Are you thinking about buying an investment property? Whether you’re an experienced real estate investor or a first-time buyer, there are a few things to know before diving into the world of rental properties.
From understanding the local real estate market to securing financing and managing the property, there are many factors to consider when buying an investment property. But with the proper knowledge and strategy, you can reap the rewards of passive income and long-term price appreciation.
So, if you’re ready to take the leap and invest in your financial future, read on to learn more about the factors to consider before buying an investment property.
What is an Investment Property?
An investment property is a real estate property purchased to earn a return, either through rental income or future gains, when the property is sold. Investment properties can be single-family homes, townhouses, condos, or commercial properties, typically purchased by an individual or a group of investors.
The primary goal of a rental property is to generate income. For this reason, many real estate investors hold the property for the long term. Others prefer short-term investment, where they flip properties.
Things to Consider Before Buying an Investment Property
If it’s your first time venturing into the world of investment properties, there are many things to keep in mind. Whether you want to buy a condo in the city, a vacation rental property, or commercial real estate, you need a wealth of knowledge to know what makes a good purchase.
To help you make an informed decision, here are major factors to consider before buying a real estate investment.
Current Housing Market
You want to buy a rental property that rises in value over time. But how do you tell an area has a high growth potential? You need to look at the current real estate market.
With the help of housing market indicators, you can look at home prices, rental rates, and vacancy rates to get a better sense of whether the market favors buyers or sellers. This data will help you make an informed decision about whether or not to invest in a property and at what price point.
Location is the most important factor to consider when buying an investment property to maximize return on investment (ROI). Put yourself in the shoes of your potential tenants and consider what you’ll look for in a rental property. Access to public transport and proximity to schools, restaurants, and stores make a property more attractive.
Here are a few factors to keep in mind when choosing the right location for your real estate investments:
- Neighborhood: The neighborhood you choose for your rental property investment determines the number of tenants you will attract and vacancy rates. If you buy investment property near a college, it means most of your tenants will be students. When schools are not in session, you may find it challenging to get tenants, translating to high vacancy rates. Some neighborhoods may impose strict regulations or high permit fees on rental properties. Ensure that you do thorough neighborhood research before buying a rental property.
- Crime rate: No one wants to live in an area with high crime rates. Neighborhood safety is paramount when choosing a location. Be sure to get accurate crime rate statistics for your neighborhood.
- Taxes: Property taxes significantly vary depending on the area you want to invest in. It’s a good idea to know the current tax rates and if they will likely increase in the future. To get an idea of what you’ll pay in taxes, talk to a local real estate agent or visit the municipal assessor’s office for all the tax information. Typically, the amount you’ll pay in taxes is directly related to the property value. If the value of your property is high, you pay more, and vice versa.
Type of Property
Once you’ve decided on the location you want your new rental property to be in, you need to know the type of property to purchase. There are different types of investment properties, and the most common include:
- Residential Property: Residential real estate is a building or a unit zoned specifically for living either as an individual or family. It can be single-family homes, condos, duplexes, townhouses, or apartments. As an investor, you’ll generate income by leasing these properties to tenants and collecting rental income.
- Commercial property: Commercial real estate is property used for business purposes. It can come in various forms, including an office building, restaurant, or warehouse. Commercial properties are typically leased out to tenants for income-generating activities or held for capital growth.
- Industrial: An industrial property is a property used to accommodate industrial activities such as the production or processing of products on a large scale. These properties are typically set on large parcels of land in close proximity to major roadways, seaports, and airports for easy transportation of goods.
While you may not be planning to live in the property, someone else will do. How’s the overall condition? Does it have a good layout? Think about the features you’d look for as a tenant. Things like a garage, attic, extra bathrooms, or a home office will significantly increase the property’s rental value.
Remember to also look at the age of the property. Investment properties typically have ongoing expenses, and you don’t want one that will break your bank through maintenance costs. Be sure to check the condition of the roof, structure, fixtures, and fittings. You may even want to go the extra mile and hire a professional building inspector before you purchase the property.
Many investors consider capital growth when searching for good investment properties. How’s the growth trend of the property you want to invest in? What amenities are around? Is there a possibility demand will surpass supply in the future?
One way to quickly know the capital growth of the areas you’re looking at is to use a property market research tool. It will give you a detailed overview of the properties, including past sales, demographics, and median rental income. This data can give you a bird’s eye view of what capital gains will look like in years to come.
