What You Should Know Before Investing In Rental Properties

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If you have ever thought about generating a stream of passive income, then investing in rental properties could be a good idea. Purchasing a rental property and then renting it out to tenants can provide a stable source of income. 

But like any other investment opportunity, there are some risks involved in investing in rental properties, especially if you are a beginner investor. Therefore, you should know the risks you are facings before investing in rental properties, especially if you are a beginner investor. If you are wondering what you should know before investing in rental properties, then this article has got you covered.

Your current financial situation

Investing in a rental property is a long-term commitment. If you are not well prepared for this type of long-term commitment, your finances can take a hit. So, before investing in a rental property, you should assess your current financial situation to see if it is a good time to buy an investment property. 

Does the rental property you will buy need any repairs before it is rentable? Before investing in a rental property, make sure that you have enough money to cover expenses for a new roof, water-heater, or HVAC system. There are also expenses associated with ongoing maintenance that come with a rental property. 

Can you cover the costs of the mortgage until you are able to rent it? Make sure you are able to cover the costs of the mortgage if your property remains empty for a period of time.

To secure financing with favorable terms, you need to have a decent credit history and credit score. Review your credit report and ask yourself if there are any improvements to be made? Do you have the means to cover the down payment or will need to secure financing for this as well? 

These are a few of the initial questions to ask yourself. Now let’s look at the other things to consider when investing in real estate.

How will you manage your rental property?

While investing in a rental property can be a great passive income stream, being a rental property owner involves dealing with tenants, potential renters, property managers and service providers like plumbers, electricians and locksmiths. 

If you do not think you have the time or energy to handle it on your own, you can rent your property out through a property management service or hire a property manager. A property manager has the experience to manage rental properties and can help find high-quality renters.

Income potential of the rental property you will buy

Before you buy a rental property, you should know the expected income from that rental property. This is known as the cap rate, aka the ROI (return on investment) or cash-on-cash return, of a property. This is calculated by dividing the Net Operating Income (NOI) by the Purchase Price. The lower the cap rate, the more expensive (i.e. less return) the property will be for you.

The cash on cash return on a property will help you determine the property’s profitability. To calculate the annual NOI, subtract the operating expenses from the gross income. Then divide the net operating income by the rental property purchase price to get the cash-on-cash return aka the cap rate. Generally speaking, a healthy cap rate falls between 4%-12%

If you want to determine whether the rental property you will buy has positive monthly cash flow, i.e. ROI, then simply subtract the monthly operating expenses and monthly mortgage payment from the monthly net income. If your operating expenses and monthly mortgage payment are less than your monthly net operating income, then you have a positive cash flow. 

For example, if you buy a rental property for $100,000 and the average rent for that type of property is $1,000 per month, then your gross income from that property will be $12,000 per year, which means the property roughly generates a cap rate of 12% of the rental property price. Keep in mind this is without factoring in the expenses, so the cap rate would be less than 12%. For the sake of this simple example, a 12% cap rate means that this property could be a great investment.

Keep in mind, that there are a lot of factors that play into whether or not a rental property is worth the investment. The cap rate is influenced by geographical location, whether or not improvements need to be made, and more.

Benefits of owning a rental property

One of the most important benefits of investing in a rental property is the monthly rental income from your rental property. It can be a great source of recurring revenue. This is passive income, as you do not have to work actively to earn the money. You can also take advantage of tax deductions on rental property operating expenses.

You can also benefit from your rental investment property in the long term. Your property may increase in value over time and you could make a sizeable profit from it again when you sell it at a gain.

You can diversify your retirement portfolio by buying a rental property. A rental property can act as a hedge against ups and downs in the stock market. 

The risks of owning a rental property

Before investing in a rental property, you should know that owning a rental property also comes with risks. Here are some of the potential risks:

  • Your property may remain empty in the event of a lapse between renters

  • You could incur legal expenses if you need to evict a bad tenant

  • You could incur excess repair costs should a bad tenant cause damage to your property

  • You may spend more money than you make if you have to pay a lot of interest payments on your mortgage

  • Your property may decline in value due to downturns in the real estate market

If you work with a real estate agent, he or she can advise you on how to choose the best rental property based on your budget and preferences and get the best possible price for the property. Once you have purchased the rental property, working with an experienced property manager can help reduce risks, as they have the experience to effectively manage rental properties and find high-quality renters.

What kind of property do you want?

Before investing in a rental property, think about the kind of property you want to invest in. First-time rental property investors usually invest in duplexes or single-family homes.

The type of property you will buy should depend highly on your budget, location, and what type of tenant you are looking for. If you can finance the property, you can invest in an expensive rental property in a nice neighborhood to rent it out to families. 

You should choose to invest in a rental property that is suitable for the type of tenant you are looking for. There are so many options-single family homes, apartments, condos, etc.- so it is best to know the type of tenant you wish to market your property to. If your ideal tenants are students, for example, then small homes or apartments that are already furnished may be your investment property of choice.

Location

If you want to attract high-quality potential renters, location is key. Look for houses in an area or neighborhood close to quality schools, hospitals, businesses, shopping areas, retail, public transportation, etc. that will be more attractive to potential tenants.

Look for houses in a neighborhood where demand for housing is strong and where people want to live. The best location for your rental property will depend on the type of renters you plan on renting it to. Choosing the right location for the rental property you will buy will ensure that you always have tenants.

How is your local rental/job market?

Before buying a rental property, consider things like demand for housing, job market and property values in the surrounding area. The number of rental properties for sale in an area can impact the price you will pay.

A growing job market will likely result in rising rental income, as there will likely be more demand for housing. Investing in a rental property in a growing area with major improvement projects planned could be a good idea, as the location will more likely attract a lot of potential renters.

In conclusion

Investing in a rental property is a great way to generate income. But before investing in rental properties, you should know the expected income, the expenses, the return, the risks, etc. that come with a rental property so that you can make the most of your investment. 

Disclaimer: the content presented in this article is for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.