We talked to experienced real estate agents about how to invest in rental property, including the type of property, expenses, and the pros and cons. —-
DISCLAIMER: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to an advisor regarding your own situation.
Have you ever dreamed of owning multiple properties and enjoying a steady stream of income as a landlord? For many homeowners, once they buy their first house, it’s not uncommon to think about continuing to invest in real estate, creating a portfolio of properties that generate an ongoing passive income.
But let’s face it: Investing in rental property is a lot easier said than done. How do you know if it’s really for you, and what do you need to do to prepare yourself for this big financial step?
We researched some of the most popular ways to invest in rental property and spoke to experienced real estate agents about what type of property to buy, expenses you might not know about, and both the positives and negatives of being a landlord.
While these kinds of investments can be high-risk, especially if you don’t know what you’re doing, a qualified real estate professional will help you understand the rental market and show you how to get the best return on your investment.
First: Make a plan
Real estate agent Kim Alden, who is based out of Illinois and has more than 16 years of experience in the industry, often works with people looking to buy homes as a rental investment.
“The first thing buyers need to think about is what kind of property they want,” she says.”There are single-family homes, townhouses, condos, or multi-family dwellings, like duplexes. With that, they also want to consider issues such as maintenance, whether or not the property has a homeowner’s association (HOA) and the regulations and fees associated with it.”
Some buyers want a property that is nearby so they can keep an eye on it, while others might like the idea of a vacation home that they can rent out periodically. It really all depends on what will work for you, and there are lots of options!
1. Build an ADU and rent it out
Otherwise known as a granny pod, guest house, or casita, an ADU (accessory dwelling unit) is a small, separate housing unit that people build on their properties.
If you have a large lot, or you own plenty of acreage, this might be a way to create a rental income for yourself. And while it can be a great option for some homeowners, be aware that building an ADU is not without pitfalls.
First, you’ll need to check your local zoning laws. In some regions, you can build a guest house, but short-term rentals (like the vacation rentals on Airbnb) aren’t allowed. Because regulations are different in each state, it’s important to verify that you’re allowed to build an ADU and use it as a rental before you start.
You’ll also want to make sure your homeowner’s insurance will cover short-term rentals and obtain additional coverage if needed.
Cost and return
Costs to build an ADU vary, depending on the size of structure you want, what materials you’ll be using, and who is doing the building, but you can anticipate spending anywhere from $40,000 to upwards of $125,000.
The good news is, you’re likely to get a fairly significant return on your investment with rental income. While data collected by apartmentguide.com shows that rental rates have declined slightly in the last year, Rent.com cites the national average for renting a 1-bedroom apartment as still being more than $1,500 per month.
If you decide to go with short-term rentals, such as Airbnb, keep in mind that it can take time to start getting regular bookings, and the income might be more sporadic if you only get seasonal visitors. Do some research on vacation rental rates in your area (check both weekday and weekend rates) to see whether this investment path makes financial sense for you.
2. Move into a new house and rent your current home
If you’ve lived in your home for years, purchasing a second home and renting out the first could be a viable option. You get the mortgage benefits of purchasing a home that will be owner-occupied, such as lower interest rates and less strict down payment requirements.
The downside of this investment option is that you won’t be able to use the equity from the sale of your current home toward the purchase of the new one. And even if you have a renter lined up, your lender is most likely going to want you to have enough income to carry both mortgages, as well as a substantial emergency fund.
All too often, rental properties can have issues with maintenance, renters not paying on time, or sitting empty for months in between tenants. Your lender wants to know you can manage these potential problems and that you have the income to do so.
Cost and return
Costs will include the down payment on the new house, which can range from 3.5% to 20% of the purchase price, along with the usual fees and closing costs that go along with a home purchase.
If your current home is paid off or has a very low mortgage payment, you can probably generate a positive monthly cash flow when you rent it out, but you’ll also have two homes to maintain, and that can get expensive. You will, however, be building equity in both properties, which can have a healthy return when the time comes to sell.
3. Consider multi-family properties
Many savvy home buyers go with a multi-family housing option, purchasing a duplex or a multi-unit building and living in one of the units themselves. This gives you the benefit of buying as an owner-occupant, which can mean lower down payment requirements and better interest rates, while still bringing in a monthly cash flow that covers your mortgage payment.
Alden says that while multi-family properties can be a good investment, there can also be complications. “A lot depends on how much rent you’re able to charge in the current market,” she says. “And you should probably have at least a year’s worth of rents set aside.”
She adds that having a healthy reserve to cover rents and emergencies is important because rental income isn’t always stable, and as we learned with the coronavirus pandemic, events beyond your control can push rent prices down, or up, or undermine the labor market altogether.
