A rental property can be a great way to achieve a steady income stream and long-term capital appreciation, but as with any investment there are many considerations to weigh before you jump into the unknown.
Investment Components: Rental real estate can create economic value for you in two ways, appreciation and cash flow. Although tied together, they can also be independent of each other.
- Appreciation: Real estate tends to appreciate over time. Appreciation is based on supply and demand; both are cyclical and will affect your property’s value through time. An appreciating property does not have to be cash flow-positive (think of an empty lot in a “hot area”). Appreciation, or capital gain, is taxed at preferential (lower than income tax) capital gains rates. Tax is only due if you decide to sell a property.
- Cash Flow: Cash flow is your month-to-month or year-to-year net receipts from your rental property. Cash flow from your rental creates economic value in the sense that it helps you pay down the mortgage balance (if any) or provides you the opportunity to invest outside of the property. Cash flow can also aid in appreciation if you use the net proceeds to improve the property. A rental can be cash flow positive and not appreciating (think of a rental in an unattractive area of town with good tenants).
- Liquidity: A rental property is an illiquid investment. Not only will it take a minimum of several months to sell a property, but even if you have equity in your property, it might be difficult to pull out.
Finding a Rental Property: If you are not a professional, but are still interested in investing in a rental property, we suggest you look at what you know.
- Location: If you have lived somewhere a long time, you should be a good judge of which areas are up and coming, those that are over-priced and those areas in which you would ultimately be comfortable owning a rental property.
- Legal: Local rental laws differ in each municipality, county, and state. It is important to know the rights of both landlords and tenants wherever you are looking.
- Rentability: You will need to study up on the current rental climate within the area you are looking.
- What is the best way to position this property: Airbnb, vacation rental, or traditional lease?
- If the property is not ready to rent from day 1, how much additional cash outlay will be required to make the property rentable? How long will this take?
- If the property is not already rented, how long will it take to rent the property based on the current market?
- Is the property in an area where it will be difficult to find a suitable tenant?
- What are market rental rates in the property’s location?
- Will the property be cash flow-positive from the start?
Financing a Rental Property: The home buying experience does not fully translate to the rental property buying experience.
- Down Payment: Mortgage insurance will not cover a rental property loan, so you will need to provide at least 20% of the property value as a down payment. Furthermore, some lenders will ask for a 25% down payment when financing a rental property.
- Approval Requirements: Keep in mind that not all potential rental properties are eligible for a mortgage loan. Check with a lender, before you invest time, money or emotion.
- Property is existing rental: Documented cashflow can most likely be used as a component of your income qualification for a property.
- Property is not currently rented: If property lacks a history as a rental and you cannot prove your property management experience, you might not qualify for a loan even if you have the necessary down payment.
- Interest Rates: Mortgage interest rates are still historically low, which might make owning a rental property all the more enticing.
- You should know that interest rates for rental properties are often higher than those for a personal residence.
- Assuming modest inflation, getting a low, fixed-rate loan means that your mortgage payments will remain the same over time, but the rental income you will be generating should increase.
Taxes: There are many tax laws that are specific to rental properties. You should be aware of a few tax benefits and downsides associated with becoming a landlord.
- On annual taxable receipts: Net income (rents received minus allowable deductions and depreciation) must be reported on Schedule E of your Form 1040. In other words, net rental income is taxed at ordinary income tax rates. That said, a property can often be cash flow positive but not trigger any taxes due to the allowed depreciation.
- On sale of property: The normal exclusion of capital gains on home sales is limited for rental properties. The calculation depends on the number of years the property has been owned and the time split between rental and primary residence. In the case where the rental property is never used as a primary residence, capitals gains tax is due on the total difference between sale price and adjusted cost basis. The IRS also forces you to recapture depreciation and pay a 25% tax on it.
- On sale of property to buy another: Tax law does allow you to defer capital gains taxes if you exchange the property for a like-kind investment. This provision is known as a “1031 exchange” which can help you upgrade rental properties over time, without having to pay capital gains tax.
- On tax law: Tax laws change. A stipulation in the tax code that is currently favorable to landlords can be written out or changed. Do not invest in a rental property if you are only interested in the prospects of reducing your taxable income.
- On tax preparation: If you have only ever filed a simple tax return, you will probably need professional help to work through all that is involved in filing a return that includes a rental property.
Becoming a landlord: If, after reading all the above considerations, you still want to become a rental property investor, here are a few more items you need to consider.
- Tenants: Tenant selection is critical to a positive experience as a landlord. You will want to educate yourself on how to know if a tenant is qualified to rent your property (proof of income, credit report, references, etc.).
- Emergencies: Rental units, like all property, will experience wear and tear. This will inevitably lead to unforeseen emergencies that you, as the landlord, will be responsible for.
- Safety net: It is important that you factor the upkeep of your property in to your Emergency Fund. Consider keeping a separate pool of funds for rental property expenses, perhaps even putting a portion of your monthly rental income toward this fund.
- Other Expenses: Aside from any mortgage due, you will also be responsible for property taxes, insurance, and any HOA dues, regardless of the property being occupied or not.
- As your property appreciates in value, expect property taxes and insurance costs to increase as well.
- HOA dues can increase unpredictably depending on the whims of the HOA board.
- Vacancies & Income Variability: There will be weeks (or even months) that your rental may be vacant. You must be financially ready to cover the expenses if this happens. Also, your income stream may vary over time. There will be periods in which increased maintenance will be required and limit the amount of money that you keep.
- Time Commitment: The time spent on property management can vary depending on the number of units you own and the quality of the renters you find. Consider the following items and if you have the availability to manage the property yourself. Alternatively, you can offload the work to a property management company, exchanging a percentage of the rental income for their services.
- Getting the unit rented: This will require you to make a rental application, set a price and desired lease term, advertise the rental, show the rental, process applications from prospective renters, follow up on references, run credit checks and finally enter into a lease agreement with a renter. Keep in mind that short term rentals like Airbnb and VRBO require a continual commitment to this area of service.
- If you want to keep a renter happily sending you money, you will need to make sure rentals are maintained properly, working and contracting with any professionals who might be needed. You will need to document any work, keeping records and receipts of all happenings.
- Finally, you might be required to address any tenant problems that might occur. These can include delinquency in payments, neighbor complaints, insurance claims of the property, and even eviction.