Buying A Rental House: What You Need To Know
Miranda Crace6-minute read
February 16, 2021
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.
Rental Properties 101
There's more than one way to purchase an investment property and turn a profit, and if you're just beginning to look into buying rental properties, it's essential to dive deep into the specifics and learn the ins and outs of what it takes to rent to tenants.
When you purchase a rental property, you buy a house (often a multifamily home), find tenants and maintain the facility while collecting monthly rent and paying property taxes. When planned and executed well, buying rental properties can be an investment that eventually becomes a source of income and profit.
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Pros And Cons Of Buying Rental Property
A crucial part of figuring out whether you want to buy a rental property is learning about the risks and rewards associated with your purchase. Here's why people recommend investing in rental properties – and what to be aware of before you buy.
- Maintaining a rental property is essentially a passive source of income, meaning you can continue to work a regular job and earn rental income on top of it.
- As with other forms of real estate investing, rising values on the market will also increase the value of your investment.
- Rental income is not subject to Social Security taxes
- Real estate is a relatively stable investment.
Plus, a bonus advantage: 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
Consult a tax specialist if you’re not sure whether something’s deductible. Specific deductions vary by state and income level.
- You may have to work with difficult tenants.
- You won't be able to instantly sell your property if you need quick cash.
- Your success depends on finding tenants who can cover their rent, so you must advertise the property and find the right tenants. In some cities, leasing to the wrong tenants can mean fines or legal trouble for you.
- You're responsible for performing regular maintenance and repairs, such as keeping the home up to code, lawn care and snow removal.
- You’re totally responsible for paying the bills. This includes not only the mortgage and taxes, but also insurance and utilities.
- Hiring a property management company to take care of your maintenance, rent collection, evictions and advertising can be costly.
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 house is a smart investment, you need to understand the costs involved and estimate your potential return on investment.
Here are a few of the costs you might be responsible for as the owner of a rental property:
- Maintenance costs
- Landlord insurance costs
- Property management premiums
- Property taxes
- Mortgage payments
The exact amount you’ll need to budget for maintenance depends on your area and the age and condition of your rental property. Some experts recommend allocating 1% of the property value each year for maintenance. 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. As a landlord, you’re usually responsible for damage caused by flooding, fire or other natural disasters and issues with major systems in the home (plumbing, electrical, heating and air conditioning).
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% – 20% more for landlord insurance than a standard homeowners insurance policy.
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.
To Calculate ROI:
- 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.
- Determine your net operating income. You can do this by subtracting your annual rental income from your annual expenses.
- Determine your total cash investment. You can find this by adding together your down payment, closing costs and any upfront renovation or repair costs.
- Divide your net operating income by your total cash investment.
Example ROI Calculation
- 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 your real estate investment compares to other investments you’ve made.
How To Buy A Rental Property
Ready to make the leap? Here's how to find and buy your new house to rent.
Save For Your 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.
Getting a mortgage for a rental property isn't much different from getting a mortgage for a primary residence.
In most cases, you'll use a Fannie Mae or Freddie Mac loan for an investment property, and it will be either a fixed-rate loan or an adjustable-rate mortgage. As always, it's important to start with a preapproval.
Scout Your Location
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.
Check 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.
Consider 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.
Look Into Local Property Taxes
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 a rental property is right for you and you're ready to start the process of buying a house, you can get started with Rocket Mortgage®, 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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