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Adding a rental property to your investment portfolio could be a great source of passive income. Assuming you have cash on hand to easily handle regular maintenance and repairs, these types of properties can help diversify your investments and grow your wealth over the long haul. The National Multifamily Housing Council reports that over 44 million U.S. households are made up of renters, so there's no shortage of potential tenants.
Like any other investment, though, it isn't without risk. Enthusiastic buyers who jump in before they're ready could find themselves in a financially stressful situation that increases their debt load and negatively impacts their credit. Before you make any big decisions, take the time to learn how investment properties work, which can help you decide if they're right for you. Here's what you need to know.
What Is an Investment Property?
Buying an investment property is similar to a traditional home purchase. Instead of buying a home to live in yourself, however, you're focusing on buying property you can then rent out to someone else. Alternatively, your goal may be to buy and hold the property, then resell it at a higher price (a version of "fix and flip" investing often seen on popular home renovation shows). Either way, the goal is the same—using the property to generate income and ultimately turn a profit.
How Do Investment Properties Make Money?
Let's assume you plan to buy a property and rent it out to a tenant. The goal is to charge monthly rent that covers all your expenses—plus extra to keep in your pocket. How much you're reasonably able to charge has everything to do with your local market and the appeal of your property. Researching rental trends for similar properties in your area can help you settle on a competitive amount to charge. You may be able to fetch more if you make renovations such as installing a modern kitchen or updating flooring and appliances, though this will require a larger upfront investment on your part.
Maybe you're more interested in flipping properties than renting them out. Homes flipped in 2020 generated an average gross profit of $66,300, according to property data provider ATTOM Data Solutions. And just like it can help those with tenants garner higher rent payments, making in-demand home renovations can help flippers see a larger return on their investment.
Investment property owners can also make money when it comes time to sell, assuming the home's value goes up. No one can predict with 100% certainty if a property will indeed appreciate, but if you're in a thriving neighborhood or a new area that's growing quickly, those could be good signs. Every market is different, but the National Association of Realtors reported that during the first quarter of 2021, 89% of metro areas had experienced year-over-year price increases in the double digits.
What to Consider Before Buying an Investment Property
There are multiple factors to consider when shopping around for an investment property. They include:
- Access to major roadways and public transportation
- Proximity to stores and restaurants
- Any local development plans in the works that could affect home values
- Local sale prices for similar properties
- Average market rents
- Average property taxes in the area
Beyond that, below are some additional things to think about before moving forward.
- Your ability to manage the property: If you plan on renting out the property, you're signing up to be a landlord. That means you'll be on the hook for maintaining the home and addressing repairs that come up along the way—big and small. This can include everything from plumbing emergencies to issues with major appliances. You may opt to hire a property manager to handle these things for you. Just know that if you fail to keep the home livable, your tenants may be within their rights to withhold rent or pursue legal action. On top of property maintenance, you'll also need to find and screen tenants to avoid long-term vacancies and step in to take action if any issues arise with them.
- Your expected return on investment (ROI): There's a simple formula to help you estimate your ROI. First, take your estimated monthly rental income, then subtract your monthly expenses. This can include everything from property taxes to homeowners insurance and homeowners association (HOA) fees. Now multiply this figure by 12 to find your gross annual cash flow. This represents how much you're likely to profit each year, assuming all goes well. Now consider what you're paying upfront in terms of your down payment, closing costs, home inspections and any repairs that need to be made. Do the numbers make it feel like a worthwhile investment to you?
- The current housing market: If you're looking to take on a renter, you'll want to narrow your focus to properties that are attractive to potential tenants. A local real estate agent may be able to point you to neighborhoods and property types that tend to attract renters in your area. Options can include townhomes, condos, apartments or multi-family properties like duplexes. Investors with an eye on home flipping would be wise to look closely at homebuying trends for similar properties in the area. How long are listings typically staying on the market? And are the sale prices aligned with your budget and ROI goals?
- Mortgage loan terms: Mortgage rates tend to be higher when financing an investment property. In fact, it isn't uncommon for lenders to charge 0.50% to 0.75% more when compared with a regular mortgage. You'll also want to consider your monthly payment and other loan terms to make sure the numbers make sense for your budget. Shopping around and comparing offers from different lenders can help you find the best deal.
- Additional costs: As mentioned earlier, your monthly mortgage payment is just one expense of owning an investment property. You'll also have to account for property taxes, homeowners insurance and potential HOA fees. That's on top of regular maintenance and repairs. For these reasons, it's wise to have enough savings to cover everything—plus the unexpected, such as a month or two where your rental property sits unoccupied.
How to Buy an Investment Property
You may want to consider partnering with a real estate agent who's well-versed in investment properties. They can help you better understand your local market and identify potentially profitable homes. They may also be able to fine-tune your expected return on investment.
Unless you're making the purchase in cash, the mortgage application process is generally more complex for investment properties. You'll likely need a much larger down payment, often to the tune of 20% to 30%. And again, interest rates tend to be higher when compared with home loans for a primary residence.
Another important detail is that most lenders have higher credit score requirements if you're seeking a mortgage for an investment property. The minimum credit score is generally 620, though it can vary from lender to lender. Meanwhile, it may be possible to get a mortgage for a traditional home purchase with a credit score as low as 500.
The Bottom Line
Whether you're looking to purchase a rental home or an investment property to buy and flip, your credit will be closely examined if you're applying for a mortgage. Enrolling in free credit monitoring with Experian can alert you to suspicious activity and provide credit score updates and other resources to protect your credit every step of the way.