During the housing bust, when home prices fell nearly everywhere, you could easily buy a home at a low-enough price and charge a high-enough rent to generate a few hundred dollars a month in cash flow. Now, although the rental market is strong, with low vacancy rates and rising rents, home prices have risen, too — by 31% nationally since the housing market bottomed in mid 2011, according to Clear Capital, a supplier of home-price data. Plus, the supply of single-family homes is slim in many cities. You can still find foreclosures, but their numbers have shrunk. That means you will probably have to look longer and harder to find the right rental property.
Jeff and Donna Zibley of Apple Valley, Minnesota, a suburb of Minneapolis, looked at about 20 properties before they found the right one. They started with duplexes downtown but soon gravitated toward neighborhoods closer to home. Finally, they decided on a nearby townhouse that seemed like a comfortable fit. The 20-year-old, two-bedroom, two-bath home had been meticulously maintained, plus it was located in a good school district and was close to public transportation. In the first year, the Zibleys’ return on investment (annual rent minus expenses divided by the cash they spent to buy) was 12%. In the second year, they hit 15%.
Find the right house
Start your search for a property by identifying an economically stable neighborhood where you can reasonably expect long-term price appreciation, recommends Robin Voreis, a real estate agent in Minneapolis who owns half a dozen residential investment properties with her husband, Aaron. Voreis, who advised the Zibleys, helps clients find homes to buy and rent out.
To ensure a large, consistent pool of tenants, Voreis buys in the entry-level price range, which is $300,000 or less in her market. She says that the bigger and more expensive the house, the harder it is to find tenants because at that level, people are more likely to buy their own home or want only a short-term rental. Plus, a cheaper property will sell more easily and quickly when she’s ready to let it go.
Single-family homes generally have the widest appeal. Condos, in addition to charging monthly homeowners association fees, may prohibit rentals within the first year of ownership and may limit the number of rentals to avoid a transient feeling, says Dawn Rae, an exclusive buyer’s agent in Tampa, Florida. It can also be harder to get a mortgage on a condo.
How much it costs to fix up a house is less important than what it will be worth afterward, says Voreis. For example, if she can buy a house for $100,000 that needs $25,000 worth of work but will be worth $150,000 afterward, that’s a better deal than a house that costs $140,000 and needs $10,000 of work but will be worth only $150,000 afterward.
For any property you’re seriously considering, it’s worth the $250 to $450 for a home inspection to find problems, as well as identify components and systems that work now but may need to be replaced in the near future. Before the Zibleys closed on their townhouse, they got a home inspection, which turned up a few things the seller fixed free.
Run the numbers
When you invest in a rental property, the goal is to make a profit using other people’s money. That means you put down as little of your own money as you can, borrow the rest and let the tenants pay the mortgage, says Voreis.
Being successful can mean different things to different investors. For some, it’s all about positive cash flow: If rent minus all expenses, including a management fee and a reserve fund for vacancies, yields a few hundred dollars a month, the transaction is a go. Other investors are content to break even every month and wait for the home to appreciate.
Cheap money will help boost the bottom line. The interest rate for a mortgage on an investment property is about one-half to three-fourths of a percentage point more than lenders charge for a mortgage on a primary residence or vacation home (recently averaging 3.7% for a 30-year fixed-rate loan). If you choose an adjustable-rate mortgage, the bar will be higher for your down payment and credit score.
You can get a conventional mortgage backed by Fannie Mae or Freddie Mac for an investment property with four or fewer units. For a property with one unit, Fannie and Freddie require a minimum down payment from your own funds (not a gift) of 15%. As a practical matter, however, lenders will require a minimum of 20% down because private mortgage insurance isn’t available for investment properties. The minimum down payment on a property with two to four units is 25%.
The biggest hurdle for most first-time investors is meeting the requirement for debt-to-income ratio, says Josh Moffitt, president of Silverton Mortgage, in Atlanta. Your total mortgage debt, including any outstanding debt on your own home, can’t exceed 36% to 45% of your gross income. If you can meet that requirement without including projected rental income, no problem. However, if you need rent to qualify but you lack experience as a landlord or the house has no history as a rental, then you must provide the lender with proof that you’ll receive the required income. If the home is already rented out, lenders can accept a signed, current lease agreement from the seller with no contingencies about the sale. If the home is not rented out, a market-rent analysis from an appraiser may suffice. Lenders include just 75% of gross rents to account for the cost of ongoing maintenance and losses due to vacancy. You must also prove that you have reserves equal to at least six months of mortgage payments.
The Zibleys ran the numbers using Voreis’s rental calculator—an Excel spreadsheet that looks ahead for 10 years. They paid $160,000 for the house and closed on the purchase in August 2014. They put down 20% and took out an adjustable-rate mortgage with a rate of 3.75% fixed for the first five years to minimize the payments and improve cash flow.
