Buying an investment property can be a smart financial decision. Do it right, and you can get a strong return through passive income, tax breaks, and equity gains. But a big return on your investment is not a guarantee—you need to think strategically when choosing and purchasing your investment property, and to work in line with both market trends and the general guidelines that dictate whether your investment is poised to succeed.
If this is your first time venturing into the world of investment properties, then it’s normal to feel a bit overwhelmed by the process. There is a lot to consider, and a lot on the line, too. Whether you’re planning to buy a vacation rental property, a condo in the city to rent out year round, a commercial investment property, or some other type of real estate investment, you need to go in with a clear head and a strong understanding of what makes a good purchase.
To help you get there, we’ve put together this quick guide to the major factors that you need to consider when buying an investment property. While each situation needs to be considered individually and with local trends in mind, these factors are a good jumping off point for determining whether it’s a good idea to take the leap.
1.Location, Location, Location
You have to consider your investment property in context. A stunning vacation home isn’t going to have much luck with vacationers if it’s located somewhere that people don’t tend to visit. Likewise, while a fixer upper might be a good choice somewhere like the Bay Area, where housing competition is high and you can easily recoup your renovation costs, you might end up at a loss with a fixer upper in a less competitive market.
Think location first, and the property itself second. It might seem backwards—after all, it’s the physical structure that you’re actually buying—but the “right” property in the wrong location isn’t likely to be the right property at all.
2.Down Payment Differences
The down payment requirements when you’re buying an investment property differ from when you’re buying a standard family home. Instead of being able to get away with putting down as low as 1% to 10%, you’ll typically need to put down at least 15% to 20%. Investment properties don’t qualify for mortgage insurance, plus there are stricter approval requirements when it comes to securing your financing, which results in the need for a more substantial down payment.
The variables that determine how much will be expected for your down payment include your credit score, your income, and your debt-to-income (DTI) ratio. As with any real estate purchase, wrap up the details of your financing before going on a property hunt so that you know what’s viable and what’s not.
3.The 1% Rule
When calculating your expected return on a property, it’s almost always going to be a good idea to abide by the 1% rule. The 1% rule is a real estate investment term that investors use to determine whether a particular purchase is worth making. Under the rule, each month you should be set to bring in no less than 1% of the price you paid for it, including both the purchase price and any additional money you put into it, such as repairs or renovations.
Here’s how this looks: Let’s say you buy an investment property for $225,000 and put in $25,000 worth of renovations for a total initial investment of $250,000. Ideally, you’d want to be pulling in at least 1% of that—so, $2,500—a month in rent or other returns.
Of course, as with all rules, there are caveats. If you’re buying a million dollar property, for example, or buying a property in an up-and-coming neighborhood that isn’t likely to see strong returns right away, you might choose to shirk the 1% rule and focus long-term instead. In those cases, at least seek to keep your monthly mortgage payment at 1% of your investment or lower so that you’re not paying out significantly more than you’re gaining.
To get a feel for what your annual return might be (and whether it’s worth it), use an investment property calculator, which can tell you what you’ll make on the property after accounting for financing and expenses.
4.Fixes and Variable Expenses
An investment property is not a one-and-done purchase. There are expenses inherent in maintaining any property that you own—both fixed and variable. And while it’s not always possible to anticipate these expenses with complete accuracy, you’ll still need to budget appropriately and make sure that you won’t end up in the red every year.
Fixed expenses that you’ll need to consider include:
Property management expenses (if applicable)
HOA fees (if applicable)
General upkeep costs (cleaning, landscaping, etc.)
Variable expenses are harder to predict, but make sure that you account for wiggle room in your budget for unexpected repair costs, such as needing to replace the water heater or fixing a roof after a bad storm.
How hands on do you want to be with your investment? Some real estate investors choose to engage directly with their renters by serving as landlords or otherwise personally overseeing day-to-day operations, while others pay a management company to do that sort of work for them. Your own involvement depends on how involved you want to be and whether you want to add on the cost of a professional property management service.
Keep in mind that while hiring a property management service is a considerable expense, it’s not necessarily more expensive than doing things on your own. In fact, it might even be more cost effective. Take a vacation rental, for example. You’ll need to pay to market the property on various websites, which also tend to charge additional fees like booking or leasing fees. With a property management company, you might just have to pay a set commission fee per rental—usually around 10%.
Do some research to figure out which would be the better option, and then keep these expenses in mind when making the ultimate decision about whether or not to move forward with a particular property.
6.Know the Risks
As with all things in real estate, buying an investment property is not without its risks. And it’s crucial that you know what these risks are.
Some of the most significant risks to keep in mind:
You might not have the rental interest that you anticipate.
You could end up having to front for expensive repairs.
Property taxes could go up.
The local market economy could change.
You could have bad tenants, resulting in repair costs or even eviction costs.
Don’t focus on the risks alone (if that’s what everyone did, no one would ever buy an investment property), but don’t ignore them either. No investment is ever a guarantee; you just need to make sure you’re not blindsided if something does go wrong and that you have some flexibility worked in to your finances.
An investment property can be one of the most fruitful purchases that you ever make. Work with an experienced advisor who can help you navigate the process and make the best purchase possible, and be sure to thoroughly evaluate all of the factors above to ensure that the investment you make is a smart one.