Rental Properties Can Make Good Investments, but They Come with Risk

Rental Properties Can Make Good Investments, but They Come with Risk
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Maybe your financial house is in order. Your debt is manageable or paid off. You have an emergency fund and now you’re looking for ways to grow your wealth. Or, perhaps you’re not there yet, but as you build toward stability you’re planning ahead by learning about different investments options. While investment can take many forms, perhaps you may have considered becoming a landlord.

Rent prices tend to rise over time, providing an inflation-protected income into your retirement years. You also might be able to cash in big later if the unit’s value increases.

It doesn’t always work out that way, though. Perhaps you’ve heard the horror stories of landlords left with a trashed property after evicting a tenant. Or even worse, losing their property and savings in a natural disaster.

In between the extremes of easy, hands-off income and total ruin are the everyday concerns, benefits and risks that most landlords face. Filling empty rentals and managing a property can feel like a part-time job, but the extra income could be more than worth it. Be honest. If you’re not up for the work or risk of a fluctuating housing market, that’s okay. When you are, educate yourself and put in the time to do it right to protect your investment.

A few risks you could face as a landlord. If you’ll need to borrow money to purchase a rental property you should be aware that investment property mortgages tend to be a little more difficult and costly to secure than primary residence mortgages. It can also be harder to take cash out of investment properties — either with a cash-out refinance or a home equity line of credit. In other words, you might not have easy access to the money during an emergency and if you can’t make a mortgage payment, your life’s savings could be on the line.

Owning a rental property outright can be risky as well. Especially if you’re placing a significant amount of your savings in a single investment, the lack of diversification could put you in a precarious situation.

Those aren’t the only risks you could face when owning a rental.

  • Finding and keeping good tenants. Landlords learn from experience that it’s worth leaving their rental empty for a month or two rather than take on tenants who are likely to cause problems later. They’ll have to cover expenses without the rent income, but that’s often better than dealing with tenants who can’t pay rent and going through the eviction process. Worse are tenants whose security deposit doesn’t cover the carnage they leave behind. Many landlords pay for professional tenant screening reports or credit reports and call applicants’ references before offering a lease.
  • There are a variety of free contract templates online but if you decide to use one, do some research to be sure that the template you selected complies with federal, state and local laws. You may want to hire a landlord-tenant attorney to help you draft a template lease agreement. Also discuss how you can legally screen applicants, renters’ rights and common problems landlords face with the attorney. You want to clearly understand what laws apply to you and how to act in a fair and legal manner.
  • Covering your expenses. Even with a steady income stream, you could wind up losing money on your rental property. Between taxes, insurance, repairs, maintenance and mortgage payments the monthly and one-off costs can quickly stack up. When your rent is too high you’ll have trouble attracting tenants, but if it’s too low you might not be able to cover your expenses.
  • Choosing a property with a good capitalization rate (discussed below) can help you hedge against this risk. However, if the housing and rental markets drop, you could still get stuck choosing between losing money each month or selling the property at a loss.
  • The time or cost of managing a rental property. Becoming a landlord is often far from a hands-off job. When the phone rings in the middle of the night because the roof is leaking or the water heater breaks you’ll need to figure out how to solve the problem.
  • You may be able to hire a property management company to take on this work for you. They often charge about 8 to 12 percent of your rental income or a flat monthly fee. Depending on your contract, the cost of labor might not be included, and you’ll often pay for supplies that the company uses for maintenance or repairs.

Set yourself up for financial success. What separates the successes from the sorrow-filled landlords? Luck certainly comes into play, but you can also take steps to get started on the right foot.

If you’re looking to purchase an investment property, first try to determine its capitalization rate, or cap rate. This is the estimated annual return you could make on your investment. To calculate the cap rate, divide the annual net income by the property’s purchase price.

Your net income will be your rental income, which you can approximate based on rental prices for similar properties in the area, minus your costs, such as maintenance, upgrades, vacancies and emergencies. Try to understand the tax implications of owning a rental property before assuming your costs. Many deductions, including the cost of supplies and mileage for rental-related driving, might be new to you if you haven’t run a business before. Mortgage interest and depreciation could also drastically lower your tax bill.

Cap rates tend to change depending on the area and type of property. Regardless of what’s considered “good” in your area, you can use this formula to compare different investment opportunities.

Bottom line: Many people focus on the positives of owning investment property. An extra income and potential to build equity with their tenants’ money seems too good to be true, and it just might be. If you’re going to be successful, you should acknowledge the risks that come with the territory and plan accordingly.

Nathaniel Sillin directs Visa’s financial education programs. To follow Practical Money Skills on Twitter:

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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