“Ring, ring” – it’s your tenant calling you in the middle of the night to fix that leaky toilet. It’s one of the most undesirable facets of being a landlord, but it comes with the territory. It’s not all bad though, of course. An investment property has great benefits to your financial plan – if offers diversification, tax incentives, and solid monthly cash flow. Your first property can be a challenge since you may be new to the game. We’ll explore the pluses and minuses of taking on an investment property.
Many individuals are lured into the prospect of buying a house, fixing it up a little bit, then renting it out to solid, vetted tenets. The goal is to have the value of the house rise while collecting monthly rental payments. You can think of it as buying a mutual fund – there is price appreciation of the fund that provides investment gain, but also the quarterly dividend payments which yield cash flow. There is more grunt work that goes into maintaining a house, of course. Done the right way, you may have a gem of an investment asset on your hands.
When going about identifying and purchasing an investment property, you want to be sure you are not paying too much relative to your expected rental income. The “cap rate” is critical. The cap rate is simply the net operating income of the property relative to the price.
Of course, sometimes the house will be empty as tenets move out and in, so you have to take the vacancy rate into account. And then there are operating expenses like repairs & maintenance, utilities, and taxes. Your target cap rate should be between 6% and 12%. Compare a hypothetical 9% return to the puny yields on savings accounts and bonds right now!
So that’s the financial angle of it. What about the non-financial piece? Do you want a house that is nearby so you can manage it easily? Perhaps you want to find someplace far away that one day can be a retirement home or a second house – in which case you could outsource the day-to-day issues to a management company. Maybe the house is one you inherited, and you just don’t want to let it go for nostalgic reasons. These are all good reasons to own a house – you can still make some dough by renting it out as an investment.
There are some key things to know about being a landlord and maintaining the property. It’s hardly “passive income” as many real estate gurus like to proclaim. Here are a few items to be aware of before and during your first journey down the path of being an investment property owner:
- The grunt work. From listing ads to screening tenants to handling repairs, there is a lot of manual labor that goes into the job. And it is a job. Think of it as earning a part-time income.
- Be diligent about picking the right property with a good cap rate. Investigate several areas, see what rents are going for, and how property values are trending – is the market overvalued or undervalued? It might be part art, part science.
- List out all operating expenses. The litany of routine expenses can eat away at your rental income each month, so knowing in advance where cash will be flowing is critical to getting started on the right footing.
- Your time is valuable. If you are clearing $1200 per month but also putting in 30 hours a month in labor, maybe it’s not a great deal. And you are taking risk by buying a property, probably with a mortgage (meaning you have more debt) – you must be compensated for that risk.
- Consider alternatives to owning physical real estate as an investment. There are REITs and other hybrid methods to getting real estate exposure with little effort. Just keep an open mind and be sure to make the rental property just one piece of your overall portfolio.
Purchasing an investment property is a big deal. Sit down with us at TFC before embarking down that road. It’s important to review your financial situation to ensure it fits with your long-term financial plan. Assuming it does, continue to work with us regarding your cash flow plan and your tax situation. Having a second home to manage can create cash flow issues at times. And we want to be sure you take advantage of the tax benefits that come with an investment property, too!
Here’s the point
- There is a lot of due diligence & hard work that goes into researching, buying, and maintaining an investment property
- There are fantastic financial benefits, but it may come with some significant risk
- It takes a special kind of person who doesn’t mind getting their hands dirty in the process and taking the time to manage the property
- It’s important to understand how the rental property will fit into your financial plan – particularly with regard to your cash flow plan and tax situation
Action items
- Sit down with us at TFC to review your financial situation to determine if an investment property makes sense for you
- Research several areas where you are interested in owning a second house
- Due diligence also includes analyzing the expected rental income and operating expenses that come with owning an investment property
- Manage risk. Don’t get caught up in the ‘passive income’ fairy-tale – it’s not magic. It’s a serious job, and things can go wrong sometimes. If you approach owning an investment property as a business and manage risk properly, it will be a great long-term asset.