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Do you spend hours watching HGTV or looking at houses on Zillow? It may be time for you to get serious about real estate investing. With the housing market hotter than it has been in years, real estate investing newbies should ask themselves the following six questions before taking the plunge.
1. Is rental property investment right for you?
When property values seem to be only going up, it’s tempting to think of investing in real estate as an easy way to generate passive income. Like any other investment, however, you need to be prepared for the possibility that real estate may not pay off immediately. This is especially true when investing in rental properties, which will invariably have more maintenance and requirements than you might expect.
First, take stock of your financial situation. Do you have enough emergency funds to cover six months of expenses? Do you have high interest debt, such as credit cards or personal loans? Are you setting aside 15% of your income for retirement? Do you have enough money saved to pay for things like maintenance, insurance, or a mortgage between tenants, without going into debt?
The answers to questions like these can tell you if the time is right to buy an investment property without derailing other financial goals, notes Brian Walsh, Certified Financial Planner (CFP) and Senior Director of Financial Planning at SoFi. “People who have a strong financial foundation can take on additional risks and new opportunities,” he says.
Don’t overlook another fundamental question: Do you really want to invest in real estate? You need to be prepared for the potential risks and headaches that come with being a landlord, including fluctuating rental prices and selecting reliable tenants who pay rent each month, says Chris Dolan, CFP and Financial Planner Principal at Baird Financial Advisors.
“Ask yourself: Do you have the heart to evict someone? Because sometimes that’s exactly what it’s all about,” Dolan says. you let someone live in your property for free?Because if you do, your business will fail.
Finally, you’ll need to approach investing with “eyes wide open” so you know exactly what you’re getting into, especially when it comes to costs and risks, says Justin Halverson, a Certified Retirement Income Professional. and Executive Vice President of Wealth Management Strategies at Great Waters Financial. “The first thing I always tell people is: you have to proceed with caution because it’s not as easy as it might seem from the outside,” he says.
2. What type of rental property should you buy?
A key part of deciding whether to invest in a rental property is determining how much money you need to spend and whether you are going to pay cash or take out a mortgage.
If you’re using financing, lenders will want to know your credit score, how much money you have for a down payment, your debt-to-equity ratio, and whether you’ll be using the equity in a current home you own to seed your investment. .
As long as buying a rental property makes sense for your financial situation, it can be a unique opportunity to grow your wealth, notes Dolan. “Most middle-class Americans won’t be able to walk into a bank and say, ‘I want to borrow half a million dollars to invest in the market,'” he says. “You can leverage someone else’s money to make that investment [with real estate].”
When comparing the pros and cons of various real estate investments, be sure to make a reasonable estimate of how much rent you’ll be able to charge so you can come up with a realistic cash flow plan, recommends Walsh.
The money that comes in each month has to cover expenses, including mortgage payments, insurance and unexpected costs, so “do the math,” Walsh says.
Identifying your goals and objectives can also help you decide which property to buy. Do you plan to use the house occasionally and rent it out the rest of the year? Or are you looking for a property that is purely an investment to generate passive income that could eventually become your sole source of income? “Start with the end in mind,” advises Halverson.
3. How will you manage your real estate investment?
Most rental property owners fall into one of two camps: they buy a home relatively close to where they live, or they convert a previous residence in a different geographic area to a rental property after moving, Walsh says. .
Whichever approach you take, you’ll need to decide whether you’re going to handle maintenance issues yourself or hire a management company. Most people Halverson has worked with start out managing a property themselves, but often move on to paying a management company. “You’ll have less profit, but you’ll also have the peace of mind of not having to do it yourself,” he says.
Property management companies can also help screen tenants or evict them, if necessary, as well as with day-to-day maintenance, like mowing the lawn or making repairs, Dolan says. If you’re taking the DIY approach, consider the time it takes to get to your rental property and manage those issues, he adds.
“That’s usually what ends up killing the deal for someone — the time and the emotional trauma when it comes to dealing with tenants,” says Dolan. “The property manager is going to tone it all down.”
4. How will you manage the commercial aspects of rental properties?
In addition to helping manage your rental properties, there is another benefit to working with a management company: you can deduct these expenses on your taxes, as well as other expenses such as mortgage interest, property tax , depreciation, repairs and operating expenses. While this is a nice perk, it’s also a sign that your financial situation becomes more complex once you own rental property.
“Talk to a tax professional, as they can help you significantly reduce your taxable income,” advises Halverson. Additionally, you should open a separate bank account dedicated to your rental property or consider setting up a limited liability company (LLC) to handle all income and expenses. “Treat it like a business,” he adds.
Dolan recommends creating a separate business entity to manage your rental income to minimize the associated risks. If someone files a lawsuit, for example, they can only file a lawsuit against the LLC and not against you personally. And finally, don’t forget the insurance. “It will help protect you for liability purposes,” he says.
5. Can you avoid common rental property investment mistakes?
Because you probably view rental properties as a long-term investment, you want to avoid some mistakes that could cost you money or give up on the idea altogether.
“The biggest mistake I see is people making a plan and assuming they’ll have tenants in units every month without interruption,” Walsh says. “That’s fine for a best-case scenario, but I encourage people to think about a more realistic assumption, like a tenant gap, late payments, or major, unplanned repairs.”
Likewise, Halverson has seen people get burned assuming they can rent a property without first checking with the landlords association or city bylaws. Some newbies also make the mistake of investing too much money in a home improvement or rehab or taking on too much debt, which eats away at your profit. Still others buy too many rental properties too soon instead of learning the ins and outs of a property first.
Take-out? As with many things in life, be careful and do your research. Investing in rental real estate is a major commitment.
6. What are the alternatives to owning a rental property?
When working with clients on retirement planning, Dolan says he breathes a sigh of relief every time he sees rental income because it provides a stable source of cash flow after they have stopped working.
That said, owning rental properties is not for everyone. Perhaps you are put off by the idea of becoming a landlord or taking care of the upkeep of the property. Or maybe it’s all about dollars and you don’t have enough money to buy a property. Whatever the reason, there are alternatives.
For example, you may choose to make an investment with someone else. Before doing so, however, make sure you have a solid agreement drawn up and consult with a lawyer, advises Halverson. “It sounds like a great idea and it can be, but be too careful when preparing yourself from the start for all the possibilities that could arise,” he warns.
A less risky strategy is to micro-invest in real estate using a number of platforms like Fundrise or CrowdStreet. The advantage is that you pool money with many other micro-investors to buy a property and eliminate a lot of the hassle (choosing a property and managing it). You also need a lot less money to invest.
Another option for people without a lot of money: invest in real estate on the stock market by buying shares of companies in the housing sector, investing in funds exposed to the real estate market or buying REITs (short for trusts real estate investment). This strategy will provide exposure to a wider range of properties in various locations, which can help spread risk.
Finally, there’s a “try it before you buy” option: Take small steps toward becoming a landlord by first regularly renting out the property you live in, advises Walsh. It’s a way to test the transition to owning a property just for the purpose of renting it out,” he says.