This is the first in a ten-part series about residential rental properties based on my experiences.
Looking to diversify your investments and take advantage of the current dip in real estate prices? While by no means a passive investment, if you’re up to the challenge, residential rental property ownership can provide not just additional short- and long-term income, but tax benefits as well. While I’m no tax expert, dummies.com has a nice little overview in their article, Enjoying Rental Property Tax Breaks.
But the trick’s in the buying. An error at this critical stage is one you’ll pay for again and again over the life of the property, so it’s important to be a well-informed and cautious buyer, taking the time to do the necessary research.
My own experience with six rental properties has taught me a few things worth sharing. My first tip follows:
1. Buy at the right price.
While this may seem obvious, there’s more to this topic than meets the eye. A bargain now will help you to better withstand fluctuations in property value over time so you can profit if and when you eventually sell. Whether working with a realtor or solo, you need to develop a deep understanding of what constitutes a “value” price in the neighborhood(s) you’re looking at. As an investor, you can keep making low-ball offers and wait for the deal you want, but great bargains generally get snapped up, so you need to be able to act quickly once your target’s in sight. Obtain pre-approval if you’re hoping to mortgage the property, and know your expected interest rate and monthly payment, since that’s part of your profit equation.
You also need to benchmark rental prices for comparable units in the area, getting a feel for demand. The local classifieds are a great starting point for this, and a few hours of research should give you a good basis for determining what you can charge. Just make sure to factor in for utilities (electric, gas, oil, water, sewer, cable, etc.) if they’re included.
Depending on your personal goals, there may not be enough of a spread between what you will pay out monthly in mortgage, taxes, and utilities and what you can charge. Figure out what your spread needs to be, and analyze every house you consider against this amount. My rule of thumb, since I’m looking to make a yearly profit without much additional out-of-pocket investment beyond the down payment, is that there needs to be at least a $500 difference per month between income and costs.
This doesn’t mean that if I take in $1,500 in rent monthly and pay out $1,000 monthly in costs, I’m making $6,000 a year in pre-tax profit. Things like licensing, repairs, maintenance, advertising, court costs and even months of lost rent may need to be covered out of this money. It is unwise to assume that your unit will be consistently rented all year, so make sure you can cover the mortgage and expenses even with a few months of vacancy. For me, $500 a month is the minimum spread acceptable, as it means I can absorb a reasonable number of additional expenses per year and still at least break even. Of course, a bigger spread is preferable, as it means more profit. If you’ve got a few good options to consider, the spread can aid in your decision-making.
Updated July 14, 2010 and originally published August 23, 2007.