Down Payment Differences
As with any other real estate, you’ll need to put down a certain percentage of the purchase price when buying a rental property. Unlike traditional family homes, where you can put down anywhere from 1% to 10%, you’ll need to put down at least 15% to 20%.
Investment properties have high down payment requirements because they don’t qualify for mortgage insurance, and it’s hard to get approved when securing financing. How much you’ll put down depends on many variables, such as your credit score, income, and debt-to-income (DTI) ratio.
Finally, you want to decide whether you’ll handle all the repairs, tenants, and overall maintenance yourself or you’ll hire a property manager. Some real estate investors choose to serve as landlords, while others prefer to pay a management company to take care of everything.
A property management company can take the weight off your shoulders by managing daily maintenance like repairs. They can also collect monthly rent on your behalf. However, the service comes at an extra cost. While this is an additional expense, it might be cost-effective over time.
Do some research on which option is best for you, and keep these expenses in mind when deciding whether or not to purchase a particular property.
An investment property isn’t a one-time purchase. It has ongoing expenses (fixed and variable) that you must keep in mind. Because you can’t anticipate most of these expenses, it’s always a good idea to set aside some funds, so you don’t end up with a negative cash flow each year.
While variable expenses are difficult to predict, it’s best to have wiggle room in your budget for unexpected repairs. Depending on the type of property you purchase, you’ll be on the hook for some of these fixed expenses:
- Property taxes
- Homeowner’s insurance
- HOA fees
- Property management expenses
Pros and Cons of Buying an Investment Property
Rental properties can provide a strong return on investment, but they also come with their own set of challenges and risks. Before you decide to invest in rental property, it’s essential to understand the pros and cons.
- Positive for cash flow: An investment property can offer a steady stream of passive income, especially if your rental income is more than your monthly mortgage repayments and maintenance cost. Not only will the revenue pay off your mortgage, but you’ll also gain positive cash flow to build wealth over time.
- Potential tax benefits: Another major benefit of being a property owner is the potential tax benefits. You can enjoy tax deductions that can allow you to maximize your ROI. For example, you can claim expenses incurred in daily management and maintenance of the property against your rental income. In addition, you can deduct interest on a mortgage or any loan you took to finance the purchase of the property.
- Build an investment portfolio: Properties are long-term investments that can rise in value over time and boost your ROI. You can use the revenue to invest in other ventures or expand your property investment portfolio. Once you’ve built equity, you can use it to invest in other properties. A considerable property portfolio means high capital growth and rental yield.
- Maintenance: One major disadvantage of owning an investment property is the maintenance cost. You can expect to spend 1% of the property’s value each year on maintenance, but this will vary based on factors like the number of units, when it was constructed, and the overall condition.
- Management responsibilities: As a landlord, you’re on the hook for managing the property. While you can hire a property management company to handle everything on your behalf, the service is an additional expense.
- Bad tenants or none at all: Dealing with bad tenants can be stressful for landlords. Not only do they cause stress, but they can lead to substantial financial loss, especially if they fail to pay rent on time or damage your property. You could also end up without tenants and have to cover property expenses and other costs.
Is Buying Investment Property Right for You?
Buying an investment property can be a great way to generate passive income and build wealth over time. However, it also comes with risks. The real estate market is unpredictable. For this reason, it’s important to carefully evaluate the risks and benefits before investing in real estate.
Whether or not buying a rental property is right for you depends on your individual financial goals and risk tolerance. If you’re willing to do the research and are prepared for the responsibilities that come with being a landlord, an investment property is a great addition to your portfolio. Otherwise, it may be better to consider other types of investments.
Josh is a financial expert with over 15 years of experience on Wall Street as a senior market strategist and trader. His career has spanned from working on the New York Stock Exchange floor to investment management and portfolio trading at Citibank, Chicago Trading Company, and Flow Traders.
Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business. He has held multiple professional licenses during his career, including FINRA Series 3, 7, 24, 55, Nasdaq OMX, Xetra & Eurex (German), and SIX (Swiss) trading licenses. Josh served as a senior trader and strategist, business partner, and head of futures in his former roles on Wall Street.
Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh currently holds areas of expertise in investing, wealth management, capital markets, taxes, real estate, cryptocurrencies, and personal finance.
Josh currently runs a wealth management business and investment firm. Additionally, he is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses professionally.