If you’re thinking about buying an income property, there are generally two types of rental arrangements to consider. One option is to rent to the same tenant on a long-term basis, or you could position your property as a “short-stay” rental, using services like as Airbnb or VRBO to find short-term vacationers looking for accommodations.
No matter which income stream you’re leaning towards, there are several things you should consider before purchasing a rental property:
Benefits of Buying a Rental Property
Rental properties can provide a great source of passive income while allowing you to diversify your investment portfolio. You can typically hold onto the property until the time is right to sell, and you can use the rental income it produces to help pay off the mortgage. Any increase in property value will further appreciate your property - making it more valuable if and when you decide to sell it down the road.
There are also tax benefits to holding rental properties, including depreciation which allows you to write off costs associated with buying and improving the property come tax time. This can help lower your taxable income. Mortgage interest and property taxes on income properties may also be tax-deductible as a business expense, although you’ll want to check with a tax advisor to be sure this applies to your situation.
Potential Risks Associated with Purchasing an Income Property
While rental properties can be a lucrative investment for some, it’s important to understand the potential risks involved with purchasing one. At the end of the day an income property is an investment, and is not guaranteed to be profitable. Here are some risks to consider:
• Vacancy. One of the biggest risks involved with rental properties is not being able to fill them. Without someone to rent to there is no rental income coming in, which can prove disastrous if you are relying on that cash flow to pay the property’s mortgage. Regardless of whether you’re renting out the property on a long-term or short-term basis, you should plan for having to market the property in order to fill it. You should also factor vacancy rates into your financial calculations when estimating your expected annual rental income.
• Problem Tenants. Even if you have a thorough process in place for legally screening prospective renters, there’s no guarantee that they’re going to be model tenants. What if they refuse to pay rent? There is also the potential for tenants to cause property damage, disrupt neighbors, or conduct illegal activity. You should think through your game plan for dealing with bad tenants, and understand that eviction can be a lengthy and expensive process for property owners.
• Landlord Responsibilities. A rental property can be a great way to earn passive income, but that’s not to say that there isn’t real work involved. Unless you’ll be hiring a property management company to handle day-to-day operations, you should consider the various things you’ll be responsible for. This includes making sure the property adheres to all safety and building codes and is properly maintained.
• Market Conditions. Another consideration is that your rental income can fluctuate based on market conditions. If you have a lease in place with an existing tenant, they’ll be locked into paying the agreed-upon amount until the lease expires, but if you have month-to-month tenants, short-term rentals, or are entering into new leases, you’ll need think about the current market rent or fair market rent in your area. While you might expect rental prices to increase every year, that may not always be the case. Changes in the economy and housing market can cause rent prices to drop just as easily as they can cause them to rise.
Costs to Consider
The costs involved with a rental property include more than just the purchase price and property taxes. Here are some additional costs to factor into your planning:
• Maintenance and Upkeep. Besides taxes, insurance, and any loan you have on your rental property, you’ll also be responsible for maintenance costs. If you’re a handy person, you may be able to make many repairs yourself, but if you aren’t, or if you don’t live near the property you may have to hire a property management company, or find a repairman every time there’s a problem. Either scenario can put a big dent in your wallet.
• Third-Party Fees. If you choose to use the property as a short-term rental, there will be fees to use services like Airbnb or VBRO to list and market the rental. In some communities, short-term rentals require special permits and licensing as well. There’s also the cost involved with cleaning the property in between guests or tenants. It’s also worth noting that in many cases, the COVID-19 pandemic has created stricter sanitation guidelines for rental properties to adhere to.
• Legal Fees. There may be legal fees to draft leases or contracts for your renters to sign. You may want to lay out items specific to your property in the agreements, such as trash responsibility, pets allowed, parking guidelines and more. You may also want to consult with a lawyer to ensure you understand the landlord-tenant laws in your state and how to deal with things like fair housing requirements and security deposits. You’ll also likely want legal representation if you have to take a tenant to court or begin eviction proceedings.
