Rental property can seem like an attractive opportunity for investors looking for income. Especially at times when interest rates are low, the idea of rents rolling in every month is appealing and there is also the possibility of the property appreciating in value.
However, owning rental property is also a much more risky and labor-intensive form of investment than passive income generators such as certificates of deposit or savings accounts. For starters, it takes some careful analysis upfront.
Here are eight key things you should figure out before taking the plunge:
1. Owning rental property can be time-consuming
You might be looking at rental income as an alternative to low bank rates, but that is really an apples-to-oranges comparison. Unless you want to take on a significant amount of extra costs by hiring people to handle these details, owning rental property can mean a great deal of hands-on involvement, from screening tenants to handling repairs. You have to decide whether you can afford to commit that kind of time in addition to the money you invest.
2. Comparable rents in the area will help set your price
In most areas, rentals are a competitive market, so think of rents on comparable properties as a reality check on how much you will be able to charge. Do some research on this before you buy a property so you can start to get a sense of how much your investment will pay you back.
3. Local rental vacancy rates may be a red flag
Besides researching local rental rates, find out about vacancy rates as well. Historically, vacancy rates in the U.S. have averaged 7.4 percent, so if you find that an area has a significantly higher vacancy rate, figure on there being long periods when your property is vacant and thus not producing income.
4. Develop a comprehensive projection of ongoing expenses
Offsetting the rent will be a list of regular expenses: taxes, insurance, utilities, upkeep, etc. Get as much precise information as you can about what these figures are for the property currently, so you can make an accurate projection of what you will be paying.
5. You may have to put some additional money into the property upfront
Make a careful note of any repairs or upgrades you may have to make in the beginning in order to get the property in a condition to be rented. You will need to get credible estimates on what these renovations will cost, and where possible, try to negotiate for the property's seller to take care of them as a condition of sale so you will face less of a burden if you buy the place.
6. Create a short-term and long-term cash flow projection
The previous four items should all be factored into creating a detailed cash-flow projection: the rent you are likely to be able to attract, the time it might take to find a tenant, the ongoing expenses and the upfront costs. Between the time it takes to rent the place out and the extra costs involved in buying and fixing a place up, you are likely to face negative cash flow early on. You need to make sure you have the liquid financial resources to see you through that period. Then, you should make a long-term projection to see how long it will take your eventual positive cash flow to pay back your upfront costs.
7. Return-on-investment (ROI) should compensate you for risk and effort
Your cash flow projection can also be used to see how your long-term profit will compare to your total investment. The ROI should not merely be competitive with other income alternatives - it should adequately compensate you for the risk of financial loss and the time you will put into this investment.
8. There are other ways to invest in real estate
A vehicle called an equity real estate investment trust, or REIT, generates income from the rents and price appreciation of properties in which it invests. These should not be confused with mortgage REITs, which invest in mortgages. Many REITs are publicly traded, and can give you diversified holdings in income-producing real estate without your direct involvement in the underlying properties. However, you should put some careful analysis into how the price of the REIT compares with the value of the properties it owns.
Some landlords are able to make rental properties a productive source of income. The most important distinction to make is that this is often far from passive income - it is an income opportunity where what you get out of it is very much a function of the thought and effort you put into it.
Tell us: Are you thinking about investing in rental properties? How do you evaluate which properties to buy?
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