At first glance, buying a rental property seems like a surefire way to earn a second income. Buy a house, fix it up, rent it out, and then sit back and collect the checks. Even better, buy a second home on the beach and rent it out when you're not there. TV shows make it look easy. However, the reality is often far more complex. Buying rental properties can be profitable but requires hard work, careful planning and some luck. Also, margins are often slimmer than most people expect.
Brandon Smith, owner and partner at S & S Texas Properties and a HomeVestors franchise owner, has completed over 300 property transactions since 2009, and he currently manages a portfolio of 80 rental units. Smith says buyers' first step should be to determine their goals. "Personally, I got into the rental business to help offset ... the taxes of a high income." Alternatively, he notes some "buy rental property to hold it for the appreciation value later or to use it for cash-flow purposes."
Finding the right property is not just a question of neighborhood. What separates the right property from the wrong property is a carefully planned budget. For example, Smith describes a house worth $100,000: "My goal would be to have the purchase price, the cost of complete remodeling -- both cosmetic and functional -- and finance costs total between $70,000 and $75,000." This 70 to 75 percent "loan-to-value" threshold is Smith's red line. If the budget strays above that line, he will not buy. Smith continues, "I would charge about $1,200 per month in rent, and my target cash flow would be about $200 per month."
Smith says, "I think the biggest hurdle people get caught on is financing." But this hurdle is easily overcome. Smith explains, "If you have a W-2 job and two years of tax returns, you can still get Fannie Mae and Freddie Mac loans for up to four to five units at 80 percent loan-to-value." Alternatively, buyers can arrange financing through local community banks (an option Smith uses). And most cities have real estate clubs, private investors or companies that can offer private loans, but often at a higher interest rates. Remember, all the costs of financing -- closing costs, interest rates, title insurance, etc. -- need to be rolled into that 70-75 percent loan-to-value threshold. Higher financing costs might force a buyer to pay less for remodeling or to offer a lower purchase price.
Like financing, remodeling can appear intimidating. But Smith reminds buyers, "99.9 percent of everything is fixable." The trick is to pick reliable, appropriately priced contractors. Smith advises buyers to research contractors and what they typically charge. Select contractors with a reputation for low prices, on-time delivery, quality work and transferable warranties.
When deciding what upgrades to make, Smith says to choose options that are "built to last." Pick simple but attractive and quality elements. Not every house needs top-of-the-line fixes. For example, Smith uses ceramic tile instead of travertine. A big problem, Smith highlights, is that "people don't rehab a property fast enough, so they have added holding costs, or they try to over-improve for the area." Added time and costs will cut into your profit, if not eliminate it entirely, so plan for surprises.
Renting a vacation home can be enticing because of the exotic locale, but the added excitement is matched by added risks. With added distances come added costs: construction costs, repair costs and taxes will all likely be higher. Service providers will have to be hired remotely, and references might be hard to obtain. Furthermore, whereas a rental home will likely have a resident year-round, vacation properties will be inhabited only seasonally, reducing the amount and consistency of a buyer's profit.
Profit margins for buyers of rental properties are often slim. Surprises and delays can quickly eat up that profit, turning a $200 monthly income into $100 or even a loss. To protect your profit, Smith's last bit of advice is to find a local mentor. "Find a local real estate club that is free or charges a minimal fee. Go out, mingle and talk real estate. Find a friend who will give you information and connect you with contractors." A good mentor will help a buyer learn faster, pay less and profit more.