Dreaming of new investment property with young businesswoman in a thoughtful face

Want an investment property? Keep your cool and think things through (Photo credit: Tierney)

Purchasing your first rental property is the biggest (and possibly the most nerve-wracking) decision you’ll make as an investor. Don’t think you can do it? With a bit of knowledge and common sense, you’ll secure your first investment and be on the way to earning passive income. Age isn’t a factor for your qualifications — Mynd reported in its 2022 Consumer Insights survey that the younger generations are buying investment properties before they purchase their primary residence. 43 percent of Millennials and Gen Z  are considering buying an investment property, while 68 percent of Millennials and Gen Z concur that real estate investment is a wise financial decision.

This guide will provide you with everything you need to know before purchasing an investment property.

How do you know if you’re ready to purchase? Five questions to ask yourself:

1. Can you handle a larger down payment? Mortgage insurance is unavailable for investment properties in the United States. Be prepared to put at least 20 percent down if you don’t have a mortgage for your primary residence, but 25 to 30 percent is optimal. If you have a mortgage for your home, you will need closer to 15 percent, but remember that lenders scrutinize investment loans because there’s a higher risk of default and foreclosure.

2. Have you checked your credit rating? Most fixed-rate mortgages require a 15 percent down payment with a 680 qualifying credit score for a one-unit investment property.

3. Have you done your research? Do some investigative work where you want to buy, and don’t hesitate to expand your area of interest. Remember: You want to buy into a place on the upswing. It doesn’t have to be the hottest area in town (unless you’re willing to shell out for the luxury) but have a look at the surroundings. What kinds of amenities are in the area? Are there supermarkets nearby? Are businesses moving in, or are they leaving the community? What about parks and green space? Hospitals, transit, and schools? A tenant will seek out all these amenities, and the closer they are to your property, the greater the appeal – which translates into higher rental rates.

4. Do you know your renter profile? Ask yourself if you are comfortable renting to a younger person who may be moving into their first apartment. Perhaps you want a single professional? What about a family? You need to establish your target audience before your purchase because it will influence the type of property you want to buy (and how much it will cost). For example, a one-bedroom apartment in an up-and-coming or older neighborhood will cost significantly less than a four-bedroom home in an established part of the city.

5. Are you ready to devote significant time to maintenance, and if not, do you have the money to hire a property manager? Investment property management requires savings but also a great deal of time. You need to place online advertisements, interview potential tenants, run background checks, make sure that tenants pay their rent on time and chase down payments from those running late, perform maintenance on your property and make timely repairs if something in the home breaks down. You also must do all of this while working around your tenant’s “right to privacy,” a legal standard that prevents you from dropping by unannounced without at least 24 hours of warning in most states.

Wooden block on stacked coins with wooden house model. Depicts the growth of the investment property business.

Understanding all of the risks involved will help you make an informed decision (Photo credit: IndySystem)

Significant risks, big rewards – what to think about before buying an investment property

So, what should you think about before you buy an investment property? Like most investments, several variables are at play. The investment property game is much different from sinking money in stocks. The stock market’s return may be in the mid-single digits annually, but if you run into a tenant who doesn’t want to fork over their rent, your returns will be zero. However, with greater risk comes greater rewards.

To give you some idea, consider this: The Dow Jones average return is 8.70 percent, measured by the SPDR Dow Jones Industrial ETF (DIA), from its January 1998 inception through March 2022. The S&P 500’s average annual returns over the past decade have measured 14.7 percent (as of May 2022).

By comparison, single-family rental yields sat at about seven percent for the first quarter of 2022. This measurement was taken from 212 counties in the U.S. on an average three-bedroom home. This number is expected to decline, especially in areas with lower yields.

It may seem discouraging but remember that in the case of the stock market, you have zero control over the ebb and flow of your investment. When you own a rental property, even minor improvements like new doors on the kitchen cabinets or some basic landscaping can improve the quality of your tenant pool, allowing you to charge more for monthly rent.

You run the show, so do the work to ensure your property looks its best. Investment properties are the right choice for the person looking to have more control over the return on investment (ROI), but you must be proactive.

