Billionaire Andrew Carnegie was once quoted as saying that 90% of millionaires got their wealth by investing in real estate. That’s what makes rental investment properties so appealing.
What Carnegie might not have said is that real estate investments can just as easily turn into a money pit. NextAdvisor contributor Jannese Torres-Rodriguez became a landlord to pursue the American dream, she says. In reality, the constant stress and expense of dealing with renters and repairs landed her in therapy. She ultimately sold the home and began cultivating other sources of passive income instead.
If you’re thinking about taking the plunge, this rental property investment loan guide will give you an overview of the process.
What Is an Investment Property?
An investment property is a real estate asset that’s purchased for the express purpose of making a profit by renting it out. “Many people have second homes or properties, but investment property is typically a rental for a third party to use,” explains Luke Smith, owner of We Buy Property In Kentucky, a real estate investment company.
An investment property typically requires a 20% down payment for the purchase price, although there are some lenders that may cover up to 85% financing. “Then the investor would only need to put down 15%,” says Smith.
An investment property can be flipped and sold, or it can be purchased to rent out on a long term or short-term basis (think Airbnb).
Questions to Ask Yourself Before Buying an Investment Property
There’s a long list of questions that you need to ask yourself if you’re thinking of buying an investment property. Among them:
- How much are you willing to spend on the property?
- Where would you like the property to be located?
- Will you self-manage property or use a property management company?
The price and location are the most important decisions. “The answer to these questions will dictate where you look and narrow your search to the ideal properties,” says Smith. How you manage your property is also critical, because the wrong tenant can make or break your investment. For example, choosing a tenant who will care for your property is important. “It’s best to vet the tenant on the way in than to find troubling information once they’ve already moved in,” says Smith.
Management is important for another reason: managing a property can be a time-consuming process. You can hire a management team, which will alleviate time concerns, but this will decrease the return on your investment.
- Do you know contractors who can do the work?
- Are you ready to hire and fire contractors?
- Can you handle financial surprises that come up during the rehab process?
- Are you prepared for break-ins and people stealing tools off the job site?
- Can you design the layouts and pick the best finishes – or find someone who can?
In addition to these questions, there are financial questions you should evaluate to determine if you’re truly ready to buy an investment property:
- Do the numbers work out for the intended purpose, when you consider principal and interest, taxes, insurance, vacancy, repairs (and possibly, management fees)?
- Is this the best use for your money right now?
- Do you have six to nine months of emergency savings in place, in case something comes up?
- Do you know the rental laws? (For example, do you know whether there are caps on late fees, or if you have to accept service animals, etc.). Do you know what financing you’ll be using, since rental properties are usually financed differently?
If you’re relying mostly on income from an investment property, you need to have money in reserve. Investors may assume that their property will always be occupied, but this may not be the case. And your expenses are not waived during the months when your property is vacant. “Occupied or not, you’re responsible for maintenance, property taxes, insurance, utilities, HOA dues, debt service (and possibly) management fees,” says, Bill Samuel, licensed real estate broker, and owner of Blue Ladder Development, a homebuying company in Chicago, IL.
Also, if you decide to manage the property yourself, here’s something else to consider. “Are you prepared to handle calls at night or on the weekends when something is broken, and are you prepared to evict tenants?” Naig asks.
Pros and Cons of Real Estate Investing
There are numerous advantages to having an investment property. “You can use a bank or lender’s money to purchase an asset and then rent it out at a price that allows for you to have cash flow on a monthly basis,” Smith explains. And while you’re getting monthly cash flow, the tenant is paying down your debt.
From a tax perspective, one key part of owning an investment property is depreciation, which is the process of deducting the cost of investment real estate from your taxes over time — specifically the costs of buying and improving it. “In addition to the cash flow, and loan amortization, the owner of a property depreciates the structure over time,” he says. While depreciation helps the owner offset taxes, make sure you know all of the IRS’ rules around this process.
Another benefit? In addition to a rental property being an appreciating asset and providing certain tax advantages, it allows you to build an investment portfolio that provides passive returns in the form of rents or loan payments.
“It’s also a big tent, in that real estate investing provides so many different ways to make money,” says Christian Cruz, J.D. owner of WeOfferCashforProperties.com, in Florida. “For example, you can flip houses, develop land, become a lender, change property use, and so on.”
Another advantage is the freedom it affords investors. “You can work when you want to, although to be successful, you will likely work a lot, but it’s on your terms,” says Cruz. If you play your cards right, you can earn a lot of money.
