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When it comes to home buying, many people see investment properties as reserved for the upper echelon of homeowners, an aspirational investment strategy for well-heeled landlords who preside over a fiefdom of rental properties that allow them to live large off of passive income.
The truth, of course, is more down-to-earth and achievable—and usually not a quick path to riches, but one that involves preparation, hard work, lots of research, and even more luck. We’ve talked to experts on this often difficult but often ultimately rewarding segment of real estate investment.
We spoke to Brad Rempel and Jennifer Wayne, hosts of the Design Network’s Flip U; Thomas McCormack, senior partner and broker for Resources Real Estate; Brian Shahwan, vice president and mortgage banker with William Raveis Mortgage; and Jennifer White, an associate at RE/MAX.
What is an investment property?
First of all, what is an investment property? Basically, it’s any piece of real estate that you buy with the return on investment in mind, whether that’s through the rental income or profit you realize from the resale purchase price after the property value has gone up.
So it’s quite a broad category of real estate that could technically even cover a house you buy with the intention of living in.
In practical terms, though, people tend to differentiate between a home and an investment property, and when they refer to an investment property, they typically mean a property you buy that isn’t your primary residence or vacation home.
Though an investment property could also technically include a home you buy and then put on the market right away, people often differentiate between house flipping and investment properties, with the former meaning an almost immediate resale and the latter meaning a property with a longer-term real estate investment strategy that involves rentals or that sits out the real estate market for years for a bigger payoff at resale.
What types of investment properties are there?
Any kind of real estate can qualify as an investment property. That includes residential property, commercial property, industrial property, and even undeveloped lots that remain vacant and untouched the entire time you own them. It’s just a matter of whether you find real estate of any sort that you think will yield a good return on investment.
What are the pros of investment properties?
Rental income provides a steady source of passive income that can really make a difference—that monthly rent is guaranteed cash flow for you, no matter how the rest of your income streams are faring. (Assuming you have responsible renters, of course.)
Once you decide to sell, you can benefit from the increase in the property value of your investment property. When you cash out, you could theoretically realize a huge return on investment—depending, of course, on the real estate market you bought into and sell in, the improvements you’ve made to the property, how eager your seller is to buy, and, let’s face it, a whole lot of luck.
It’s a way to diversify your wealth too. Many experts see real estate as a less volatile investment than stocks, high-yield bonds, cryptocurrencies, IPOs, and the like. Some homeowners see investment properties as nest eggs that they can count on to provide them a reliable source of capital come time for retirement.
What are the cons of investment properties?
If you don’t fully match an investment property’s purchase price with cash outright, you’re probably going to be making mortgage payments for a while, adding to your monthly expenses. If buying an investment property means your monthly net will become unaffordable, then it’s likely going to drag you down sooner or later.
Until you sell the property, you’re still dealing with all the associated expenses of being a homeowner as well, like taxes, repairs, utilities and maintenance, HOA fees, and so on. If you have to renovate the property to raise its value or make it more attractive to rent or sell, that becomes part of the money you to sink into and adds to the red ink when you finally determine how much of a return on investment you’re getting.
Any investment—no matter how much of a sure thing it’s supposed to be—carries risk. Real estate may be seen as more stable than many other investments, but it’s definitely not risk-free, and many an investor has lost their shirt in real estate investments, especially when a housing bubble goes bust. Even in supposedly bulletproof real estate markets like New York City or San Francisco, you’re not guaranteed that your property value will go up. And if you overpaid, you may never get your investment back and have to accept a loss on resale just to unload the property and stop bleeding money into its associated expenses.
Finally, if you want to turn the property into a source of rental income, you’re going to have to become a landlord, which often isn’t a walk in the park. Your tenants will have expectations (and rights), and you’re going to be spending both time and money to keep them satisfied and to keep the monthly rent coming in. And if you draw the short straw and get nightmare tenants? Add legal fees to your expenses column as you face the worst-case scenario, eviction proceedings, and attempt to get your investment property back on the market quickly so you can find more suitable tenants and get that monthly rent going again.
What’s the 1% rule or 2% rule for investment properties?
The 1% rule states that your investment property should bring in at least 1% of your total investment every month. So if you were thinking of a home with a purchase price of $900,000 and would have to make $100,000 worth of renovations and repairs, the 1% rule would say you should ensure you could bring in $10,000 in monthly rent (1% of $1 million) before buying it.
The 2% rule is the same idea but for more lucrative (and expensive) markets, like parts of New York City or San Francisco. So for the same imaginary house, you’d want to be able to charge at least $20,000 a month in rental income.
