Buying real estate can be a smart investment—over time, real estate can be a powerful wealth-building tool, as well as an avenue for “passive income,” that is, income that you realize each month without working. Today renters make up one-third of U.S. households, according to the Joint Center for Housing Studies of Harvard University, creating a vast potential market.
But that “passive income” isn’t always quite so passive when it comes to investment property. The key is buying the right investment property and setting up systems so that you are protected. Here’s what you should know about buying an investment property.
1. Choose the location carefully.
Having an investment property close by your primary residence can make it far easier to manage—you can do that drive by to ensure that the renters aren’t having loud parties, or you can make a small repair without incurring the cost of hiring it out. However, you also want to make sure that the property is in an area where it will be relatively easy to rent. Look for communities where there are low vacancies and where the average rent is higher than your mortgage payment will be (and don’t forget ancillary costs…more on that below!). You also want to look for all the other fundamentals that make a smart housing purchase—such as good schools and robust amenities—since they will eventually affect your resale price.
2. Plan for a sizable down payment.
Buying a primary residence offers you more choices for your mortgage than an investment property so you’ll need to have your finances prepared. In fact, you’ll need to put at least 20% down because mortgage insurance doesn’t cover investment properties. Aim for higher if you can, as the larger the down payment, the better interest rate you might qualify for.
3. Do all the math.
Many would-be investors jump immediately to the amount they might be able to receive in monthly rent, without considering the other expenses they’ll need to pay. Here are some areas to budget for:
- Repairs and maintenance: A good rule of thumb is to expect to pay 1% of the home’s value or $1 per square foot. And then since you’re not living there, account for the cost of hiring out the project or the time it will take you to do it. Also remember that renters can be harder on the house than you might be, so factor in extra wear and tear.
- Homeowner’s association dues: Find out if there are monthly fees associated with the location and how much they typically go up so you aren’t blindsided by huge unexpected annual increases.
- Property management: If the home is far away, you’ll need to hire someone to handle repairs and relationships with the renters. Ballpark 8 to 12% of the monthly rent for these services.
- Taxes: Don’t forget to add in the local property taxes, which can vary widely by community, and which you will owe whether you have a current renter or not.
4. Be wary of fixer-uppers.
It’s annoying to be constantly fixing things in your own home, and it’s even worse in an investment property. That’s because tenants rightfully expect you to fix things ASAP, and the older the home and it’s systems, the more likely you are to have repairs. A leaky roof or plumbing issues are going to literally keep you awake at night when your renters call to report issues. Repairs can be costly so that fixer-upper “deal” you’re looking at might end up consuming extra resources—in both time and money.
5. Make sure it’s properly insured.
Your current homeowners insurance policy won’t cover your investment property, and you’ll need to insure more than just the structure itself with your normal policy—you also should have liability insurance as well as specialty policies that might be important for your property’s location. If you are buying on a vacant property and planning to build, look into builder’s risk insurance. Talk to an insurance professional about all the applicable policies to protect your investment and yourself.