You've come across a can't miss opportunity to pick up a distressed property. You think this is a great opportunity to turn it into a rental unit to cash in on someone else paying your mortgage. Before plunging into a very big purchase, let's take a look at the pros and cons of your investment.
Expenses You'll Incur:
Mortgage:Unless you're paying cash, you will have a mortgage on the property. If this is purchased as an investment property, you will pay a higher interest rate on your loan. Since this is a second property, the bank believes your default rate is higher and thus the interest rate increases.
Mortgage part 2: If you have even one month your property isn't rented, you will be paying your regular living expenses in addition to your mortgage on your investment property. Are you adequately funded if your property does not rent for 6 months?
Property taxes: Depending on where your property is located, your property may range from.50 to 2% of the properties' assessed value
Insurance: It is paramount to be properly insured. In many cases you can purchase an umbrella policy from your local insurance agent. In addition to the standard fire, flood, and earthquake insurance (if needed), you need to be insured against accidental death and a slip and fall associated with your rental property. You might want to incorporate into an S corporation or LLC before purchasing your rental unit. This will insulate against any catastrophic events related to your property.
Management company fees: Will you be hiring a management company? Typically, this may cost as low as one hundred to several hundred dollars per month.
Legal fees: Fees associated with writing leases as well as evicting a tenant who may go into arrears on their rent payments.
Advertising fees: Chances are you will have to advertise your rental property in the newspaper to get it rented. Other options include online advertising as well as using the services of a rental broker.
Repairs: Home repairs are unknown and may put a big wrench in your cash flow. In addition to the usual updating and painting, there are other repairs such as a broken pipe, broken house fixtures, changing of locks etc which will happen during your ownership.
Utilities: Depending on your lease agreement, you may be responsible for paying water, gas/electric.
Travel expenses: Traveling expenses can be considerable if your property is a far distance from your home. It is usually recommended that a rental property be within 45 minutes to one hour away. While these expenses are usually tax deductible, you don't want to spend all your free time traveling to and from your rental property.
Cleaning and repairs caused by renters: If you have renters moving out, you may need a cleaning company to make sure your property is up showing standards. You may also have repairs due to rowdy or bad renters.
Closing costs: Upon purchasing your property, there will be closing costs. Closing costs will vary from lender to lender.
Opportunity cost:Your down payment: On top of all of the above expenses, you'll have to address the "opportunity cost" of your down payment. For example, you purchased a property for $300,000 and put down $60,000 (20% to avoid private mortgage insurance) that's money you cannot use for another investment. A conservative way to calculate your opportunity cost is to link your opportunity cost to a 30 year treasury bond. If a bond is paying 5%, your annual opportunity cost is $3000 ($60,000 x 5%). This should be added to your carrying costs since this is a guaranteed return on capital. If you believe you have other guaranteed opportunities, you must consider it and add it to your total annual operating budget.
Income and Benefits: Obviously, you will have income from your rental to offset your mortgage and expenses. In order to gauge the rental market, check out such popular sites such as rent.com or craigslist.org. There you can look up comparable units and you can properly set your rental price. You will also want to drive the surrounding streets in the neighborhood to get a better view of your competition.
Tax benefits: Interest paid on your mortgage is tax deductible.
Depreciation: Each year you have the opportunity to write off the value of building you've purchased. You get to capture depreciation every year even if your property increases in value. There is a caveat however. Every dollar you claim reduces the cost basis of your property. This will increase your tax liability when you secede to sell. In effect, you are delaying taxes. Always be sure to consult an accountant regarding current depreciation laws.
Appreciation: While it's impossible to predict if real estate will appreciate in the short term, historically you can expect between a 3-5% annual return. If a property is held long term (10 years or more), a major metro area has never seen a negative return over a full 10 year period. Here's where things get fun. If you average 3% on a $100,000 home, you've made $3,000. Remember, that $3,000 paper profit is based on you only putting down 20% ($20,000). This represents a 15% return on investment. This paper profit may compound over time, generating some nice returns once the property is sold.
Losses and expenses:You will have the opportunity to deduct any losses your property generates. You also can write off travel expenses to the property, repairs as well as additions you make to the property.
Being a landlord isn't for everyone. There are tenants and personalities to contend with. You may have someone who causes destruction to your property. Perhaps you might have to evict a tenant if they fail to pay their rent. If you are to become a landlord, it is imperative you know the tenant/landlord laws in your state. Each state has their own set of laws and rules.
That being said, fortunes have been made by many owning rental units. There are many factors to consider before purchasing. Going beyond the numbers, you'll have to determine if you have the temperament and time to be a landlord.
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