Buying a home with two to four units and living in one of them offers advantages, says Voreis. You’ll need just one mortgage, which helps to overcome the debt-to-income hurdle. As an owner-occupant, you can get an FHA mortgage, which requires a minimum down payment of just 3.5%. And because the home has multiple units, a vacancy poses less risk to your income. If you have enough equity in your current home, you could take out a home-equity line of credit and borrow from it to buy a property. The downside is that your own home is on the line as collateral.
Rent it out
After closing on their home purchase, the Zibleys researched rents for comparable properties on Craigslist and www.rentometer.com. The competition — properties of similar size and number of bedrooms — charged from $1,300 to $1,325. But the couple judged from photos that their property was nicer. They set their rent at $1,375, posted their ad with photographs and received four responses (the first call came within three hours). They asked the respondents to submit applications, and they ran background and credit checks using online tools. The applicant they chose signed a one-year lease and re-upped for a second year.
Because the Zibleys live close to their rental, they manage and maintain it themselves. However, if you decide to hire a property-management company, “you should expect it to manage better than you would,” says Michelle L. Horneff-Cohen, of Property Management Systems, in San Francisco. The manager should advertise vacancies, screen applicants, process lease documents, respond to tenant requests 24/7, and arrange for maintenance and repairs. And you can expect it will collect rent and pay expenses, enforce the terms of the lease, evict tenants and collect bad debts.
Expect to pay a monthly fee of about 8% to 10% of the rent you receive, as well as a separate leasing fee, which varies from a half to a full month’s rent and will be paid from a tenant’s first month’s rent. Interview more than one management company. (You can search for members of the National Association of Residential Property Managers at www.narpm.org.)
As a first-time landlord, you may be more comfortable buying a property close to home, where you can screen tenants and, if you’re handy, take care of small repairs yourself. But if you live where homes have appreciated sharply, you could search in another city for the right rental and hire a property manager.
RealtyTrac, a provider of housing data, calculated the return on investment for three-bedroom homes in 448 U.S. counties. Most of the top counties are located in the South, Southeast and Rust Belt, as well as Pennsylvania and upstate New York. You may find a deal by identifying out-of-state homeowners who are motivated to sell — say, because they inherited a home or have unsuccessfully tried long-distance landlording. To find them by ZIP code, visit Marketinglists.Realtytrac.com; the cost is 15 cents per property record, including the owner’s mailing address.
You could enlist a real estate agent to be your guide to the rental investment market. Or, in 13 states, HomeUnion Acquisition Services says it will provide a completely “hands-free” transaction, helping you identify properties that match your investing goals, acquire them and manage them. It charges a one-time fee equal to 3.5% of the purchase price for acquisition and 10.5% of monthly rent for management.
Yet another option, if you plan to relocate in retirement, is to buy a home now to lock in the purchase price and rent it out until you’re ready to move in. Beverly Howe, an exclusive buyer’s agent in Naples, Fla., helps many future retirees buy their retirement home in southwest Florida. Howe says owners can get almost as much in rent for a vacation-home rental of three to four months (to snowbirds in winter or to international vacationers in summer) as they can for a yearlong lease. A vacation rental must be furnished—an up-front cost—and will require more cleaning between tenants, but the wear and tear will be less.
Deal or money pit?
Investors use a few key benchmarks to compare properties. One is the gross rent multiplier: the purchase price of a property divided by the annual rent. The lower the result, the better. Another figure used to compare prospects is the cap (capitalization), which will give you an estimated annual return on a property no matter how you pay for it. To calculate it, subtract annual expenses from gross potential income and divide the result by the home’s purchase price. Expenses include the cost of liability and federal flood insurance, property taxes, maintenance and repair costs, utility bills you will pay, and property-management fees. Include an estimate for projected loss of income due to vacancy (typically 5% to 10% annually). Cash flow is income minus expenses (before taxes). If you’ll take a mortgage, add in the cost of principal and interest. Cash on cash return is net income divided by your cash outlay to purchase.
Most real estate investors don’t consider tax breaks when sizing up a property. But you can deduct rental expenses, including mortgage interest, from rental income, as well as deduct depreciation of the home’s purchase price and cost of improvements over 27.5 years. However, you don’t get something for nothing. Besides paying a 15% or 20% capital-gains tax when you eventually sell the property, you’ll pay a 25% rate on recaptured depreciation. For more information, see IRS Publication 527, Residential Rental Property, and seek advice from a tax adviser.
To help you calculate these benchmarks, use the Rental Property Calculator at www.biggerpockets.com, an online real estate networking and information resource.