Real estate investment properties are a popular method for generating a secondary source of income. Property owners who find and effectively manage a property can potentially earn significantly more money than they would through other methods, such as investing in the stock market.
The potential upside of owning an investment property is clear. However, that doesn’t mean that every property owner will necessarily be able to achieve their earnings goals. If you do want to maximize your earnings, you’ll need to be sure to choose a property whose value is well-supported by data, and you’ll also need to develop an effective property management strategy. Investment owners have to consider the size of the property they wish to purchase if they want to rent it as a vacation or long-term rental, and how to find tenants.
An investor does not need a strong real estate background to purchase an income-generating property. Continue reading to learn more about important considerations and the process for acquiring an investment property.
What is an Investment Property?
An investment property is a term used to describe any property purchased with the explicit intent of generating income. While you may have purchased your primary residence with the hopes it would increase in value, very few people would classify that as an investment property. An investor will not live in the secondary property and instead rent it to tenants. The rental income they generate from their tenants offsets the cost of homeownership, like mortgage payments, maintenance costs, and property taxes, and can then generate additional revenue.
Investors can select from several types of investment properties. Residential properties, especially multi-family residential properties, are among the most common for people entering the market for the first time. Commercial, industrial, and other investment properties can also generate substantial revenues, especially when the market conditions are strong.
How to Buy an Investment Property
When buying an investment property, you’ll need to put down a substantial down payment of at least 15% of the purchase price. As the size of the investment property increases, lenders may require a higher down payment of up to 25%. While many homebuyers strive to put down 20% for a down payment on their primary residence, many mortgage lenders will work with lower down payments, accepting as low as 5%. Therefore, investment purchasers may need to spend more time saving up to afford the initial cost of ownership. Investors also cannot rely on first-time homebuyer programs to help offset the cost of the down payment and closing costs.
Compared to buying a primary residence, purchasing an investment property is similar. Buyers who need to finance their purchase with a mortgage will work with a mortgage lender but will encounter stricter requirements. Investors typically need credit scores of at least 700 and will have to prove that they can afford the cost of two mortgages, not including the income they’ll generate from the investment property.
Getting a Mortgage for an Investment Property
Most property investment loans are agency loans, meaning a private lender issues them but receives backing from federal agencies Freddie Mac or Fannie Mae. The only time you will be to secure a loan from the FHA, VA, or another government lender is if you plan to buy a multi-family property and actively live in one of the units. Property buyers can use this strategy if they do not have as much money for a down payment, as FHA investment loans can accept as low as 3.5% down.
As is the case when you are applying for any mortgage, buyers should receive pre-approval before they begin looking for properties. The pre-approval will prove you’re serious to sellers and highlight what you can afford. The higher your credit score, the less money you will have to provide in your down payment. You’ll pay 20% if your credit score is 620 and 15% if your credit score is above 720.
Your prospective mortgage lender will ask for financial information like multiple years of tax returns, several months of bank statements, and the ability to prove your income. If you’ve managed property in the past, your lender may ask to see relevant documentation which could help you secure a lower down payment.
Benefits of Buying an Investment Property
Investment properties have become an increasingly popular component of a diversified portfolio due to their following benefits:
Regular Cash Flow
Property owners can find consistent renters who can generate steady and predictable income. For example, when you sign a tenant for a year-long lease, you can count on that rental income monthly. When your building has full occupancy, you’ll see the greatest return on your investment and be able to generate enough income to offset your operating expenses and make a profit.
Looking to find renters? Advertise your property on RentHop
On average, the value of real estate grows at a rate between 5-10% per year, frequently outpacing the stock market. Property owners will make money off an appreciating home from income while knowing that their investment continues to appreciate. When owners are ready to sell, they can use the profit to finance the purchase of a larger investment. Some owners may purchase an investment property with the sole goal of affording retirement.
One of the main appeals of primary homeownership is the ability to take out a home equity line of credit (HELOC). That benefit also applies to investment properties, where homeowners can borrow against the property’s value to finance significant purchases. For example, an investor who plans to flip the investment home and sell it at a significantly higher value can afford the renovation by taking out a HELOC.
Owners should note that HELOCs on investments have more strict requirements than those for primary homes, as this comes at a higher risk to the lender. Borrowers will need a higher credit score, typically above 720, at least 20% equity in their property, multiple appraisals to confirm the property’s value and a debt-to-income ratio (DTI) between 40 to 50%.
Investors may choose to split their assets across several industries, including real estate. A real estate asset provides security and helps diversify your wealth portfolio. Compared to most other speculative assets (like stocks), real estate is fairly recession-resistant and can hedge against inflation.
