Real estate ownership is one of the most reliable ways for most Americans to generate wealth. Whether you’re a middle-class homeowner watching your home price appreciate year after year or a wealthy landlord with a portfolio of properties, buying an investment property offers leveraged growth.
In fact, most homeowners never consider that home ownership is one of the few places in the financial landscape where the average investor can invest like a big institution. If you think of a home as an investment, you’re putting 20% down and borrowing at around 3% in a housing market where prices are growing far beyond that rate. In that scenario, your home purchase is a 5-1 leveraged investment where you’re paying rock-bottom rates.
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Now, your home is not a liquid investment, the sale process is costly and time consuming, and selling your home would leave you with nowhere to go. But you can achieve similar leverage buying an investment property. If you’re financing a second property, expect to find borrowing rates higher than for an owner-occupied primary residence. Also, you should expect to put down a larger down payment, generally at least 25% of the value of the property.
When you’re buying an investment property you first need to determine whether you’re buying as a real estate speculator or as a prospective landlord.
Buying an Investment Property as a Speculator
If you’re speculating on real estate, your concerns will be rapid appreciation and the ability to easily resell the property. If you’re a novice real estate investor, you’re better off avoiding fixer-upper properties that require extensive repairs. Unless you’re experienced in construction or are working with someone with construction or inspection experience, the risk of surprise expenses can be too great.
Instead, you’re better off targeting a home in better condition that may require only aesthetic improvements like fresh paint, new carpet or an interior refresh. Buying a property that’s in your area can be easier as you’ll be able to supervise upgrades and potentially work with tradespeople you know and trust.
If you are looking at buying an investment property out of state, bankrate.com offers a Housing Heat Index which can help identify markets that are seeing an influx of buyers. A hot buying market may make it harder to acquire that first property, but it makes it much easier to sell.
Buying an Investment Property as a Landlord
Buying an investment property with the intention of renting it out makes a lot of financial sense for investors. Ideally, you’ll buy and improve the property, and rent it out at a rate that exceeds your mortgage obligations.
One feature that makes this more attractive is the affordability. Once you’ve built up enough for the down payment, incoming rent could cover your payments for the life of the mortgage. When you’re buying a rental the first question to ask yourself is whether you’re prepared to be a landlord. That means handling requests for repairs from tenants, dealing with rent collection and potentially even with eviction. Not to mention the maintenance that will be required between tenants.
If you’re not interested in becoming a landlord, you can still invest in rental properties if you’re willing to pay a management company to handle those issues. You can typically expect to pay upwards of 10% of the rent to the management company in addition to the other operating costs like property taxes and insurance.
If you’re buying an investment property to rent out, you’ll want to consider buying in an area that has a healthy population of renters. Targeting a university, or an area undergoing gentrification that will attract a younger cohort of the population can be a great strategy here.
In addition to year-round rental properties, some investors target vacation homes with the plan of using the homes themselves during part of the year and renting it out via services like VRBO or AirBnB. If you choose to go this route, keep in mind that you’ll generate highest rents during the area’s peak season (which is probably the time you’d want to be there yourself!) and rent is less stable for vacation properties (which means there’s a higher risk that vacancies mean you’ll have to cover expenses out of pocket).
Ideally, you’ll want to be able to cover all costs associated with the vacation rental with other income and to not be reliant on the rental income at all.
Buying an investment property can be an excellent path to wealth, as long as you’re realistic about your plans and the responsibilities that come with it.