Renting out your property is a great opportunity to build wealth and passive income – when it's done wisely (for more side hustle and passive income ideas, check out these Top 25 Personal Finance Bloggers to Follow on Twitter).
Investment property and renting isn't for everyone, and there are a lot of things to consider before getting your feet wet. If you're thinking of becoming a landlord, here's what you need to know.
Buy Where People Want To Live
When you're shopping for a property, you might be dazzled by all the possibilities. But no matter how attractive they seem, remember that many won't suit renters' needs. A property might fit your finances, but there's no point in buying it if it's in a terrible location.
Buying a property in a neglected neighborhood so you can save a bit of money won't attract long-term, quality tenants. Look a little further than the price tag. Is the property close to public transportation, major roads, schools, shopping districts, and other amenities? These things might not matter all that much to you as a landlord, but you can bet they'll matter to your tenants.
Research the Rental Market
Research the rents in the area to get a sense of how much you can earn from your investment. Find out what others charge for a similar property. If you price your rent too high, your property will either sit empty or you will need to lower the rent. And if lowering the rent means losing money, your property won't seem like such a good investment anymore.
Figure out who rents in the area, too. Are the units being rented mostly to students, families, or single professionals? Their needs will vary and your property won't appeal to everyone.
Students, for instance, usually want quick access to their campus, reasonable cost, and sometimes prefer a furnished place (if their last place was mom and dad's, they probably don't have furnishings of their own). They'll also tend to stay for shorter periods, but have fewer demands.
Single professionals may want a bedroom, storage locker, access to laundry facilities, and sometimes parking. They want comfort and privacy, but may not want fuss because they lead busy lives.
Families tend to want more, but they tend to stick around longer. Access to schools and shopping and space for their kids to play are high priorities, and they’re willing to pay more to get them. They may need on-site laundry, parking, and more storage, such as a garage or shed.
Income vs. Expenses
Estimating rental income and expenses is critical. This is the one calculation that will determine whether you're putting money into a profitable investment, or a pit that loses money every month.
Buying a rental property in the hopes that you’ll recoup your investment through appreciation is not a sound strategy. It should create a positive cash flow and a good rate of return. A good rule of thumb is that residential real estate should provide between 8 and 15 percent return on your investment.
The monthly expenses you have to plan for will include your mortgage, taxes, insurance, utilities, maintenance costs, administration, and property management fees (learn more about Choosing the Right Kind of Mortgage). Rental properties also have several other potential expenses such as income loss due to vacancies, evictions, and tenant turnovers. Most landlords estimate that they lose at least a month's rent each year if their rental is in a seasonal location.
You’ll also need to either have money set aside in case tenants fail to pay their rent, or buy insurance to cover the loss of income.
Don’t forget you will incur many expenses during the buying process, too. Consider realtor and legal fees as well as taxes, mortgage insurance, and interest.
Generally, an appropriate rental amount is between 1.2 and 1.4 times the monthly expenses, with extra room for the unexpected.
Even if you dream of becoming a rental magnate managing many apartment buildings, start small. Learn the ropes and what it takes to manage your property well. Buy a single-family dwelling, condo, or duplex before you consider a large, multi-unit property (if you're thinking of starting with your own property, see What You Need to Know About Your Insurance Before Renting Your Place Out on Airbnb).
Remember, if things don’t work out as planned, you’ll need to cover the mortgage and maintain the property in the meantime. And that's no easy feat if you have too much on your plate.
Maintenance and Improvements
Many people get into the rental business with dreams of making a killing by flipping properties. They'll buy a dirt cheap fixer upper and work on it until it can fetch luxury rent prices. But unless you're an experienced contractor who understands what's involved in renovations, don't buy a property that needs significant repairs. Home improvement shows make the upgrades look so easy, but in reality it often turns into a nightmare (for related reading, see Home Renovations: When Do They Make a Difference for Your Insurance?).
Ongoing maintenance is a necessity, but avoid over-improving the property. It cuts into your cash flow, with no guarantee you’ll ever recover your investment.
Condominiums and townhouses often include maintenance in their fees, but you’re responsible for almost everything when you buy a single-family dwelling, unless you stipulate otherwise in your rental agreement. For instance, you could require tenants to cut the lawn and shovel snow, instead of paying a service.
Self-Managed or Property Manager?
It takes time, patience, and fortitude to find tenants, collect rents, follow state and municipal laws and tax requirements, and deal with problems as they come up.
Screening tenants well can minimize vacancies, evictions, abandonments, missed rent payments, and damages, but they can still happen. If you do not have the temperament or skills to deal with tenants and building demands, you may want to hire a property management company.
Property managers can handle advertising, screen potential renters, prepare proper legal forms, arrange repairs, and handle difficult tenants. You can deduct their fee as an expense, but choose wisely.
Ask professionals such as your real estate agent, lawyer, or other property owners for a referral and compare the company’s services and fees to their competitors. Check their rating with the Better Business Bureau and their current work. Are they professional and do they manage their properties well?
Most states require a property management license. Additionally, the company should have a certification through a recognized trade organization such as the National Association of Residential Property Managers (NARPM) or the Institute of Real Estate Management (IREM).
If you live on the property and want to rent out a portion of it, you may be able to add an endorsement to your homeowner’s policy. When you live elsewhere, you’ll need a separate insurance policy.
Landlord insurance does cost more than a homeowner’s policy, but it is a deductible expense and a priority to ensure your financial protection.
Dwelling policies fall into three major categories, but insurers also offer additional coverage.
- DP-1: Basic Coverage – Covers risks such as fire and vandalism. It usually reimburses you for the cash value (value less depreciation) of the loss, not replacement value.
- DP-2: Broad Coverage – Includes risks such as wind, hail, fire, vandalism, and sometimes collision.
- DP-3: Open Peril – Covers everything, except for specific exclusions. It usually reimburses you for the replacement value of the loss.
- Protective Policies – Covers boiler and furnace breakdowns
- Loss of Rental Income – Coverage for loss of income caused by a vacancy or repair
- Additional Liability – Increased protection from costs associated with lawsuits arising from an accident or injury on your property
- Under Construction – Coverage to protect the structure until occupancy
- Building Codes – Coverage if you’re legally required to make changes so your property meets city or county codes
Many tenants believe the landlord’s policy protects their personal belongings. It doesn’t. Landlords should require tenants to buy renters’ insurance as part of their rental agreement so they’re well-informed and well-protected (for helpful talking points, see 6 Reasons You Need Renter's Insurance).
Buying and renting property can be an excellent way to earn income and increase your net worth. Proper insurance coverage ensures you and your property remain protected while building wealth and your future.