• Insurance. Another cost to consider is landlord insurance, or rental property insurance, which covers your liability if a tenant is injured on your property. These types of policies can also be tailored to cover property damage or loss of rental income.
Will You Need a Loan to Purchase a Rental Property?
If you can afford to purchase a rental property outright, you will be in a better position in terms of cash flow than if you need to take out a loan. If you’re paying for the property in cash, all of your rental income can go into your pocket each month instead of towards a mortgage. However, if you don’t have cash on hand to purchase a second property, financing will be necessary.
Be aware that when taking out a loan to buy a rental property, your interest rate will typically be higher than with a traditional mortgage on a primary residence. You’ll also likely have to come up with at least 20% of the purchase price for a down payment, whereas many mortgage loans for primary residences will allow down payments as low as 3% or 5%.
If financing is necessary, the type of loan you’ll need will depend on factors such as the size of your rental property and your unique financial situation. It’s a good idea to speak with a mortgage professional to better understand which kind of rental property loan is the right fit for you.
Determine Where to Buy Your Income Property
Oftentimes with real estate, a location can be a huge factor in how valuable a property is, and what its income potential will be. If you’re buying beachfront property or a property in a popular tourist area, you’ll likely have a much easier time finding short-term renters than you would if the same property was located in a high-crime area, or a neighborhood with no attractions. When selecting a location, you’ll want to consider your rental income goals, and how often you’ll be taking on new tenants.
If you’re planning for long-term rentals, you may want to consider things like school districts, the local job market, crime rates, and public transportation. It can also be worthwhile to check websites such as Zillow or Apartments.com to get a sense of the overall demand for rentals in the area.
Many buyers look at rental properties as a long-term investment. Even if your annual profits are minimal, they could be worthwhile as long as you’re able to cover the costs of your property. It’s also worth considering that you can always sell the property down the road after its value has risen. There’s no arguing that rental properties can be a smart financial move for many, but it’s important to understand everything that goes into purchasing and maintaining one. If you’re considering buying an income property, contact BankFive today to learn more about your options and find a financing solution that fits your needs.
No matter which income stream you’re leaning towards, there are several things you should consider before purchasing a rental property:
Benefits of Buying a Rental Property
Rental properties can provide a great source of passive income while allowing you to diversify your investment portfolio. You can typically hold onto the property until the time is right to sell, and you can use the rental income it produces to help pay off the mortgage. Any increase in property value will further appreciate your property - making it more valuable if and when you decide to sell it down the road.
There are also tax benefits to holding rental properties, including depreciation which allows you to write off costs associated with buying and improving the property come tax time. This can help lower your taxable income. Mortgage interest and property taxes on income properties may also be tax-deductible as a business expense, although you’ll want to check with a tax advisor to be sure this applies to your situation.
Potential Risks Associated with Purchasing an Income Property
While rental properties can be a lucrative investment for some, it’s important to understand the potential risks involved with purchasing one. At the end of the day an income property is an investment, and is not guaranteed to be profitable. Here are some risks to consider:
• Vacancy. One of the biggest risks involved with rental properties is not being able to fill them. Without someone to rent to there is no rental income coming in, which can prove disastrous if you are relying on that cash flow to pay the property’s mortgage. Regardless of whether you’re renting out the property on a long-term or short-term basis, you should plan for having to market the property in order to fill it. You should also factor vacancy rates into your financial calculations when estimating your expected annual rental income.
• Problem Tenants. Even if you have a thorough process in place for legally screening prospective renters, there’s no guarantee that they’re going to be model tenants. What if they refuse to pay rent? There is also the potential for tenants to cause property damage, disrupt neighbors, or conduct illegal activity. You should think through your game plan for dealing with bad tenants, and understand that eviction can be a lengthy and expensive process for property owners.
• Landlord Responsibilities. A rental property can be a great way to earn passive income, but that’s not to say that there isn’t real work involved. Unless you’ll be hiring a property management company to handle day-to-day operations, you should consider the various things you’ll be responsible for. This includes making sure the property adheres to all safety and building codes and is properly maintained.
