An investment property is any property whose primary purpose is to earn the owner a return on his/her investment either through rental income, capital appreciation, or both. Such properties are not purchased to be used as primary residences. Instead, they are acquired to generate revenue in the form of rents, interests, or dividends.
What are some questions to ask yourself before buying an investment property?
Why are you buying this property?
The first and most important question you need to ask yourself before putting down the money for an investment property is, “why are you buying this property?”. Think about your ultimate goal. Are you buying it to flip it within a short time, or is this a long-term investment?
Are you buying this property to diversify your portfolio, so you don’t put all your proverbial eggs in one basket? Is purchasing this property a way to build your rental portfolio, or is this just a vanity property?
Providing the most specific answers as soon as possible to these questions will give you a clear vision of your goal and how it can be achieved. After deciding on why you’re willing to make this investment, you can start making calculations and financial forecasts based on the intended investment strategy.
What is your exit strategy?
Once you identify your reason for buying the property, the next step is to decipher your exit strategy. An exit strategy means exactly what it sounds like–a way out or an escape route. It is how an investor plans to pull out of a real estate investment.
It is crucial that you know how you intend to get your money out of an investment property or at least have various exit strategies in mind before making any payment. Your exit strategy depends on how you plan to use the investment property.
For instance, if you intend to fix and flip a house, your exit strategy will be to remodel or renovate it and then sell it to an end buyer within 4-6 months. However, if you’re looking to build a rental portfolio, your exit strategy may not be so straightforward.
You can choose to buy and hold, which involves renting out an investment property to earn monthly income from renters, refinance your property, or get a loan on the property’s equity. Identifying your exit strategy allows you to plan how you intend to
redeploy your capital over and over again.
What is your monthly cash flow?
In real estate, cash flow is defined as the monthly profit you make from an investment after paying all operating expenses. If you intend to hold on to your investment property, you should first determine your monthly cash flow.
For a rental profitable to be deemed profitable, the rental income must cover all the monthly expenses and have a considerable cash surplus. Investing in a property with a negative cash flow is simply unwise.
I have met “investors” who accept negative cash flows on rental properties because they are happy using the tenant to subsidize their mortgage payments, and they think it will all pay off in 30 years when the mortgage is satisfied.
Unless you are an institutional investor or intend to create a tax shelter, it rarely makes sense for an individual investor to have negative cash flow on an investment property. There are many other places to put that money you are losing every month to make you more money.
Reserves and repairs
Maintaining a property is very important in preserving its value. If you’re interested in making a long-term investment in a property, you must take repairs and maintenance into account and add them to your budget.
Consider the average life span of the appliances in the property so you can determine how long they’ll last before they have to be replaced. Some appliances such as airconditions start breaking down around the fifth year while others like gas cookers breakdown in 10-15 years.
So, if you buy a 10-year-old house, budget for repairing all of those items in the near term. You should also set aside some money for unexpected repairs such as a leaking roof, a burst pipe, and so on.
What are the pros and cons of real estate investing?
Real estate is known to appreciate over time. This is one of the reasons it is generally regarded as an excellent long-term investment. As long as the property is adequately maintained, real estate naturally appreciates at an average rate of 4%–5% annually. This rate can be increased by making repairs or renovations such as adding a patio or making kitchen renovations.
Real estate investors enjoy many tax exemptions and deductions that help them save money. For instance, rental income is exempted from self-employment tax. Also, the government allows tax deductions for regular expenses such as maintenance repairs, insurance, improvements, legal fees, etc. In addition, real estate investors are allowed to defer the taxes paid on capital gains by using a 1031 exchange.
A big tent
With real estate, your channels of generating income are limitless. You can flip houses and make a profit within a few months, make monthly income by renting out your property, develop land, become a lender, sell a share of your property, change property use, etc.
Over the years, real estate has proven to be one of the best ways to build wealth. Take flipping as an example. All things being equal, the average investor can make a profit of $30,000 on a single house flip–and this amount can go as high as $100,000 or more. Landlords can also earn a high ROI on their rental properties yearly. All these factors, together with tax deductions and other benefits attached to being a real estate investor, make this type
of investment highly profitable.
Real estate gives you the freedom to work whenever and however you want. Although to be successful, you will likely work a lot, but it will be on your own terms. You can build a schedule based on how much you’re willing to work each day. It doesn’t necessarily follow the rules of a 9 to 5 job, and as a plus, you get to be your own boss!
Real estate is a great way to make passive income. You can create a portfolio that provides passive returns in the form of rents or loan payments. This form of steady revenue can assist you in settling your debts, building your retirement funds, or even sending your children to college.
Investing in real estate can be expensive as you will need some capital to join in. While you don’t have to pay the full cost of a property at once, you still need to make a down payment, closing costs, and money to repair and renovate the property. There are also operating expenses that are incurred in owning real estate, such as mortgage payments, property maintenance, and taxes.
Real estate investments typically lock up a lot of capital into a property without the ability to easily retrieve it. The process of selling a property is extensive. First, you have to find an eligible buyer. Then, you have to negotiate and agree on a price, wait out the diligence period, do the required property inspections befo re closing at escrow. This process can take months or even years to complete. Thus, it often takes a long time to convert investment properties into cash.
Bad tenants are nightmares, and unless you have a portfolio with someone else managing it, you will be the one interfacing with them and managing their issues. They can cost you money by damaging your properties or refusing to pay rent, waste your valuable time in court, or even do both.
What are the steps to buying an investment property?
