If you’re thinking about buying an investment property, you’re aiming for long-term wealth and a steady income stream. But real estate investment can be tricky if you don’t know what to look for. Let’s dive in.
Get your financials in order
Investment properties are high-risk for lenders, which means you’ll need a solid financial foundation:
- Down Payment: Expect to put down at least 20-25%. Lenders usually require more skin in the game because investment properties aren’t protected by the same laws as primary residences.
- Credit Score: Aim for 700+ to qualify for a better mortgage rate.
- Debt-to-Income Ratio (DTI): Your DTI should ideally be below 43%, but lenders may be more strict depending on the size of your loan.
- Reserves: Lenders like to see six months of mortgage payments saved up, covering both your primary home and the investment property.
Tip: Ensure you’re financially comfortable with the potential for vacancies, unexpected repairs, or periods where rental income might be slow.
Location: the golden rule
When it comes to investment properties, location is everything. But it’s not just about finding a “hot” market—it’s about understanding the area’s long-term potential. Here’s what to look for:
- Growing markets: Look for cities or neighborhoods with population growth, new job opportunities, and upcoming infrastructure developments. These areas are more likely to appreciate over time.
- Rental demand: Check rental vacancy rates, average rental prices, and local tenant laws. College towns, urban centers, and tourist spots often have higher rental demand.
- Amenities and schools: Proximity to schools, public transportation, parks, and shopping centers can make your property more attractive to renters or buyers.
- Crime rates and future development plans: Research crime statistics and future zoning plans. A safe neighborhood with new developments planned is a solid bet for long-term investment.
Set a budget and stick to it
Once you’ve found a promising location, you need to set a budget for the property. This isn’t just about the purchase price—factor in ongoing expenses like:
- Mortgage payments
- Property taxes
- Homeowner’s insurance
- Repairs and maintenance
- Property management fees (if you’re hiring someone to manage the property)
Pro Tip: Don’t forget to budget for vacancy periods, especially if it’s a short-term rental property. A conservative estimate is to expect the property to be vacant for at least one to two months out of the year.
What to look for in an investment property
The condition and type of property you choose will directly affect your profits. Here’s what to watch for:
- Fixer-upper vs. turnkey: A fixer-upper can be a great deal if you have the time, skills, and capital to renovate. But be wary—unexpected repairs can add up quickly. A turnkey property (one that’s ready to rent immediately) might cost more upfront, but it saves you the headache of renovations.
- Single-Family vs. Multi-Unit: Single-family homes are typically easier to manage, but multi-unit properties can offer more income streams from a single purchase. Multi-units can also provide a cushion if one unit is vacant.
- Cash Flow Potential: The property should generate enough rental income to cover the mortgage, taxes, and other expenses, with some left over. A good rule of thumb is the 1% rule—the property should rent for at least 1% of the purchase price per month.
- Age and Condition: Older properties can have charm but may come with costly maintenance issues. Newer homes or those with recent updates often have fewer upfront repairs but might come with a higher price tag.
Understand the tax benefits
Owning an investment property has tax advantages that can significantly boost your profitability:
- Deductible expenses: You can deduct mortgage interest, property taxes, insurance premiums, repairs, property management fees, and even travel expenses if you need to manage the property.
- Depreciation: Even though your property is (hopefully) appreciating in value, the IRS lets you depreciate the cost of the property over 27.5 years for residential real estate. This can offset rental income and lower your taxable income.
- 1031 exchange: If you sell the property for a profit, you can defer capital gains taxes by rolling the proceeds into a new investment property, thanks to the 1031 exchange.
Property management: to DIY or not
Managing a property takes time and effort, especially if you don’t live nearby. Consider your options:
- Self-managing: You’ll save money by doing it yourself, but you’ll also be responsible for tenant screening, maintenance, rent collection, and handling any issues that arise.
- Hiring a property manager: Property managers typically charge around 8-12% of the rental income, but they handle everything from tenant issues to repairs. This is a good option if you’re busy or own multiple properties.
Tip: If you decide to hire a property manager, make sure they have solid reviews and a good understanding of the local rental market.
Factor in extra costs
The mortgage is just the beginning. You’ll need to budget for these extras:
- Repairs and Maintenance: Properties inevitably need repairs—factor in about 1-2% of the property’s value annually for upkeep.
- Insurance: Investment property insurance can be more expensive than standard homeowner’s insurance, especially if it’s in a high-risk area (like a vacation home in a hurricane-prone region).
- HOA Fees: If the property is part of a homeowners association, budget for monthly or yearly fees.
Utilities: Depending on the arrangement, you might be responsible for some or all of the property’s utility bills, especially in multi-unit properties or short-term rentals.
If you’re ready to start your journey to homeownership, get pre approved with Tomo Mortgage today.