• Market Conditions. Another consideration is that your rental income can fluctuate based on market conditions. If you have a lease in place with an existing tenant, they’ll be locked into paying the agreed-upon amount until the lease expires, but if you have month-to-month tenants, short-term rentals, or are entering into new leases, you’ll need think about the current market rent or fair market rent in your area. While you might expect rental prices to increase every year, that may not always be the case. Changes in the economy and housing market can cause rent prices to drop just as easily as they can cause them to rise.
Costs to Consider
The costs involved with a rental property include more than just the purchase price and property taxes. Here are some additional costs to factor into your planning:
• Maintenance and Upkeep. Besides taxes, insurance, and any loan you have on your rental property, you’ll also be responsible for maintenance costs. If you’re a handy person, you may be able to make many repairs yourself, but if you aren’t, or if you don’t live near the property you may have to hire a property management company, or find a repairman every time there’s a problem. Either scenario can put a big dent in your wallet.
• Third-Party Fees. If you choose to use the property as a short-term rental, there will be fees to use services like Airbnb or VBRO to list and market the rental. In some communities, short-term rentals require special permits and licensing as well. There’s also the cost involved with cleaning the property in between guests or tenants. It’s also worth noting that in many cases, the COVID-19 pandemic has created stricter sanitation guidelines for rental properties to adhere to.
• Legal Fees. There may be legal fees to draft leases or contracts for your renters to sign. You may want to lay out items specific to your property in the agreements, such as trash responsibility, pets allowed, parking guidelines and more. You may also want to consult with a lawyer to ensure you understand the landlord-tenant laws in your state and how to deal with things like fair housing requirements and security deposits. You’ll also likely want legal representation if you have to take a tenant to court or begin eviction proceedings.
• Insurance. Another cost to consider is landlord insurance, or rental property insurance, which covers your liability if a tenant is injured on your property. These types of policies can also be tailored to cover property damage or loss of rental income.
Will You Need a Loan to Purchase a Rental Property?
If you can afford to purchase a rental property outright, you will be in a better position in terms of cash flow than if you need to take out a loan. If you’re paying for the property in cash, all of your rental income can go into your pocket each month instead of towards a mortgage. However, if you don’t have cash on hand to purchase a second property, financing will be necessary.
Be aware that when taking out a loan to buy a rental property, your interest rate will typically be higher than with a traditional mortgage on a primary residence. You’ll also likely have to come up with at least 20% of the purchase price for a down payment, whereas many mortgage loans for primary residences will allow down payments as low as 3% or 5%.
If financing is necessary, the type of loan you’ll need will depend on factors such as the size of your rental property and your unique financial situation. It’s a good idea to speak with a mortgage professional to better understand which kind of rental property loan is the right fit for you.
Determine Where to Buy Your Income Property
Oftentimes with real estate, a location can be a huge factor in how valuable a property is, and what its income potential will be. If you’re buying beachfront property or a property in a popular tourist area, you’ll likely have a much easier time finding short-term renters than you would if the same property was located in a high-crime area, or a neighborhood with no attractions. When selecting a location, you’ll want to consider your rental income goals, and how often you’ll be taking on new tenants.
If you’re planning for long-term rentals, you may want to consider things like school districts, the local job market, crime rates, and public transportation. It can also be worthwhile to check websites such as Zillow or Apartments.com to get a sense of the overall demand for rentals in the area.
Many buyers look at rental properties as a long-term investment. Even if your annual profits are minimal, they could be worthwhile as long as you’re able to cover the costs of your property. It’s also worth considering that you can always sell the property down the road after its value has risen. There’s no arguing that rental properties can be a smart financial move for many, but it’s important to understand everything that goes into purchasing and maintaining one. If you’re considering buying an income property, contact BankFive today to learn more about your options and find a financing solution that fits your needs.