There are other general rules of thumb as well. For example, a common figure is a 10% annual return, so “if I spent $300,000 I would like to net $2,500 a month after all expenses are paid,” McCormack says.
“This number can fluctuate due to various factors, but the general rule of thumb is that a decent return is often considered to be in the range of 8 to 12%, although this range is broad as it really depends on the borrower and their specific goals,” Shahwan says.
Remember that these are all just blanket rules of thumb and not detailed mathematical equations or ironclad laws of real estate investment. You’re the ultimate judge of what return on investment you want to see, and the unique factors of your life and financial situation should help you decide whether to buy an investment property or not.
Where should I look for investment opportunities?
Real estate markets can vary wildly, and so can your opportunities for investment properties. No two property owners are the same, either, so what you’re looking for in an investment property isn’t necessarily going to be the same as what someone else is looking for.
Check the housing markets in and around the areas you’re interested in. Talk to and consider taking on an agent who knows the local market well. Do your research and check for the patterns: Are people moving into the area or leaving it in droves? Have rental prices been rising, holding steady or dropping like a stone? Has Amazon opened up a new regional headquarters nearby, bringing in money and new families who need housing?
And the most important question: Are you buying a place that people can actually see themselves living?
“When looking to buy a piece of investment property—no matter if it is your first or second, the location is the number one thing I look for,” Wayne says. “I have a few rentals in Florida that are on the smaller side but in a gorgeous location (just a block from the beach!), and have found that if you plan on transforming your investment property into a rental home, many consumers prefer a property in a great location over a large home that is farther away.”
“Mine are both overlooking a pond, and I have found great success on my ROI when prioritizing a view,” Rempel says.
What should I look for in an investment property?
Looking for an investment property isn’t necessarily much different from regular home buying. Do you want a single-family home in the suburbs or a multifamily home in the city? Is it considered a safe neighborhood? What’s the transportation like? Are the schools good? These will all help determine how much people will be willing to pay in rent or at resale.
“Return on investment should be the top priority when looking for a good investment property,” Shahwan says. “Not only is it important to consider the property itself, but also the surrounding area. Locating properties in up-and-coming neighborhoods can be very beneficial, although riskier.”
Commercial real estate can be a whole different ballgame than residential properties. Though you could make potentially a lot more money with a commercial real estate investment, you also have to so you have to make sure you’re up for the cons as well, such as typically much higher purchase prices, more intense management requirements, needing more help from professional contractors, and opening up yourself to more risks (like when someone gets into a car accident on the slippery ice in the parking lot).
“Commercial and residential properties vary drastically on returns and what to look for,” White says. “Some properties are more cash cows but won’t appreciate as much as others that may generate less upfront cash, but yield significantly higher returns down the road. It’s imperative to truly understand your market.”
No matter what kind of investment property you’re looking to buy, it’s not going to be a good return on investment if no one wants to live or work there.
“Tenant demand is key,” McCormack says. “Condition is not necessarily a factor if you have access to available contractors who can renovate quickly so you are not off-market for an extended period of time.”
In fact, buying a property that already has tenants may actually be an attractive option for you, since it essentially means the property comes with the passive income already built in—no wasting weeks or months waiting to fill the space with paying renters.
“While vacant properties are sometimes of interest because it makes it easier to upgrade and do all the necessary work up front, some investors prefer purchasing a property with tenants as long as the seller can demonstrate a consistent track record of tenant payments,” McCormack says. “Every month you are vacant is money lost.”
And don’t get hung up on size.
“More times than not, the piece of property won’t be the biggest (both of my properties are both currently around 1,200 square feet),” Rempel says. “I have found that the smaller they are, the easier to maintain.”
Is it better to buy older or newer buildings as investments?
If you have serious fix-it know-how and are truly confident in your skills with renovations, then you may want to look at maximizing your profits by buying an older building that needs some love and doing the repairs yourself. Just remember that what you’d be saving in money you could be paying for with your own time.
“Buyers familiar with doing upgrades and renovations themselves may want to purchase older buildings to do the work themselves and maximize their cost-to-benefit ratio,” Shahwan says. “Buyers with less knowledge on repairs, who want to immediately start collecting income, may opt for new construction properties. There is no one-size-fits-all here. Buyers should do what is right for them, and right for their finances.”
Though it’s appealing to buy an older home if you’re qualified to do the renovations yourself, remember that that are going to be additional expenses and some things you likely won’t be able to install yourself.
“When browsing the market for an investment property, buyers can often get trapped in the illusion of buying an old home,” Rempel and White wrote in an email. “While it can be appealing to purchase an older home, it is important to remember the maintenance costs that are going to come with it.”
