Don’t get caught up in a DIY nightmare or forget the hidden costs of being a landlord.
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Thanks to HGTV, we all think we could be homeowners and houseflippers. But in reality, it takes some forethought to decide if a rental property is really worth the time and effort.
You may have spent your pandemic days lulled into a Zillow daydream, scrolling through properties in low-cost-of-living areas and writing up future Airbnb descriptions to use when you list your home.
While there are no doubt benefits to buying a second property—whether for leasing long-term or as a vacation rental—real estate investing can be all hands on deck compared to investing in a real estate investment trust, or REIT. You’ll want to do some upfront research and calculations before buying a second home, starting with identifying the right kind of mortgage.
According to Robert Heck, VP of Mortgage at online brokerage Morty, you have to know the ins and outs of your financing before you can estimate the ROI on your rental property.
“Investment properties and different property types have eligibility nuances behind them,” says Heck.
Details like your monthly payment, interest rate, and down payment start with the type of mortgage you get. Rental property loans work differently from mortgages for primary residences. They often:
There are also different loans for multi-family units, like if you were to buy a condo building versus a single-family house at the beach. Other options exist for buying multiple residences, such as a blanket mortgage loan, where you can finance multiple rental properties under a single loan.
Since special mortgages exist for rental properties and investment properties only (compared to someone’s primary residence), prepare to have good proof of income and a solid credit score before you apply.
Once you have the details of your mortgage hammered out, calculate your potential return on investment (ROI) before you commit to buying the property. Start by looking at comparable units or homes in the same area and arrive at a reasonable median rent you think you could charge.
Then, compare the estimated monthly rental income to what your monthly mortgage payment would be. If you keep up with real estate trends, you stand a good chance of identifying when mortgage interest rates are so low and then investing accordingly.
The formula to calculate ROI is:
So, for instance, if you charged tenants $1,500 in rent to live in a house with an $800 mortgage payment, your ROI would be:
All this means is that you are able to charge rent that’s 87.5% higher than the cost to own the house every month.
But don’t over-simplify. To get the true return on investment for rental property, you also have to factor in maintenance costs (usually spread out over years, but averaged into a monthly expense), taxes, and the opportunity cost during any months your rental sits empty without tenants.
So, assuming you budget $200 per month for maintenance costs and another $50 per month for taxes, and you have one empty month per year after every tenant’s lease expires (this is kind of on the high end, but it’s good to be over-prepared), you’ll need to average these costs into the equation as well.
One month’s rent is $1,500, so letting your house sit empty is a $1,500 opportunity cost or about $125 in losses per month on average.
That $125, plus $250 for maintenance and taxes, means you’re actually paying a monthly average of $1,175 to own the house.
Therefore the true ROI would be more like $325 / $1,175, or 27.7%.
So, is owning a rental property worth it to you for a $325 cash flow increase every month?
Mac Gardner, a Florida-based certified financial planner, uses a single question to cut through the allure of being a homeowner and get down to his clients’ deeper motivations: Do you want to own that dirt?
By this he means, do you actually want to own a physical house and land, or simply use other vehicles like REITs to benefit from additional cash flow?
“The other path is you can purchase REITs, which are fairly liquid and act a lot like real estate from a long-term growth perspective,” Gardner says.
However, if owning a second property—so that you can use it one day, or perhaps pass it down to your kids—is important to you, then the potential surprises and ongoing costs of homeownership are likely going to be worth it. Not to mention, the long-term appreciation of an investment property can be worth more than the added cash flow, which can sometimes seem nominal compared to the level of responsibility and maintenance that’s required.
If all you’re looking for is higher cash flow, then REITs may be your best bet—most REITs pay dividends, so you're still getting passive income.
Investing in a rental property offers great potential for financial growth but the biggest challenge of owning a rental property is being a landlord. Getting those golden tenants isn’t always a sure thing. Sometimes your property sits unoccupied unless you’re on the ball with marketing it or paying for a property management company to fill it. You’ll also have to be ready to manage any potential issues that come from your tenants having personal issues, complaints, or concerns.
Fortunately, there are alternative ways to invest in real estate without the headaches associated with direct ownership. Let's explore some alternative hassle-free options if you're looking to enter the rental real estate market.
Real estate investing platforms, also known as real estate crowdfunding, allow you to join others in financing bigger commercial or residential deals. By investing capital into these online platforms, you get the opportunity to diversify your investments across multiple projects with relatively lower capital requirements. However, keep in mind that these investments tend to be less liquid and may come with management fees.
REITs are ideal if you seek portfolio exposure to real estate without directly owning properties. These trusts function similarly to stocks, as they trade on major exchanges. You'll receive dividends from the income generated by the properties owned and operated by the REIT. They offer the advantage of liquidity and allow you to invest in nonresidential real estate like office buildings or malls. However, REIT dividends come with tax implications.
REIGs offer a hands-off approach to owning rental real estate. In this setup, a company purchases or builds multiple rental properties, and investors can purchase units through the company, thereby becoming part of the investment group. The company handles tenants, maintenance, and vacancies, allowing you to earn income without the day-to-day management responsibilities. However, You want to be mindful of vacancy risks and potential fees associated with REIGs.
Investing in tokenized real estate involves leveraging blockchain technology to gain fractional ownership of specific properties. Tokenized real estate platforms enable you to easily diversify your holdings and benefit from the efficiency, transparency, and security of the blockchain.
Tokenization combines traditional real estate investing with blockchain technology, providing increased liquidity, diversification opportunities, accessibility for a broader audience, and transparent and efficient processes. You can easily buy or sell your real estate tokens on secondary markets, allowing for flexibility in accessing your funds. You can also diversify across different properties and regions, ultimately mitigating risk. Blockchain ensures transparency and expedites transactions, reducing administrative costs.
But tokenized real estate has potential downsides such as market volatility, limited regulation, reduced control over decision-making, and potentially less extensive property-specific details. That's why you should research, choose regulated platforms, and consider risk tolerance before entering this evolving market.
Real estate investments can be a dream for many, but it's vital to estimate the ROI before committing. Consider factors such as rental property investments, annual rental income, property taxes, mortgage payments, and the purchase price. Calculate the ROI for rental property by factoring in operating expenses, property management fees, and any potential tax benefits.
Real estate investors also want to factor in closing costs, cash on cash return, market value, mortgage value, monthly rent, and the potential to generate passive income. Consider repair and maintenance costs, as they can impact the ROI on a rental property. Additionally, calculate the potential increase in rental income to evaluate the property's ROI.
For a comprehensive analysis, take into account annual operating expenses, such as property taxes and insurance. Whether paying cash or using financing options, consider the investment cost and the total initial investment.
Aim to build a real estate portfolio with properties that generate income and offer potential for appreciation. Utilize financial tools such as calculators to assist in calculating ROI, cash flow, net income, and the capitalization rate (Cap Rate = (Net Operating Income / Mortgage Price) × 100%) for rental properties.
Furthermore, explore the advantages of investing in real estate, such as the tax benefits and the ability to sell properties for potential profits. Consider both cash transactions and financed transactions, and evaluate the annual operating costs associated with owning a rental property.
Should you decide to invest in real estate, weigh the benefits of paying cash versus financing, and consider the potential return on rental properties? Strive to calculate net income and determine the initial investment required. Whether it's your first investment property or a part of your real estate portfolio, understanding ROI is crucial.
Remember to conduct thorough research, utilize financial calculators, and evaluate all relevant factors before making any investment decisions. With a blend of financial knowledge and careful consideration, you can make real estate work for you.
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