Ultimately, your most important question regarding ROI pertains to your tenants. Doing your due diligence will hopefully ensure success in securing responsible renters. In addition, credit checks and employment confirmations are worth seeking out.

If you can’t afford to invest in an entire home, consider owner-occupied

Let’s say you’re dying to dip your toe into the investment market, but you’re struggling to afford your own home on your own, let alone a second property. You can use the tried-and-true option of living in one unit or room and renting out the remainder. This can potentially mean a smaller down payment, lower mortgage interest rates, and the ability to take advantage of tax rebates and credits.

How to get a mortgage for an investment property

You will have to secure a mortgage if you don’t plan to pay for your rental property in cash. You cannot use a government-backed loan to buy a rental property. Instead, you’ll need to meet your lender’s requirements for a conventional investment property loan. These loans can be more challenging to qualify for, especially if you’ve never managed a rental property before. However, if you’re going the route of owner-occupied, you will generally have an easier time landing that mortgage because the terms and requirements lean further in the borrower’s favor. Be prepared for the variable of interest rates. They’re going to adjust according to the market and your financial profile.

Generally, interest rates on a mortgage on your first home will be significantly more favorable when compared to a rental property.Again, there is a considerable risk for the lender due to the higher risk of foreclosure and default, so be prepared for the bank to consider these factors. Expect an increased interest rate of anywhere between one to three percent on a rental property purchase.Regarding proof of income, lenders expect to see more from borrowers applying for an investment property mortgage. But, again, this is due to the risk involved.

Generally, the underwriter will want to see at least two years of income in the form of W-2s and tax returns. You’ll also need at least six months of liquid reserves on hand. These reserves can come in the form of cash or assets that can be quickly converted.Use a loan-to-value calculator to determine your likelihood of securing the mortgage. LTVs have a significant impact on the mortgages of investment properties. The lower the LTV, the better your chance of securing the mortgage. You can get to as high as 80 percent, but it will cost you in the long run.

Is any part of an investment property tax deductible?

Don’t consider your investment property an endless money pit until the rent arrives at your door. There are several costs that an investor can deduct from their taxes.

1. Mortgage interest on an investment property is tax deductible. All interest paid to the lender is an above-the-line deduction and remains that way throughout the life of the loan.

But what’s an above-the-line deduction? This is a calculation where the IRS allows you to subtract from your annual gross income to arrive at your “adjusted gross income,” or AGI. It is the AGI on which you are taxed. Above-the-line deductions are beneficial because they reduce your AGI, which reduces the taxes you owe.

2. Landlord’s insurance is also tax deductible, like the homeowner’s insurance you would pay on your primary residence.

3. The cost of essential repairs and maintenance you perform qualifies as a tax deduction. Think of things like installing new carpeting, painting, and fixing broken ovens or fridges. However, if you need to undertake extensive repairs like new windows or a new roof, these are classified as “capital improvements” and won’t qualify for a deduction.

4. If your investment property is part of a Homeowners Association, the fees you pay to the HOA for community services, landscaping, and maintenance are tax deductible.

5. Property owners who contract with a property manager to handle the day-to-day management of their rental units can deduct service costs from their taxes as a rental expense.

6. If the property owner pays for utilities, those costs are tax deductible. But if the tenant reimburses the landlord for those costs, they will be considered income and must be reported.

ROI, Return on investment, Business and financial concept for an investment property

Understanding your ROI is critical to discovering your investment property’s true worth (Photo credit: WrightStudio)

How do I determine my return on investment?

The point of an investment property is to make money, but how much will you get back? There’s an easy way for you to find out. Learn how to quickly calculate your earnings to discover your return on investment (ROI).

Here’s how to do it:

• You need to find your property’s net annual income. So, what’s being deducted from the gross amount of rent money? Taxes, property management fees (if any), insurance, potential repairs, utilities not paid by the tenant, vacancy periods, and HOA fees (again, if any).
• Now, divide the annual income by the amount you spent on the property. For example, if the yearly net income is $20,000 and you paid $400,000 for the property, your ROI is 20 percent.

