Question: When is it a good idea to buy a house to rent out to others (using them to pay off the mortgage) as an investment?
Real estate has historically been a good investment. This is because it can provide cash flow (in the case of rental income property) and appreciation. While some will correctly point out that homes after 2008 declined in value (some by a great deal), most areas have recovered and have returned to pre-crash values.
To your question: before investing in rental properties, you should have an excellent idea of what your expectations are. This includes the cash flow (which could be negative at times). Here is how you might go about doing that analysis.
First, get a good idea of what the market rents are in your area. There are many ways to do this online, and the appraisal that any lender will require will include a rent survey. Use the market rents as your income. You should adjust your gross income by a factor of at least 75% for vacancy and collection losses—yes, some tenants do not pay their rent and have to be evicted. This is an expensive proposition. It happens rarely, but it does happen. Allow for repairs and maintenance. 65% to 75% of the rents projected by the appraiser is the maximum a lender will want to use as qualifying income.
Even though the house may be in excellent condition now, repairs are inevitable. Your projections should allow for this. It is also a good idea to allow for replacements. How much remaining life is there on the roof, for example. You should expect to make a larger down payment for a rental than you would on an owner occupied loan. And, the lender may also require that you have 6 months’ reserves available, but this varies by borrower. Having cash reserves is a good idea in any case.
Interest rates for investment properties are higher than a primary residence. Calculate your principal and interest payments using a spreadsheet or any of the many online calculators available. Find out what the tax rate is in your area, and estimate your hazard insurance premium. Add these monthly figures into your monthly payment. Or you can just call me, and I’ll give you an accurate rate and payment quote.
Subtract from the gross income on the property from all those negative numbers: vacancy, repairs and maintenance, replacement reserve and monthly mortgage payment, including taxes and insurance. The result will be your cash flow. If the number is positive, great. If it’s negative, that means that you’ll have to “feed the alligator” each month to make up the deficit. If this is the case, you should ask yourself whether you have enough stable income to cover it OR if you have enough liquid assets to cover for a significant period.
The other factors you should take into account are these: Is your regular income secure and high enough to cover any monthly shortfalls? Do you have funds set aside for emergencies—both related to this property and to any personal events that might require cash to fix? Are you willing to hold this property for a significant time—say, five years or more? Will your work situation allow you to stay in the area? If your job transfers you, you may have to pay a property manager. The going rate for that is around 10% of the monthly rent.
If you're looking for a market valuation and honest assessment of how you can succeed in the rental real estate market, call us at 760-385-8660.