Is Buying Rental Property A Smart Investment?
As a rental property owner and landlord, the primary goal is to end each month with a positive cash flow. To decide whether a rental house is a smart investment, you need to know the costs involved and estimate your potential return on investment.
Rental Property Annual Expenses
Here are a few costs you may be responsible for as the owner of a rental property:
- Maintenance costs
- Landlord insurance costs
- Property management premiums
- Property taxes
- Mortgage payments
- Utilities
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 budgeting at least 1% of a property’s annual value for maintenance.
Before your tenants move in, you can require a security deposit. If they damage the property beyond normal wear and tear, you can use the deposit to cover 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 a unit that belongs to the landlord. Some insurance policies may also cover lost rent or attorney’s fees if a tenant stops paying rent.
The price of your landlord insurance will depend upon your property’s value and the area. Generally, you should expect to pay 15% – 20% more for landlord insurance than a standard homeowners insurance policy.
Return On Investment (ROI) For Rental Properties
Return on investment (ROI), which is typically expressed as a percentage, is a way to understand the profit potential of your investment. Simply put, it’s how much money you make divided by how much you spend.
There are several ways to calculate ROI, but the cash-on-cash return approach may make the most sense if you’re using a mortgage to buy your rental home.
Calculating your ROI involves the following steps:
- 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 can 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 (NOI): Calculate your NOI by subtracting your annual rental income from your annual expenses.
- Determine your total cash investment: Add your down payment, closing costs and any upfront renovation or repair costs to determine your total cash investment.
- Divide your NOI by your total cash investment: The result will determine your ROI.
Rental Property ROI Calculation Example
Let’s say you purchase a three-bedroom home for $200,000, and you think you can rent the property 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. And you pay about $1,500 a year for landlord insurance. All the expenses come to $20,300 a year.
- Your NOI is your annual rental income minus your annual expenses, which is $4,900.
- 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 NOI ($4,900) divided by your total cash investment ($56,000) is approximately .09, which means your ROI is 9% (.09 ✕ 100 = 9).
Is 9% a good ROI? That depends upon your area and your circ*mstances. A “good” ROI may look different in California than in Michigan. To assess whether it’s a good ROI for you, research how your property compares to other rentals in the area and how your real estate investment compares to other investments you’ve made.
1. Decide Whether You’re Buying With Cash Or A Mortgage
You may be tempted to buy with cash and forgo monthly mortgage payments, but buying with cash may tie up all your money in the house. Additionally, you may miss out on mortgage interest deductions if you make an all-cash purchase. Look at how much money you’ve saved and decide whether you can purchase the property without applying for a loan. If not, explore your financing options and choose the type of loan that best fits your needs and budget.
2. Save For Your Down Payment
The down payment for a rental property is typically higher than a primary residence down payment. If you’re buying a rental property, you need a 15% – 25% down payment, depending on the loan type. It’s a good idea to start saving once you think you’re interested in investing in real estate. If you’re short on cash, you may be able to cover the rest of your down payment with a loan. Consult a financial professional to discuss the best options for your situation.
3. Get Preapproved
Getting a mortgage for a rental property, also called a non-owner-occupied loan, 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 that is either a fixed-rate or an adjustable-rate mortgage (ARM).
As always, it’s important to start with a preapproval since it specifies the interest rates and terms you qualify for. A preapproval also demonstrates that you’re a serious and reliable buyer – all good signs of a responsible new landlord.
4. 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 the neighborhood and the more popular the area, the more likely it is that you’ll 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.
5. Check The Rental Market And Rental Prices
Research a neighborhood’s rental statistics. What’s the average price of rent? How many bedrooms and bathrooms are typical in 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 must price your unit to compete with other vacant rental units and charge enough rent to make money.
Look for properties in areas with higher average rent prices and lower vacancy rates to maximize your return.
6. Consider Fixer-Uppers Vs. Ready-To-Rent Units
You should also consider the rental property’s condition before you invest. As a landlord, you are legally responsible for providing a safe home for your tenants. If you buy a home with a broken heating system or a damaged roof, you’ll need to fix these issues before you can rent.
It’s usually a good idea for first-time landlords to choose a turnkey property – a property that’s in ready-to-rent condition. However, if you have experience with home repairs, you may save money with a fixer-upper.
7. Look Into Local Property Taxes
Homes in areas with highly rated school districts and many public amenities often have higher property tax rates. If you’re buying an investment property in a desirable neighborhood, be prepared to pay higher taxes and price your rent accordingly.
