have a list of all the expenses you might incur so you know if you’re prepared for them. Assume that your expenses will be about 50% of your gross annual income.
Rental properties include operating expenses and capital expenses. The former includes rent lost due to vacancy, insurance, property taxes, routine maintenance and repairs, and property management costs or costs for your time doing these tasks. Capital expenses include unplanned expenses that happen in isolation, like a sudden need to replace a water heater, HVAC system, damaged roof, or faulty plumbing.
3. Conduct A Risk Assessment
One of the most obvious risks of owning rental property is the chance of vacancy. So learn what vacancy rates are in your area and think about what you can do to make your property stand out to potential tenants. There’s a chance you’ll get a bad tenant and have to spend money on eviction and possibly repairing property damage. If you can’t get a tenant at all, you’re stuck with expenses.
Compared to stock investments, rental property has less flexibility. You can’t sell quickly if the markets turn, and you can’t sell just some–it’s an all or nothing game. And, as with any other investment, there’s the risk of losing money on a rental property if you have to borrow a lot or if the property decreases in value.
4. Pay Down Other Debts
While you may carry debt if you get a mortgage for your rental property, this is considered good debt. Bad debt, on the other hand, includes student loans or credit card payments. This type of debt usually has a high interest rate and doesn’t contribute to your wealth over time.
Experts say that paying down your student loan (or other bad) debt before investing is the way to go.
Assessing the Value of a Rental Property
If you’ve figured out that your finances are in shape, the next step is to look at the property itself.
5. Choose The Best Location
Location can be a big deal when it comes to your vacancy rate and quality of tenants. Before you decide to invest in a property, look into the area. How are the schools? What’s nearby: grocery stores, restaurants, shopping, nightlife, cafes, and other amenities? How accessible is public transportation?
Consider location when you’re investigating what a competitive rental rate will be–not just the city, but the neighborhood. Also, think about who your market might be. For instance, is there a teaching hospital or large university nearby?
6. Make Sure The HVAC System Works
As part of your home inspection, it’s imperative to find out if the property’s HVAC and/or furnace is working properly. You may be able to troubleshoot the furnace yourself, but if not, try to get an estimate from your local HVAC specialist.
If you’re going to include heating and cooling costs in the rent, you’ll save yourself a good bit of money by ensuring this system is functioning well. If you won’t be including them, your future tenants will appreciate the lower heating/cooling costs—it will make your property more appealing.
7. Inspect The Plumbing
Though a home inspection will include the plumbing, you may want to seek the input of a plumbing pro in addition, because plumbing can be quite expensive to repair when there’s a system-wide problem. This person might do a camera inspection of the main sewer line, for instance.
You can also do some sleuthing yourself by checking the water pressure and drainage time in the kitchen and bathroom. Visually inspect pipes wherever you see them for discoloration, which is a sign of moisture where it doesn’t belong.
8. Check For Roof Leaks
It’s easy to forget about what’s out of sight, but the condition of the roof is essential information when you consider an investment property. A leaky roof and the resultant water damage can cause a number of problems inside, including mold, compromised structural integrity, and a fire hazard from damaged electrical components.
And if you live somewhere with heavy rain or winter weather, the condition of that roof is critical. Remember that any roof problems don’t just mean putting out a bucket for you; mold or water damage might lead to a tenant filing a claim against you.
9. Evaluate The Entire Property
The building itself is not the only important part of this investment. All the land on the property, and sometimes even considerations on bordering properties, must be part of your consideration.
If there’s a yard, do you notice any problematic drainage spots? How’s the health of the trees? What condition is the driveway in? Are there any structures other than the building that might require repair or maintenance so they don’t pose a hazard? When you live somewhere, you can get away with ignoring the sagging old garage; no so when you’re managing a rental property.
10. Make Sure It’s Well-Insulated
As with the HVAC system, insulation will have a significant impact on heating and cooling costs, regardless of who’s paying for it. Many older buildings don’t have insulation; on the other hand, if you’re buying a property from someone who’s lived there, it may be better insulated.
At the very least, you’ll want to make sure window and door frames are well sealed to prevent air leaks. This is easy to check by lighting a candle and moving it slowly along the edges of windows and doors—if it flickers, there’s a leak. You should also consider investing in attic insulation if it’s not already there, as this is the biggest source of heat loss.
11. Check For Needed Repairs
Obviously, if you’re considering this investment, you’ll get a building inspection, which should alert you to any immediate repair needs. Having a clear sense of the cost of initial repairs gives you a bargaining tool with the seller as well as making it easier for you to decide if you can afford this investment. Remember, though, that even properties in decent shape when you buy them will need repairs eventually, so make sure you understand the condition and lifespan of everything on the property (how old is the water heater, for instance?).
Maintaining the Property
Finally, consider your costs over time—and how much work you’re willing to give to owning a rental property.
12. Prepare For Ongoing Maintenance Costs
Figure out what kind of regular maintenance you’ll need to pay for, which will be part of your capital expenses. If there’s lawn or landscaping, how much will that cost to maintain? What about the cleaning of interior common areas? HVAC systems and water heaters perform best with regular maintenance.
If you have hardwood floors and allow pets, they may need attention after each lease is up. If you have carpet, it will need professional cleaning (some landlords build this into leases and require tenants to do it when moving out). Depending on the area, regular extermination might be required.
13. Do You Want A Property Manager?
If you’re buying a rental property far away from where you live, you’ll almost certainly want a property manager. But if you’re local, you may consider doing it yourself. You have to weigh the value of your own time against the costs of paying someone else to manage leasing and ongoing maintenance/repairs.
Some questions to ask yourself: Do you have spare time? How organized are you? How easy is it for you to stop by your rental property on short notice? Do you know how to market? Can you afford it with the budget you’ve laid out (property management expenses run anywhere between 4 and 10% of monthly gross income, depending on the size of the property)? If you’re excited about the project of investing in a rental property and generally like to be hands-on, it may be worth it to you to manage it yourself. If you’re treating this as just another long-term investment, you may want to consider a manager, just as you work with a financial advisor for your other investments.
- The Best Rental Property Management Companies for 2021
The Benefits of Owning a Rental Property
One of the biggest draws of investing in a rental property is to receive passive income. This can be a great way to build wealth while you’re at your day job and plan for early retirement. The side hustle is becoming a well-respected tradition, and this is a potentially lucrative side hustle. This form of investment grows your income, and what’s more, rental income isn’t subject to social security tax.
Owning rental property is also a way of diversifying your investment portfolio, which any expert will recommend. If you choose well, the property is likely to appreciate over time, increasing your long-term return on investment. And with this type of investment, you get some tax deductions, like operating expenses and the interest you pay on a loan, to reduce your tax burden. Real estate investments are considered one of the more stable investments you can make.
For more information on real estate investing, you can also check out these real estate investing books.