Identify your “why”
The first thing you should do before buying an investment property is to identify why you’re making this investment. Knowing why you’re choosing to invest in real estate will help you define your ultimate goal as well as decipher the best investment strategy to achieve it. You can adopt various investment strategies, including “buy and hold,” flipping, short-term rental, etc.
Identify your target area
The area an investment property is located in plays a significant role in determining its value. You have to choose a target area with properties that align with your goal and are highly profitable. Some areas are in high demand due to the amenities and service they have to offer. The properties in such areas will appreciate faster than other areas that do not offer these amenities. You should also go for an area that offers its occupant maximum comfort. This comfort could be in the form of easy access to transportation routes, proximity to supermarkets, schools and tourist attractions, security, etc.
Run preliminary numbers to determine a target property type and price
Go through the properties available in your target area to determine the available type as well as the prices. For example, if I want to flip a house, I’m going to look at neighborhoods with houses that need updating around a price point I can afford. Also, consider the kind of property you’re looking to purchase–either a single-family home or a multi-family property. Note that these houses have their own specific benefits. Multi-family homes will generally earn you more cash flow, while single-family homes have more equity appreciation potential.Scour the market for deals: After deciding on your preferred location for your property, the type of property you want to buy, and the price you’re willing to pay for it, then you’re ready to start scouring the market for deals that fit your choices. Scouring
the market involves contacting local realtors, looking on Zillow and Craigslist, sending postcards, calling, driving the neighborhood for properties, or running digital ads.
Identify funding sources
How do you plan to pay for your investment property? Are you going to self-fund, get a conventional mortgage, or pay with a hard money loan? Purchasing an investment property requires a lot of capital which could be tied down for months or even years.
This is why borrowing to finance your investment is one of the best options as you won’t have to pay for your property out-of-pocket. However, if you have tons of cash just lying around, self-funding will probably be your best option. Evaluate your financial situation carefully so you can choose the financing option that allows you to make the most out of your available resources.
Implement investment strategy
After closing the deal on the investment property of your choice, it’s time to start implementing your investment strategy. For example, if you plan to fix and flip, you’ll need to start renovating the property so it can be sold quickly.
What makes for a profitable rental property?
I would define a profitable rental property as one that has a positive Net Operating Income(NOI). This means the income from the rental property pays for all the expenses and maintenance while also generating a net gain. The profitability of that property depends mainly on the market. Large apartment complexes in primary markets operate on 4% cap rates or less (Net Operating Income /Price = Cap Rate) and are usually for institutional investors. In contrast, single-family homes in blighted neighborhoods can fetch up to 20% cap rates.
However, if you want to find a “good deal” on an investment rental property, you need to find a property where you can force appreciation through improvements and increased rents. You can make improvements like adding new features such as a new room, renovating the kitchen and refurbishing it with the latest state-of-the-art equipment or improving the exterior aesthetics of your property. That will increase your NOI and your cap rate, making the property more valuable.
What are the tax implications of owning real estate investment properties?
Full-time real estate companies can deduct more expenses than an individual part-time investor:
While individual investors can deduct expenses such as property insurance and maintenance costs, real estate companies are entitled to make even more deductions. For instance, real estate companies are allowed to deduct professional and legal fees, travel expenses, the cost of office space, advertising or marketing expenses, and so on.
You can avoid taxes on gains by using a 1031 Exchange:
A 1031 exchange allows investors to defer taxes on capital gains by swapping “like-kind” properties that are held for business or investment purposes. Note that residential houses do not qualify for a 1031 exchange.
You can reduce your tax liability by using depreciation:
Real estate depreciation allows an investor to recuperate the costs of an income-producing rental property. It reduces the investor’s taxable income by considering the costs of wear and tear, deterioration and obsolescence over the property’s lifespan.
What are some rental property loan options?
Conventional financing: Conventional lenders offer rental loans, but typically retail banks don’t specialize in this area. The main factor that determines whether you’re qualified for conventional financing is your current income. Other factors include the type of property, employment, your credit score, other debts, and assets. Although the process and rates can be onerous, conventional financing is one of the best financing options for rental properties.
Private mortgage: Private mortgage is a loan financed by private individuals for the purpose of purchasing real estate. The lender could be a family member, friend, or colleague. A private mortgage allows individuals to bypass all the obstacles associated with obtaining a loan from traditional mortgage lenders. Private lenders have many programs for buying rentals loans, and they’re usually based on your track record and the market rent amount.
Seller financing: If you want to get creative, you can make a deal with the seller to finance part or all of the purchase price. Also known as “bond-for-title,” seller financing is a loan provided to the buyer of an investment property by the seller. This type of financing is beneficial to both the seller and the buyer. It assists sellers in moving homes faster while getting substantial returns on their investment. On the other hand, buyers enjoy more flexible qualifying and downpayment requirements and lower interest rates.
Take over the owner’s existing mortgage payments: You can choose to take over the mortgage of the owner of the property you’re interested in. This is different from assuming a loan.
Assuming a loan: This involves transferring a seller’s loan to the buyer. Assuming a loan helps buyers avoid obtaining their own mortgage. This can save buyers a lot of money, especially if interest rates are increasing. Provided that specific requirements are met, FHA(Federal Housing Agency) and VA (Veteran Affairs) loans are assumable.
While purchasing an investment property is a highly worthwhile expenditure, it does come with its own risks. This is why it is crucial to learn as much as you can about investment property before diving into it. Having the right information will not only help you earn the most returns out of your investment but also protect you from making very costly mistakes.