However, there are also some drawbacks of owning an investment property to consider. You’re not going to just buy a property, sit back, and watch the money roll in. “It’s not an armchair investment, so it will require more of your time and oversight — even if management is outsourced,” warns Samuel. And if the property isn’t outsourced, it’s your job to handle maintenance requests and repairs, which can disrupt your plans. And depending on the repairs needed, they can put a dent in your profits. Also, it will usually require a higher amount of capital to invest, making it an expensive investment option.
The reality is: Investing in real estate isn’t an easy process when compared to other types of investments, like investing in index funds within tax-advantaged accounts. You also need a considerable amount of money upfront, whereas other types of investing allow you to get started with whatever money you have, even $50 a month.
“Real estate is a physical asset, so unlike paper assets, it’s harder to get in and out of a deal,” Smith explains. “Transactions are cumbersome and you often have to wait to find a buyer.” And you’re not making money — but you still have expenses — when the property is not occupied.
Plus, if you don’t have a property management team, you’ll have to chase people down to collect rent. “And you run the risk of getting into a lawsuit,” says Naig. “Typically someone that does not live at your property will fall and sue the owner.”
Another con is the cost of competition. Regardless of the type of tenants inhabiting the property, it’s important to keep the property attractive to new and current tenants, who are choosing from dozens of other potential homes. “Every time you change tenants, you need to freshen the apartment,” says Rachel Lustbader, real estate broker at Warburg Realty in New York, NY, and also an investor. “It needs to be kept in good condition from one tenant to the next.” Any time you switch tenants, you’ll lose income while the house is being refreshed and marketed.
Other cons, according to Lustbader, include the fact that you can’t be certain what your return will be, and it’s impossible to know by how much — or even if — the property will appreciate.
How to Buy an Investment Property
The steps to buying an investment property are pretty straightforward.
- Determine how much you want to invest and the financing method.
- Start looking for houses in your target area (drive around, ask friends, search ads, ask realtors).
- After you find a property, make sure it’s financially profitable.
- Secure funding to buy the property.
- Make any necessary repairs or upgrades.
- Find suitable tenants to occupy your property.
What Makes for a Profitable Rental Property?
Obviously, you need more money coming in than going out. To make a rental property investment profitable, you need to balance how much you’re charging in rent with your expenses (interest, property taxes, insurance, and also possibly repairs and management fees) to determine your profit margin.
While the profit is not the taxed amount, it shows you what to expect each month. “Not every investor may have a positive number every month because they use it for the appreciation and depreciation benefit, but if you’re looking for cashflow this is a good spot to start,” says Naig.
To get the most profit, Naig recommends buying a distressed property that has a much higher value after repairs. “This is called the BRRR method: you buy a distressed home, rehab the home, rent the home, then refinance the home to pull out your original purchase price and rehab costs.” And if you do it right, Naig says you won’t have to put any of your personal money into the home.
Another key to finding a profitable rental property is to make sure that it’s in a desirable location to live or vacation. “You can offer short-term rentals — like Homeaway or Airbnb — or you can find a tenant that lives in the area that needs a residence,” recommends Smith.
If you get the home at a favorable price, it may be easier to turn a profit. “Also, the debt and terms on the agreement with your lender really can play a significant role in the profitability of an investment property,” Smith explains.
Tax Implications of Owning Real Estate Investment Properties
There are tax advantages of owning real estate. “One of the major benefits is that you get to write off the depreciation of your property every year, which is the estimated value of the structure on the property minus the land value, divided by 27.5 for residential properties or 39 for commercial,” Samuel says. These numbers come from the IRS’ set depreciation periods for real estate.
You can also avoid taxes on capital gains using a 1031 Exchange and purchase a larger property, according to Naig. Here are three additional tax benefits:
- Income taxes are lower than self-employment income
- Interest expense deduction (if you itemize rather than take the standard deduction)
- Operation expenses can be deducted from rental income
Rental Property Loan Options
There are several options for financing your investment property:
- Conventional financing: Retail banks can provide a loan for your rental property, much like a loan for your home.
- Private mortgage: Private lenders have many programs for buying rentals loans They usually base it on your track record in real estate and the market rent amount.
- Seller financing: You may be able to buy the home directly from the seller and get them to finance the mortgage.
- Buying a home that’s “subject to”: A “subject to” mortgage is when you take over the owner’s existing mortgage payments, without having to qualify for a mortgage yourself.
- Assuming a loan: If you’re a veteran, you can assume a loan from another veteran.