You’ve come across a can’t-miss opportunity to own a distressed property. You think this is a great opportunity to turn it into a rental unit to take advantage of having someone else pay your mortgage. Before you dive into a very large purchase, let’s take a look at the pros and cons of your investment.
Expenses you will incur:
Mortgage – Unless you are paying cash, you will have a mortgage on the property. If it is purchased as an investment property, you will pay a higher interest rate on your loan. Since it is a second property, the bank believes that your default rate is higher and therefore increases the interest rate.
Mortgage Part 2 – If you go a month without renting your property, you will pay your usual expenses in addition to the mortgage on your investment property. Are you adequately financed if your property is not rented for 6 months?
Property Taxes: Depending on where your property is located, your property can range from 50-2% of the properties appraised value.
Insurance: It is essential to be properly insured. In many cases, you can purchase an umbrella policy from your local insurance agent. In addition to standard fire, flood, and earthquake insurance (if required), you must be insured against accidental death and slip and falls associated with your rental property. You may want to join an S corporation or LLC before purchasing your rental unit. This will protect against any catastrophic event related to your property.
Management Company Fees: Are you hiring a management company? Typically, this can cost anywhere from a hundred to several hundred dollars per month.
Legal Fees: Fees associated with drafting leases, as well as evicting a tenant who may be behind on rent.
Advertising Fees: You will most likely have to advertise your rental property in the newspaper to rent it out. Other options include advertising online, as well as using the services of a rental broker.
Repairs: Home repairs are unheard of and can put a big wrench in your cash flow. In addition to the usual updating and painting, there are other repairs such as a broken pipe, broken house fixtures, changing locks, etc. that will be done during your ownership.
Utilities: Depending on your lease, you may be responsible for paying for water, gas, or electricity.
Travel Expenses: Travel expenses can be significant if your property is a long way from home. It is generally recommended that a rental property be within 45 minutes to an hour away. While these expenses are usually tax deductible, you don’t want to spend all of your free time traveling to and from your rental property.
Cleaning and repairs caused by tenants: If you have tenants who are moving, you may need a cleaning company to ensure that your property meets standards. You may also have repairs due to noisy or bad tenants.
Closing costs: When you buy your property, there will be closing costs. Closing costs will vary from lender to lender.
Opportunity Cost – Your Down Payment – In addition to all of the above expenses, you’ll need to address the “opportunity cost” of your down payment. For example, you bought a property for $300,000 and paid $60,000 (20% to avoid private mortgage insurance), that’s money you can’t use for another investment. A conservative way to calculate your opportunity cost is to peg your opportunity cost to a 30-year Treasury bond. If a bond is paying 5%, its annual opportunity cost is $3,000 ($60,000 x 5%). This should be added to your maintenance costs, as this is a guaranteed return on capital. If you think you have other warranted opportunities, you should consider it and add it to your total annual operating budget.
Income and Benefits: Obviously, you will have income from your rental to offset your mortgage and expenses. To gauge the rental market, check out popular sites like rent.com or craigslist.org. There you can search for comparable units and can correctly set your rental price. You’ll also want to drive through the streets around the neighborhood to get a better view of your competition.
Tax benefits: Interest paid on your mortgage is tax deductible.
Depreciation: Each year you have the opportunity to write off the value of the building you have purchased. You can capture depreciation each year, even if your property increases in value. However, there is a caveat. Every dollar you claim reduces the base cost of your property. This will increase your tax liability when you separate to sell. In effect, you are delaying taxes. Always be sure to consult an accountant about current depreciation laws.
Appreciation – While it is impossible to predict whether real estate will appreciate in the short term, historically you can expect a 3%-5% annual return. If a property is held long-term (10 years or more), a major metropolitan area has never seen a negative return over a full 10-year period. This is where things get fun. If you average 3% in a $100,000 home, you’ve earned $3,000. Remember, that $3,000 paper win is based on you only depositing 20% ($20,000). This represents a 15% return on investment. This paper profit can accumulate over time, generating good returns once the property is sold.
Losses and expenses: You will have the opportunity to deduct the losses generated by your property. You can also write off travel expenses to the property, repairs and additions you make to the property.
Owning is not for everyone. There are sympathizers and personalities to contend with. You may have someone cause the destruction of your property. You may have to evict a tenant if he doesn’t pay rent. If you are going to become a landlord, it is imperative that you know the landlord/tenant laws in your state. Each state has its own set of laws and regulations.
That said, many rental unit owners have made fortunes. There are many factors to consider before buying. Going beyond the numbers, you’ll need to determine if you have the temperament and time to own.