Traditionally, real estate has generally been a good investment option for people looking to grow their money. It can generate ongoing income and can be a great long-term investment. If you’re thinking about entering the world of property investment, there are a few things you should consider first.
Do You Want to Be a Landlord?
Perhaps the most important thing is to ask yourself if you even want to be a landlord. Being a landlord can be both rewarding and frustrating. Do you know how to market a property for rent? How about screening applicants? How comfortable are you with unclogging toilets and making repairs? Do you have a system to collect rent? What happens if someone doesn’t pay their rent? Do you know what your legal responsibilities are as a landlord?
Is your head about to explode? Don’t worry. Just because you answered “no” to all these questions doesn’t mean property investment isn’t for you. It just means you may want to consider a property management company to take on all of it for you, particularly if you’re a new investor.
Property investment is not the way to get yourself out of debt. It is a way to make money and diversify your portfolio. Experts highly recommend paying off your debt (or at least most of it) before making the jump into the world of property investment. You also want to consider potential expenses in the long-term. Do you have kids getting ready to go to college? How secure is your job?
Not every home is a good fit for property investment. If you were in the market for yourself, it’s perfectly reasonable to look at the property from a personal standpoint. However, purchasing a property for an investment is a bit different. Just because you like the property personally, doesn’t mean it’s a good fit. Is the property financially viable? Are there significant repairs that need to be made before it can be rented, which would delay your income? Is the property in a desirable area that can fetch the monthly rent necessary to make it a profitable income producing property?
Cash vs. Borrow
Do you have the financial ability to pay cash for the property or will you need to finance it through a bank or mortgage lender? Much of this comes down to what your financial situation is. It is important to remember however that while you may face a vacant property between tenants, the bank will not excuse mortgage payments. It’s important to ensure you have the financial ability to pay all of the expenses associated with the property – including utilities – if your property is vacant for a period of time.
It should also be noted that interest rates for non-owner-occupied residences (such as rentals) tend to be higher than traditional mortgages for owner occupied properties.
Rate of Return
Rental rates differ from area to area and property to property. It’s important to ensure that what you’ll be able to rent your property for is enough to cover your expenses and then some – otherwise what’s the point? In general, it should be between 35% - 80% of your gross operating income. So, if you charge $1,500 per month and your expenses are $600 per month, your monthly operating expenses are 40%.
This goes hand in hand with rate of return and determining whether a particular property is the right property for you. In addition to closing expenses, repairs, and upgrades, it’s also important to consider long term expenses as well, such as property taxes and HOA fees. Any money spent needs to be included in determining whether the property is a financially sound investment.
Risk vs. Reward
Real estate, stocks, bonds, money under the mattress…. Every financial decision is about weighing the risks alongside the rewards. So, what are the risks and rewards of real estate investment?
Let’s talk about the rewards first:
- Passive income – yes, there is some work upfront and an initial investment, but past that you can earn money while putting most of your time and effort into something else.
- Income growth – while market values do fluctuate, in general real estate increases in value over time. Not only will you be earning a monthly income, but your initial investment will also grow in value over time.
- Tax benefits – real estate can be put into a self-directed IRA and rental income isn’t included in that which is subject to Social Security tax.
- Stability – in general, real estate is less volatile than other investment options such as the stock market.
Now, let’s talk about the risks:
- While rental income is passive, some tenants are easier to deal with than others. That is why many property investors decide to hire property managers to do it for them.
- Depending on your adjusted gross income, your investment income (including rental income) may be subject to additional taxes.
- There are times such as vacancies, where the rental income does not cover the total mortgage payment resulting in money out of pocket until the property is rented again.
- Unlike stocks, rental investments are not a liquid asset and therefore cannot be easily sold off if the real estate market takes a downturn.
- It is expensive to get in and get out of the real estate market.
Done correctly, real estate investment can be a great way to earn a bit of extra money, but it’s not right for everyone. Therefore, it is important to examine all your resources before making the decision to invest in real estate.