The government wants to encourage property ownership and is willing to offer a wide range of tax deductions and credits. While owners must pay taxes on their rental income, they can offset that cost by claiming deductions on operating expenses, real estate taxes, repairs, mortgage interest payments, and depreciation. Those who wish to purchase investment properties should consult with tax professionals during the tax season to ensure they properly file and claim all possible deductions.
Learn more: A Guide to Rental Income and Expenses
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Risks of Buying an Investment Property
While the benefits of owning an investment property are clear, there are certainly quite a few drawbacks, as well. Consider the following risks when deciding if purchasing an investment property is right for you:
Even when you are well leveraged, owning an investment property will require a major financial commitment, and that means there will likely be other investment opportunities you’ll have to pass on. As miscellaneous expenses pop up, you may have to scale back your investments in other areas and revisit your budget. In more extreme cases, your investment could end up losing money and putting you at a financial disadvantage.
Real estate is notoriously illiquid, meaning it will be much harder to turn your investment back into cash. This limits your financial flexibility and decreases the freedom you have with your money. If you wish to turn your investment into cash, you will have to go through the extended process of getting your property ready to sell, putting it on the market, and completing the closing process. If you need to access cash quickly, you will not be able to through your property.
Rental Market Uncertainty
The only way to make money on your property is to rent it out to tenants. If you’re unable to find tenants and cannot generate consistent income, you’ll risk losing money. There are some years where you can charge more for rent and some years where you may need to scale back and minimize your potential profit.
The current real estate market can influence when you conduct real estate activity. If you decide to sell your property, you may want to wait for a seller’s market to take full advantage of the financial reward.
Management and Other Expenses
Your property will require upkeep and consistent management to ensure renters renew their lease and continue to stay in the property. While you can complete this task on your own, you may decide to hire a management company to attend to daily tasks. Generally speaking, the larger the size of your property, the more help you will need to manage it.
Property management costs money, and you will also have to pay for repairs and general maintenance, taxes, insurance costs, and other ownership expenses. If you have a high vacancy level, these costs quickly eat into any potential revenue and decrease the opportunity to generate profit.
Metrics to Use When Comparing Investment Properties
After deciding to embark on investment property ownership, you will then have to make the difficult decision of which kind of property to purchase. You can use the following metrics to compare properties and consider which one to buy:
Net Operating Income (NOI)
This number represents how much you can earn from your investment. To calculate NOI, simply subtract all operating expenses (excluding your mortgage) from your revenue (projected rent). When browning available listings on RealtyHop, you can refer to the Property Analysis feature that will display the anticipated monthly income and operating expenses.
Pro tip: When determining your project revenue, it will prove beneficial to research current rental market conditions. You can refer to online sources, like the RentHop Average Rent Costs to see how much you can expect to generate from a rental unit of varying sizes.
The capitalization rate, also called the cap rate, is the most common way for real estate investors to evaluate the return on their investment. To calculate the cap rate, divide the total income produced by the property by the total amount you paid for the property. The cap rate evaluates the level of risk associated with purchasing that property as an investment. A lower cap rate in a city indicates lower risk, which can appeal to investors seeking a steady income-generating stream.
Learn more: Cap Rate – What Is It and Why Is It Important?
Debt Service Coverage Ratio (DSCR)
Mortgage lenders use the DSCR to determine the borrower’s ability to repay their property investment loan. Specifically, it analyzes if the potential property can generate enough income to finance mortgage payments. While lenders specifically use this factor, buyers should also pay attention to the DSCR as it directly reflects a property’s potential income-generating power.
Internal Rate of Return (IRR)
The IRR, sometimes known as the “great equalizer” among investors, helps show how much money you receive per dollar invested.
How to Compare Investment Properties
When exploring different properties, you’ll want to contextualize your research and compare like properties against one another. Comparable properties, also called comps, should be in a similar location, have a similar price per square foot, and serve a similar function (for example, don’t compare a commercial property to a multi-family residence).
You can consult your real estate agent to conduct a comparative market analysis (CMA) that directly analyzes the differences between prospective properties. The CMA can consider each property’s NOI, cap rate, DSC, and IRR. You can also refer to your real estate agent to help provide resources and more information about the investment property search.
Is an Investment Property Right for Me?
Various life factors will influence your decision to purchase an investment property. If you’re financially stable and looking to diversify your wealth portfolio, an investment property can prove itself a strong source of revenue. Owning an investment property can become a risky move, as you must properly manage your property and continue to find renters to fill vacancies.
As with any significant financial decision, you should consult with an advisor to explore your options and consider the benefits and risks of property ownership. When you’re ready to take the next move, reach out to real estate professionals and mortgage lenders to begin searching.