Investing in real estate is raising its visibility in the investment world. You likely know someone starting to flip houses or fix up vacation homes for Airbnb, and maybe you’re getting the itch to begin the journey as well.
While real estate can be a vehicle to generate income, there are also many risks and challenges involved in an investment property. Before you get serious about this adventure, you’ll want to understand the advantages and disadvantages, your overall investment goals, and more. As a long-time real estate investor, I can tell you that it is not for everyone! Here are a few things to consider before making the leap.
Define Your Investment Goals
Before you embark on any investment journey, it’s helpful to begin by defining your investment goals. First, ask yourself the question, “Why do I want to purchase an investment property?”
- Do I need the additional income?
- Am I interested in a vacation home?
- Is the capital gains tax deferral attractive?
Buying an investment property is a big decision, so take time to consider your long-term financial and life goals.
Along with understanding your goals, consider evaluating your risk tolerance and capacity. Risk tolerance is the degree of risk you can withstand within your investments. If you’re nearing retirement, your risk tolerance will likely be lower, and you’ll proceed with less risky investments. Risk capacity measures the volatility and potential losses to determine how much risk you can take before it impacts your goals.
As you search for an investment property, only consider options that align with your goals. You don’t want to bite off more than you can chew.
Location, Location, Location
The location of a potential investment property is one of the most critical factors. You can have the most beautiful vacation home the world has ever seen, but if it’s in an area that doesn’t attract many visitors, it may not be as successful. A popular, well-sought-after location could potentially earn a better return on your investment.
As you search for the perfect neighborhood, consider looking for an area with plenty of amenities, including:
- Good schools
- Restaurants
- Shopping
- Medical centers
- Cafes
- Museums
- Entertainment
- Parks
- Public transportation
- Safety
Research the areas you’re interested in and assess the neighborhood’s desirability and growth potential. Investing in an up-and-coming area can be a more cost-effective investment with long-term success.
Property Type and Condition
Even if your heart is set on a condo, consider exploring different property types, including single-family homes and multi-unit buildings. A single-family home can often be more expensive up front than a condo, but if your goal is to attract larger rental parties or long-term stays, a home could be the better choice.
As you tour different properties, evaluate the condition of each and note any needed renovations. If you live nearby and enjoy maintenance work, a fixer-upper may be the right option. But if you don’t have the time or funds to undergo massive renovations, you may want to tour more move-in-ready buildings.
The age of a property can also impact potential returns. Older homes and buildings tend to require ongoing maintenance investments, but if it’s in the location you want and fits your financial goals, an older property may work for you.
Rental Income Potential
The rental income potential of an investment property is a significant factor to consider. Potential rental income is the total rental income for a property if it were 100% leased at competitive market rates.
A rental property calculator can provide a more accurate breakdown of rental income, property expenses, and return on investment. This tool considers vacancy rate, management fees, recurring operating expenses, and purchase price information to help determine rental income.
In a pinch, you can utilize the “one percent rule” as a starting point for calculating rental income. The one percent rule states that a property’s rental rate should be at least 1% of the total property value. For example, for a $150,000 property, rental income would be at least $1,500.
If the monthly rent does not exceed or meet the mortgage payments, it may not be an ideal investment opportunity.
Financing and Costs
Once you find the perfect property, the biggest challenge is yet to come: financing. Buying an investment property is an enormous financial responsibility, and you may not be able to pay for everything in cash up front. That’s why creating a comprehensive budget and cash flow analysis can assist in identifying what’s financially possible.
There are many different and creative ways to finance a rental property. You can choose the traditional route and contact your bank for approval for a home loan. Keep in mind that interest rates for investment properties are higher than traditional loans and often require a larger down payment. If that’s not an ideal option, you can consider tapping into your home equity, find other investment partners, or opt for a private mortgage.
Remember that the mortgage is only one part of the equation. You’ll also want to account for operating and maintenance costs, property taxes, and the average vacancy rate. It’s easy to focus on the price tag of a property, but the ongoing costs add up quickly.
Property Management
The money and funding is only one piece of the puzzle. A significant portion of your time and energy can also go into property management. Property managers are responsible for the day-to-day operations of the property. Duties include, but are not limited to:
- Screening tenants
- Repairs
- Maintenance
- Rent collection
- Marketing
- Communication with the tenants
- Move-out inspections
If you’re not residing in the same area as your investment property, managing it alone can be extremely difficult. There are property management services available, but you will need to account for those costs in your overall budget.
Plan an Exit Strategy
An exit strategy is a plan for how you will eventually sell your investment property, whether in 5 years or 15 years or beyond. An exit strategy is critical when evaluating a real estate investment because it gives you a timeline, manages the risks involved in real estate, and can help enable you to maximize profits to the fullest extent.
Your exit strategy should take several things into account, such as market conditions, tax implications, inflation, and strategies for property disposition (the gift or sale of property from one person to another). The most common exit strategies are:
- Buy and Hold: Buying a property and renting it out
- 1031 Exchange: Tax-deferred exchange of one investment property to another
- Flipping: Rehabbing a property and renting
- Wholesaling: Buying at a low price and selling to another investor
The best exit strategy for your investment property will depend on your goals and the type of real estate you invest in.
Risk Assessment and Due Diligence
Purchasing an investment property can be a great way to achieve your investment goals and build wealth, but it’s not without risks. The most noteworthy risks include:
- Decrease in rental interest
- Rising property taxes
- Changes in the local market economy
- Bad tenants that cause significant damage
- Expensive repairs and maintenance needs
All investments come with risks, but real estate can be particularly risky. You can mitigate these risks by doing your due diligence and choosing the right insurance coverage. Conduct a thorough property inspection and identify any potential issues or necessary repairs. Protect your investment with adequate insurance coverage, including property and liability insurance.
Don’t Go on This Journey Alone
Taking on an investment property can be a great way to diversify your real estate portfolio and reach your financial goals, but many risks are involved. To better understand the risks and rewards of this investment, seek advice from real estate agents, property managers, trusted financial advisors, and other professionals with knowledge about investment properties. This isn’t something you want to jump into without a clear understanding of the risks and requirements.
If you’re interested in learning more about evaluating investment properties for your portfolio, schedule a call with an Abacus advisor today.
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