Pitfalls and other things to avoid

Given the risk involved with investment properties, you need to pay attention to all the details — regardless of size — to set yourself up for success.
One of the biggest mistakes new investors make is taking a chance on a property that needs a lot of work. Everyone loves a deal but be realistic with yourself. Unless you’ve got an extensive home repair background, you don’t want to be dealing with the headaches of replacing walls, fixtures, and other major structural issues.

That fixer-upper with all the charm could hide nasty secrets, such as a leaky basement or a poorly maintained roof. Any home inspector worth their salt will warn you about these issues before you purchase, but it’s up to you whether you want to take that chance. The goal is always making money — not sinking your cash into an endless hole of expenses.

You need to avoid vacancies for the simple fact that a lack of tenants equates to zero income. But going without any vacancies isn’t realistic for most investment property owners. There are times when you may need to evict someone and other periods when you need the unit empty to accomplish upgrades quickly and efficiently.

So, what’s an acceptable vacancy average? Five percent or lower is your sweet spot. If you begin to hit eight percent or higher, you’ll need to consider the reasons why. Some things you can do to avoid vacancies involve common sense. Keep your property in top condition and make it as appealing as possible for quality tenants.

Also: Do your research on comparable rentals in the area. If you’re charging too much, you aren’t going to secure tenants as quickly, and the ones you do land may not stay for very long.

A tactic to consider is offering incentives, including utilities and free parking. Incentives are especially effective if you have many competing rentals in the area. Incentives can also encourage quality tenants to stay longer.

Speaking of competing rentals, don’t choose a neighborhood with a ton of selection. If you select an area that has gone out of fashion for whatever reason, you will get a far higher turnover rate. The U.S. Census Bureau has the percentages for vacancies in each state for the first quarter of 2022.

The top states with the lowest vacancies were Vermont (2.5 percent), Massachusetts (2.8 percent), Delaware and Idaho (3.3 percent), and Colorado and Montana (3.4 percent).

iProperty Management reports that Vermont’s rental vacancy rate is 51.8 percent lower than the national average, and the state’s rental vacancy rate has dropped by 40 percent since 2015.

Meanwhile, 38 percent of households in Massachusetts are renting, and the rental vacancy rate has been declining at a rapid pace year-over-year.

The largest cities in the country saw a rise in vacancies throughout the pandemic, thanks to the shift many people made into more affordable areas. However, some of these metros are seeing an influx of renters once more as the pandemic effects subside.

Finally, you’re going to want to do everything possible to research your potential tenants. The Canadian Broadcasting Corporation has reported multiple cases of landlords being put into staggering debt due to fraud.

Shady tenants have gotten extremely clever, forging everything from employer bank statements to credit reports. As a result, landlords can be fooled by an allegedly stellar credit rating and long-time employment, only to end up with tenants who won’t pay the rent and continue to squat. What’s worse, government red tape can make it extremely difficult to get the help you need to evict these problematic tenants.

Don’t believe everything you receive from a potential tenant. Instead, follow up and do your homework to ensure everything is factual. A little research is worth it to avoid major headaches down the road.

Time to take the plunge

It’s understandable to be nervous when getting ready to purchase your first investment property. There are a ton of moving parts to consider — from the market to the property itself, not to mention your tenants — and it’s easy to get overwhelmed.

Don’t let your emotions sway you. Taking the time to properly research will serve you best. A solid and desirable property will help you to get the best tenants. Budget your time accordingly, from researching areas and potential tenants and property managers.

If you’re going to handle everything yourself, your duties as a landlord require a lot of time and patience. Be honest with yourself and consider if you’re capable of taking on the responsibility.

Remember that investment properties can be a highly rewarding opportunity. The income is the priority, but you’ll also be providing a quality home to someone who needs a place to live. It’s a chance to build relationships and contacts, and that’s an appealing benefit.

The experience you gain in purchasing your first investment property will give you the confidence and know-how to expand your property portfolio. So, do your homework, take the plunge, and become a landlord.

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