Cost and return
Purchase prices on multi-family properties are almost always higher than a single-family home, unless you’re talking about a luxury home. However, you also might be able to live rent-free if you owner-occupy one of the units and can charge enough rent to cover the mortgage, and depending on your lender, that rental income can help you qualify for a larger loan amount.
Keeping a large amount of cash reserves is imperative when you own a multiplex, as unexpected repairs can crop up quickly. According to information collected by SFGate Homeguides, a landlord should anticipate setting aside 1% of the value of the property per year for maintenance. So if you purchase a property valued at $250,000, plan to potentially spend about $2,500 a year on maintenance and repairs.
4. Buy a second home and rent it out
Maybe you’re thinking about owning a second home somewhere, one that you might retire to one day or just keep as a vacation spot, using it as a rental property in the interim. Or you want to be a landlord, but you really love the house you’re in and don’t want to move.
If you decide to invest in a rental property by purchasing a second home, you have some flexibility in the ways you choose to rent it.
You can go with a more traditional, long-term rental with tenants that sign a lease, or you can do the short-term, vacation rental model, with different rentals on a daily or weekly basis.
A long-term rental is great for a steady flow of income, but that also means you probably won’t really get to use that second home yourself. Short-term rentals give you the opportunity to pick and choose when you want to make the property available, but that kind of high turnover can mean a lot of wear and tear, not to mention needing to get the place professionally cleaned between each guest.
If you purchase a second home that isn’t near your current home, you may need to also hire a property manager to make sure everything runs smoothly and to complete any repairs or maintenance in a timely manner, which can add to the monthly expenses.
Cost and return
While you’ll have to come up with a larger down payment with a non-owner-occupied property, that down payment means a lower monthly payment and no mortgage insurance, so it’s likely your rental income will generate at least a small positive cash flow.
5. Rent to own
If you own a home and want to move, but aren’t quite ready to sell, you could consider a “lease to own” option for qualified renters. This can be a way to maintain your existing mortgage while also collecting a little additional income, but you’ll want to make sure that you cover all your bases if you decide to enter into this kind of agreement.
According to Alden, rent-to-own situations can be tricky. “People want to determine a purchase price, but it can be hard to estimate what a house will be worth in a year or two,” she says.
Alden also recommends that you have rent-to-own tenants put down a deposit or earnest money to secure the property, and if the tenants are doing a rent-to-own because of something like a low credit score, it may take several months for their score to improve enough to qualify to buy.
Other considerations include making sure you agree on who is responsible for repairs or maintenance during the term of the lease, how much the monthly rent payment will contribute toward the down payment on the house, and whether or not either party can terminate the agreement at some point.
Cost and return
Entering into these agreements can be risky. Making sure the tenant is qualified to purchase the home when the time comes and that they will be able to cover the down payment and closing costs is important, as well as establishing a purchase price that won’t be too low or too high in a year or two.
The benefit of a rent-to-own is you’ll be able to keep building equity in your home until such time as the renters are able to close on the purchase. While home appreciation varies greatly between states, the average is about 3.8% per year, according to data collected by analytics provider Black Knight. If you aren’t sure how much your own house might appreciate, you can make use of the Federal Housing Finance Agency’s HPI calculator to get an idea.
6. Become a silent partner
If you have money to invest in rental properties but don’t want the responsibility of being a landlord, you could look into becoming a silent partner with a friend or family member.
Being a silent partner has its perks, as you’re able to avoid the day-to-day issues that often come with being a landlord. You will, however, want to make sure you trust the person you partner with, and have legal documents drawn up by the bank or your attorney to protect your investment.
Cost and return
Unless you’re able to rent the property out for much more than the mortgage payment, you’re unlikely to see much of a monthly income from it. But you can potentially net a large return on your investment over time as equity accrues, especially if you’re purchasing a property that is expected to appreciate quickly.
Your return can also depend on how long you maintain your investment in the property. Motley Fool’s Millionacres real estate site suggests holding onto investment properties for at least five years, and cites the average yearly return, depending on property value and rents, at 7% to 8%.
Investing in rental property might sound like an easy way to increase your cash flow, but being a landlord is a big responsibility.
“You need to think about things like maintenance, credit checks, if you’re going to allow pets, and security deposits,” says Alden. “And according to the Fair Housing Act, landlords must treat all tenants equally, and be consistent in their dealings.”
Alden also suggests that landlords require any long-term tenants to carry renter’s insurance, which protects both tenants and owners.
Most importantly, you’ll want to make sure you partner up with a real estate agent who can guide you in the right direction. Becoming a landlord can be both fun and profitable, as long as you find an investment that works for you, and understand all the ins and outs.
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