For HVAC systems, for example, they recommend following the $5,000 rule: Multiply the age of the equipment by its estimate repair cost. If that figure comes to under $5,000, you should repair it. If it’s over $5,000, you should replace it.
In the long run, replacing systems in an old home can actually save you a lot of money, especially if you’re upgrading to be more energy efficient.
How much money of my own money should I spent on investment properties?
Before buying, know how much you can put down for your investment, because if you don’t get tenants right away bringing in passive income, you’re going to have to be able to cover the property’s maintenance and expenses till you do, as well as paying the mortgage and offering enough of a down payment that you don’t trigger requirements like mortgage insurance.
“If you are not paying cash, you would need at least 20 to 30% down for an investment property in addition to 6 to 12 months of carrying costs in the event you don’t rent it right away or reap a return immediately,” White says.
Lenders may also impose their own requirements on you.
“Many lenders require the borrower to have reserve funds in case any additional expenses arise,” Shahwan says. “Reserve funds are funds left in your account post-closing. The reserve requirements could be anywhere from 6 months to 36 months.”
What are the tax benefits of an investment property? What’s a 1031 exchange and how does it apply to making money on an investment property?
Real estate taxation rules are byzantine and can make or break a real estate investment venture. For example, you might want to take advantage of a 1031 exchange under the right circumstances, which allows you defer capital gains taxes when you swap one investment property for another in some cases.
“There could be several tax benefits of an investment property that include capital gains taxes, mortgage interest deductions, property depreciation, 1031 exchange, etc.,” Shahwan says. “It’s important to speak with your tax professional to understand exactly what applies to your specific situation.”
Also be aware of so-called mansion taxes, which are additional local taxes on higher-value properties that are usually applied regardless of whether the property’s the owner’s primary home or an investment property.
How do rising interest rates affect my return on investment properties?
Are you locked into a mortgage rate? If not, you need to keep a close eye on interest rates, which could move your investment from profitable to unprofitable.
“As rising interest rates will increase the overall monthly mortgage payment, if you are not currently locked into a rate, this could mean that your overall monthly profit between rental income and expenses changes,” Shahwan says.
How long should you expect before you see decent return on investment? What’s a good return on investment?
When you start realizing the return on investment you want depends on a number of factors, starting with whether you bought the property for monthly rent and continuous passive income or you intended to make the bulk of your money upon resale. And the biggest factor of all may be your tolerance for risk and your patience. If you already have an idea of when you want to make your purchase price (and renovation costs) back, you can build your search for an investment property around your timeline.
“I find a comparable piece of property and see what it goes for per month and then multiply the yearly income by seven,” Rempel says. “I do that because by the time I am done buying the property and renovating it, I want to ensure I can get my money back in seven years. While it is not always doable, if it is, I will seriously consider buying it.”
Who should I be renting my investment property to? In what cases do I want to not have renters? Should I consider Airbnb?
Ensure you know the rules and laws about renting out the property you have in mind. If it’s a unit in a co-op, for example, potential tenants may have to be interviewed by the co-op board, and you may find a substantial sublessor fee tacked onto your monthly maintenance.
Short-term rentals are certainly a possibility, but managing a property with a constant flow of short-term guests can be like running a B&B or small hotel—it’s a lot of work. You may end up paying for a management company to help run your Airbnb or short-term rental property, which will add to your expenses. Be aware, as well, that different municipalities have different laws regarding Airbnbs. Learn the laws thoroughly wherever you’re buying before you finalize the purchase.
How much time should I expect to spend dealing with each investment property?
Property management companies can take care of your investment properties for you, though they naturally will reduce the return on investment—they’re not going to do it for free, after all.
Expect to spend some time or money doing renovations and upgrades once you’ve have the investment property for a while, but the amount of time you spend on investment properties doesn’t necessarily have to be a lot—you don’t even have to be in the same state or region as your investment properties.
“In a perfect scenario, investors should not have to spend copious amounts of time dealing with issues, whether because of the property itself, or the tenants,” Shahwan says. “It really depends on the overall picture to determine how much time it may require from the investor.”
How many investment properties is a good number?
For many experts, there’s no maximum number of investment properties to add to your portfolio, if it works out for you that way. It all depends on your circumstances and how lucky are with finding low-maintenance tenants.
“If you have properties that are in good shape and you have responsible tenants, managing them can be relatively easy, which should allow you to take on more properties,” McCormack says. “I would prefer to have really solid, trustworthy tenants at an under-market rent than charge top dollar for ‘trouble’ tenants. I know many investors who say that 20 properties is the magic number for them, but I think this can vary widely.”
Originally Appeared on Architectural Digest