In the US, rental properties are in high demand due to growing populations. High rental rates have made rental properties extremely profitable for real estate investors. Recently, the housing market is starting to return to normal as the coronavirus pandemic slowly ends. Employees are returning to urban cities as states start to reopen, which is further increasing the demand for rentals.
In June 2021, the national median rent price increased by over 5% compared to June 2020, and this number is expected to continue rising. With the high potential upside, many potential investors are correctly seeking out rental properties. However, before spending tens of thousands of dollars on a down payment, you should make sure that you know exactly what you’re getting yourself into and that you have the knowledge required to succeed.
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7 Things To Consider Before Investing in Rental Properties
1. Practice with a Room First
Instead of diving straight into the deep end of managing a full property, you should try renting out a room or section of your primary residence. Not only will you familiarize yourself with dealing with tenants and handling rent, renting out just a room reduces the risks of vacancy or tenant damage. You can even start with renting out rooms on a short-term basis through homestay websites like Airbnb or Vrbo.
This makes it easier to repair any damages or perform maintenance after each tenant leaves. You’ll also receive some level of protection as a host for any damages caused by guests. If you ever change your mind about wanting to become a rental property investor, then you can easily abandon this ambition and remove your house as a listing. Using these websites, you can expose yourself to the different responsibilities that come with renting property without over-investing.
2. Dealing with Tenants
As a rental property owner, you are responsible for the regular maintenance of the home and you must deal with the tenants who occupy it. Since you are liable for the tenants living in the property, there is some added risk because tenants can be unpredictable.
If you would rather just own the property, you can hire an external property manager, but then you should expect a much lower capitalization rate, which is the net operating income as a percentage of the property cost. Unless you are managing several properties, it is recommended that you manage the property yourself and handle repairs as they arise.
3. Sort Out Your Finances
Investing in a rental property is an even larger financial commitment than buying your home. You’ll have to make a 20% minimum down payment because rental property mortgages cannot be insured. If you have existing debt or low savings, buying rental property is a large risk that you should avoid. Most new rental property investors will have to get a mortgage to afford the property, which means large monthly mortgage payments.
If you have pre-existing debt, not only will it be much harder to make monthly debt payments, you’ll also end up paying a higher mortgage rate because you are a riskier borrower. If you don’t have pre-existing debt, take the time to improve your credit score and build up an emergency fund you can use for repairs and unexpected expenses. With a solid credit history and financial stability, you can expect much lower mortgage rates, which reduces your monthly expenses.
4. Pick a Solid Location
As with any real estate decision, location is the most important factor in determining your success. With a rental property, this is even more true because your income is dependent on the local demand for rentals. Urban cities with high population growth and development plans are the best places to target. These ensure that you will have a steady stream of tenants and if you need to sell the property, that you’ll be able to easily find a buyer.
You’ll also want to look into the different real estate markets between states. High-growth states with good infrastructure and low crime rates are attractive for both employees and companies. Before buying a home, you should know the real estate market and forecast of the state before looking into local areas and cities. Each state has unique benefits and drawbacks, so depending on your goal for the rental property, the best state will vary. For example, expensive states like Florida have very high median rents, but the median home value is also much higher, so you’ll have a higher minimum down payment and higher monthly mortgage payments.
5. Do the Math
Even if you think you have a great location and a great price, it’s essential to calculate your profits on a rental property. Many investors underestimate the high operating expenses and vacancy costs associated with a rental property. These include property taxes, insurance expenses, and maintenance expenses among many other costs, which reduce your operating income.
This doesn’t include a monthly mortgage payment that you’ll probably have to pay as well, which would likely end up costing you money each month. While operating costs are fees that you cannot recoup, mortgage payments increase your home equity, so if a tenant pays enough rent to cover your regular monthly expenses, you can use the remainder to help pay off your mortgage. But whether or not your rental property is profitable comes down to the accuracy of your numbers.
Regardless of how profitable of a property you determine your upcoming investment is, you need a reserve of money that you can use for unexpected expenses. You should set aside 20-30% of your rent payments as a “rainy-day fund”. If you cannot afford to set at least 20% of the rent aside, you should build up your finances before taking on this heavy financial burden.
6. Buy Cheap to Start
If you’re just entering the rental property market, you should start with a low-cost home in a high-growth potential area. By investing a smaller amount of money and operating a property with lower expenses, you can get accustomed to the unexpected expenses associated with a rental property. If you have a large financial cushion, a small investment is a good low-risk way to expose yourself to dealing with long-term tenants and managing a property.
If you pay off the mortgage or decide you want another property, you can look for a slightly more expensive home and work your way up. In general, you should aim for a home valued at no more than $150,000 for your first rental property. As you go, you should gauge what you’re comfortable with having had more rental property experience.
7. You Have Options
Like with any investment, rental properties carry some amount of risk and reward. You have to carefully consider your knowledge on the topic and financial circumstances. Property investments generally carry more risk than stocks or bonds because they are fairly illiquid and have higher minimum capital requirements.
If you are simply looking for an investment, you should look into the many options available. There are even different investment options for exposing yourself to the real estate market like REITs, REIGs, and online real estate investing platforms. But above all else, you need to understand the market you’re investing in. Real estate varies greatly depending on location, both in terms of potential returns and risk. You should have first-hand knowledge of a given real estate location before buying any property.