The idea of owning rental real estate seems to be gaining popularity as investors tire of the swoops and swoons of the stock market. But not everyone has what it takes to be a landlord. But those who do may find rentals to be a good way to build wealth.
Once you’ve made the decision to buy rental property, your real work begins. Finding a profitable rental property usually takes time, connections and plenty of research.
Know your time horizon
As with any other investment, you should have a good idea how long you plan to own a rental property before you buy it. The longer you plan to own the property, the more you’ll probably need to invest in maintenance, repairs and improvements.
You also may face more investment risk with a shorter time horizon. Although your rental will almost certainly appreciate over 20 years, it could easily lose value in the next five, particularly if you’re buying in an overheated market. You’ll need a bigger potential annual return to make up for that risk.
For many small investors, long-term ownership makes the most sense. You’ll have plenty of time to ride out any swings in the market, and rental income can make a nice supplement to your day job. Find enough rental properties, and being a landlord may become your day job.
Develop a network
Experienced landlords find their properties in a variety of ways. Some hunt for foreclosures, making friends with city hall clerks or bank employees who know which properties are about to be sold. Some run ads in local newspapers. Others work with real estate agents who keep their eyes peeled for possible buys.
Several landlords recommended joining a local landlord or property owner’s association to make contacts. You also can try approaching landlords directly to see if they’re willing to sell, by calling the numbers listed on rental ads in the classifieds, by cruising neighborhoods looking for “for rent” signs or by talking to any landlords you know personally.
Get your finances in shape
The better your credit, and the less credit card and other consumer debt you have, the better your prospects for getting a decent loan. Lenders usually require bigger down payments, higher interest rates and generally stronger finances when you’re buying rental property. That’s because they know people are more likely to default on investment property than they are on their own homes.
Landlords say it also pays to have a substantial cash reserve left over after buying a property. This can help pay for unexpected repairs and vacancies. Although there are few rules of thumb, setting aside at least one month’s rent for each unit is a good start. You may also consider having a line of credit, secured either by the property or your own home, to cover larger costs.
You also should make sure you can save enough for retirement and other goals before investing in rental real estate. While rental income can supplement your retirement kitty, most people shouldn’t count on it to replace other investments or allow themselves to be entirely exposed to the whims of the local real estate market. Rents and property values can fall as well as rise, and those who are adequately diversified with investments in stocks, bonds and cash will be better able to endure the bad times as well as the good.
Avoid overpaying
You make your profit when you buy a property, not when you sell it. Pay too much, and you’ll never recoup as much as you could have had you driven a better bargain.
The rental real estate market is generally tougher on investors who overpay than on homeowners who do the same thing. While a home is often an emotional purchase, which can lead to “I must have it!” offers and bidding wars, most landlords look strictly at the numbers to see if their investments will pay off. If you pay too much for a rental, you can’t count on a “greater fool” coming along later to bail you out.
Some landlords use formulas, such as not paying more than six to eight times the rents they expect to make the first year. Others try to estimate what the property could be worth after needed repairs and upgrades are made, and they don’t pay more than 70% of that price, less the cost of those repairs.
What’s key is to make sure your rental income will cover your out-of-pocket costs. That includes the mortgage payment on the property, as well as taxes, insurance, maintenance, repairs and a vacancy rate of around 5%.
If you can at least break even, you’ll be able to profit from any price appreciation as well as from tax breaks available to rental property.
Longtime landlords say all this work pays off in profitable properties that build their net worth while providing a steady income stream. It doesn’t matter if you’re a professional or a laborer, it’s the equal-opportunity wealth builder.”
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