Owning and managing rental properties can be a rewarding and profitable investment. However, before taking the leap, there are many things to consider. Carefully weighing the risks with the benefits will propel you to rental investment success. Unsure how to choose a profitable rental property? Check out these considerations below before buying rental property.
Essential Tips for Buying Rental Property
Are you thinking about becoming a landlord to your very own investment property portfolio? There’s no doubt there is money to be made in real estate. However, to get the most bang for your buck, there are some fundamental principles you should understand. So, before investing, consider the list below of steps you should take.
- Pay Off Personal Debt First
- Secure a Sizeable Down Payment
- Research Local Markets
- Weigh Benefits of Buying versus Financing
- Shop Around for the Best Interest Rates
- Determine Your Margins
- Invest in Landlord and Liability Insurance
- Set Up Separate Fund for Unexpected Costs
- Calculate Operating Expenses
- Determine Your Return
- Understand Your Legal Obligations
What to Know Before Investing in Rental Property?
Rental properties are an effective way to create income. However, there is a lot to consider before proceeding. Follow along as we look at a few factors to evaluate while searching for investment properties.
How to Evaluate Rental Property Income – The 1% Rule
Generating income is a significant focus for potential investors. When evaluating a property, it is crucial to determine if the property will produce the income you are looking for and be profitable. So, thoroughly research the local area looking at both properties currently on the market and those that have rented recently.
As one way to evaluate if the property is a viable choice, consider the 1% rule. In other words, your gross rental income should be a minimum of 1% of the property’s purchase price. Following this, guideline helps to ensure the property will generate enough revenue to cover potential expenses. This should not be the only factor you consider, but it can help when deciding between options.
How to Anticipate Expenses of Owning a Rental Property – The 50% Rule
Planning for expenses you will incur is the next important part of property investment. As a helpful guideline, you can use the 50% rule. Simply put, this rule states that an owner can plan for 50% of the gross income going to operating expenses. Ordinary operating costs include:
- Property Taxes
- Landlord and Property Insurance
- Maintenance Expenses
- Owner-Paid Utilities
- Vacancy Loss
- Management Fees
For the best and also most accurate representation of expenses, there are two types of property owners should evaluate:
- Operating expenses: Operational expenses are any that are reoccurring in nature. For example, items such as property taxes, insurance, routine maintenance, property management costs, and vacancy costs would all be operating expenses.
- Capital expenditures: Large or unplanned expenses make up capital expenditures. This can range from fixing a damaged roof to any other irregular expenses.
How to Calculate Returns and Choose Profitable Rental Property
Taking into consideration the two types of expenses you will incur, you can now focus on cash-on-cash return. The cash-on-cash performance is essential, as this dictates a property’s profitability.
To calculate cash-on-cash return, follow the following formula:
- Step 1: Gross Income – Operating Expenses = Annual Net Income
- Step 2: Annual Net Income / Purchase Price = Cash-on-cash Return (convert to percentage)
A good rule of thumb is to look for a return of between 8% and 12%, which is considered reasonable. However, also keep in mind that this percentage does not factor in any unexpected costs, monthly mortgage payments, or capital expenditures. So, consider all factors carefully before making a purchase.
Need additional help? Check out the free Investment Property Calculator from AARP.
What are the Benefits of Owning a Rental Property?
- Income from Renters
- Property Appreciation
- Tax Deductions
- Diversify Your Portfolio
What are the Risks of Buying a Rental Property?
- Potential Lost Income from Vacancy
- Risk of Bad Tenants
- Unexpected Costs Resulting in Financial Strain
- Potential for Depreciation
- Large Concentration of Assets
How to Choose Profitable Rental Property
Many factors contribute to how well a property will do as a rental and in turn, how much you make as profit. As you search, remember these key factors below.
- Great Neighborhood: Location, location! Choosing the right neighborhood directly impacts your pool of tenants. For example, areas near college campuses mean students will likely make up a large part of the rental group. Also, check out local codes and requirements; you could pay hefty fees in some areas as opposed to others.
- Property Taxes: Taxes can fluctuate from location to location. If there is a fantastic neighborhood that will attract the ideal tenants, higher taxes may be worth it. However, even non-desirable markets can have high taxes, so do your due diligence.
- School Ratings: When looking at area schools, especially if purchasing a larger single-family home, consider both rental and resale value. If you plan to sell the house after some time, eventually, school districts can directly affect the value. So, choose wisely.
- Crime Statistics: Everyone wants to heel safe and secure in and around their home. Local police or even online searches can provide a wealth of information on the frequency and type of crimes in a particular area.
- Job Market: The U.S. Bureau of Labor Statistics (BLS) offers a great resource to check on how the local job market is doing in a particular area. Employment growth both draws and keeps tenants in a specific place.
Additional Factors to Consider
- Amenities: Spend time in the neighborhood you are researching. Check out local gyms, coffee shops, and amenities, anywhere that might appeal to your tenants. Not only will this help you decide on a location, but it also aids in marketing the property to potential renters.
- Future Development: Is the area growing? Growth means an influx of people in the area, which is a plus. However, it also means potential competition driving up rent and housing prices.
- Existing Listings and Vacancies: Scope out your competition and see what the local rental rates are. High volume on the market could simply be a seasonal trend or a sign of trouble. High vacancy rates mean landlords may need to lower rental rates to fill units.
- Average Rental Rate: Compare your potential purchases against similar units currently on the market or those recently rented. You likely already know the rent you need to cover expenses and mortgage. So, if that isn’t in line with the market, it is time to reevaluate.
- Natural Disasters: Locations in flood zones or areas with a higher risk of natural disasters incur higher costs and fees you need to plan for. Be aware that higher or additional insurance rates can cut drastically into your monthly profit.
Buying rental property in Wayne, PA, Delaware County, or the greater Philadelphia area as part of your financial portfolio can be profitable, but it does come with risk. How you balance and evaluate those risks is crucial to your success. The helpful tips and guidelines above on how to choose profitable rental property will get you started, but you don’t have to go it alone. Professional property management services are a fantastic way to take the stress out of being a landlord. Looking for an expert in Pennsylvania? Reach out to Bay Property Management Group Delaware County today!