Buying a rental house is a big decision with big financial implications. Let’s look at what you need to know when investing in a rental home, the different factors you’ll need to consider and what to look for when buying the property.
Are Rental Properties A Smart Investment?
As a rental property owner and landlord, your main goal is to end each month with a positive cash flow . To understand if a rental property is a smart investment, you need to estimate your potential return on investment.
Understanding Return On Investment (ROI)
Return on investment (ROI) is a way to understand how valuable your investment is. ROI is typically expressed as a percentage. Simply put, ROI is how much money you made divided by how much money you spent.
There are many ways to calculate ROI, but if you’re using a mortgage to buy your rental home, the cash-on-cash return approach might make the most sense. This is the basic calculation:
Net Operating Income/Total Cash Investment
Here’s how to calculate your net operating income:
- Estimate your annual rental income. This requires a bit of research. You can start by researching rent prices for similar properties in the area to understand what you could expect to rent your property for.
- Estimate your annual expenses. When calculating this, include taxes, insurance, maintenance, repairs and any homeowners association fees. Add your mortgage payments, including interest.
- Subtract your annual rental income from your annual expenses.
To calculate your total cash investment, add the following items:
Here’s what a real-life example could look like:
- Let’s say you purchase a three-bedroom home for $200,000. You think you can rent the property out for $2,100 a month – which is $25,200 a year.
- Your monthly mortgage payment on the property (including taxes and insurance) is $1,400 a month. You set aside 1% of the property value ($2,000) for annual repairs and maintenance. You pay about $1,500 a year for landlord insurance. All those expenses come to $20,300 a year.
- Your annual rental income minus your annual expenses comes to $4,900 a year. This makes up your net operating income.
- Your down payment ($50,000) plus closing costs ($6,000) comes to $56,000. You didn’t invest any money in repairs upfront, so $56,000 represents your total cash investment.
- Your net operating income ($4,900) divided by your total cash investment ($56,000) is .09, which means your ROI is 9%.
Is 9% a good ROI? That depends upon your area and your personal circumstances. A “good” ROI might look different in California than it does in Michigan. To assess whether it’s a good ROI for you, try to find out how your property compares to other rentals in the area, and how you real estate investment compares to other investments you’ve made.
The Down Payment
The down payment required for an investment property is higher than the down payment required for a primary home. If you’re buying a rental property, you need a down payment of 15% to 25%, depending on the loan type.
When your tenants move in, you can require them to pay a security deposit. If they damage the property beyond normal wear and tear, you can keep the deposit and use it to pay for repairs.
Some damage is unavoidable, especially if the home is older. As a landlord, you’re usually responsible for damage caused by flooding, fire or other natural disasters. If there are problems with the appliances or major systems in the home (plumbing, electrical, heating, air conditioning), you’ll be responsible for addressing those issues as well.
The exact amount you’ll need to budget for maintenance depends on your area and the age and condition of your rental property. Some recommend allocating 1% of the property value each year for maintenance. However, there are a lot of variables at play that make maintenance costs hard to estimate.
Landlord Insurance Costs
Landlord insurance is different from homeowners insurance. Landlord insurance policies usually cover the property itself, any additional structures attached to the property (like a garage or mudroom), and any property inside the unit that belongs to the landlord. Some insurance policies may also cover lost rent or attorney fees in the event that a tenant stops paying rent.
The price of your landlord insurance will depend upon your property’s value and your area. As a general rule, expect to pay 15% to 20% more for landlord insurance than a standard homeowners insurance policy.
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Other Things To Consider Before Buying A Rental Property
There’s a lot of work that comes along with owning a rental property. Here are some of the things you’ll need to do as a landlord:
- Advertise the property and find the right tenants. In some cities, leasing to the wrong tenants can mean fines or legal trouble for you.
- Perform regular maintenance and repairs. The home must be kept up to code. You may be responsible for things like lawn care and snow removal. If things break, you’ll need to fix them in a timely manner. This might mean doing the work yourself, or it might mean setting appointments with repair people.
- Pay the bills. This includes not only the mortgage and taxes, but also insurance and utilities.
If this sounds overwhelming, you may want to hire a property management company to handle most of the day-to-day annoyances for you. Here’s what property management companies do:
- Keep staff on call to handle repairs and maintenance requests
- Collect rent
- Monitor your property to make sure tenants respect your space
- Handle evictions
- Find tenants
When you hire a property management company, you can expect to pay a monthly premium, which is usually a percentage of the home’s rent.
You’re entitled to a number of tax deductions and benefits if you rent out your property for at least 14 days a year. Here are some things you may be able to deduct:
- Mortgage interest
- Attorney’s fees
- Travel costs for traveling to and from the property
- Advertising costs from searching for tenants
Make sure you consult a tax specialist if you’re not sure whether something’s deductible – specific deductions vary by state and income level.
What To Look For When Buying A Rental Property
If you’ve decided that investing in a rental property is right for you, the next step is locating the perfect unit. Here are some things to consider when shopping for a rental home.
Look for a rental property in a neighborhood that’s safe and sought-after. Research local amenities, school districts, access to public transportation and crime statistics before you choose a property. The more appealing your neighborhood and the more popular the area, the more quickly you can rent out the home. Our sister company Rocket Homes can connect you with a local real estate agent who can help you find the right rental property.
Rental Market And Rental Prices
Look at a neighborhood’s rental statistics. What’s the average price of rent? How many bedrooms and bathrooms are common for the area? Do most residents choose to buy a home or rent their space? How many vacancies are currently on the market? Vacancies and rental prices will directly affect your bottom line as a landlord. You need to price your unit to compete with other vacant rental units, but you also need to charge enough rent to make money. Look for properties in areas with higher average rent prices and lower vacancy rates to maximize your return.
Fixer-Uppers Vs. Ready-To-Rent Units
You also need to consider the condition of the rental property before you invest. You have a legal responsibility as a landlord to provide a habitable home for your tenants. If you buy a home with a broken heating system or a damaged roof, you need to fix these issues before you can rent.
It’s usually a good idea for first-time landlords to choose a “turnkey” property – that is, one that’s in ready-to-rent condition. However, if you have experience in home repair, you may be able to save money with a fixer-upper.
Homes in areas with highly rated school districts and plentiful public amenities often have higher property tax rates. If you’re buying an investment property in a desirable neighborhood, you need to be prepared to pay high taxes and price your rent accordingly.
Being a landlord is a lot of work, but it can also be lucrative and rewarding. If you’ve done the math and decided that buying a rental property is right for you, you can get started with Rocket Mortgage® by Quicken Loans® which lets you apply for a mortgage online and see how much you can afford so you can start shopping for the perfect investment property today.
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