Investment real estate is one of the best ways to build steady cash flow, but getting started in the industry is daunting. Aside from everything you need to learn about buying and managing real estate, you also need a 20 percent down payment and enough income to qualify for a mortgage. Those barriers reinforce the adage that “it takes money to make money,” and keep a lot of low- and middle-income people out of the real estate market. Here's a solution.
Start with a duplex and live in one side
There are many programs to help the average person get around those barriers to homeownership. One of the best is FHA lending. FHA requires a much lower down payment (less than 5 percent) and will count 75 percent of your future rental income from the other unit toward qualifying for the loan (biggerpockets.com/blog/2015-03-04-how-to-use-future-rental-income-to-qualify-for-duplex-loan) – but FHA loans are only available for owner-occupied properties. If you buy a duplex and live in one side, the property will qualify as “owner-occupied,” and the world of FHA lending will open up for you.
A duplex has many hidden advantages
Besides making an FHA loan accessible, there are several reasons why an owner-occupied duplex makes a perfect gateway for a new investor. Duplexes are often priced similarly to single-family properties, but come with the added advantage of an income-producing unit that could pay your mortgage. Beginning with a single rental unit in this way also helps you learn the ropes of property management.
Pay yourself rent
Set up a separate bank account for the building so you can track its income and expenses. You may be tempted to enjoy the rent-free lifestyle, but it's better to pay rent into that account as if you were a tenant. You were going to have to pay rent somewhere. If your mortgage payment and expenses are $1500 a month and you have $1000 income from the other side, you won't be accumulating any cash in the account. But if you also pay $1,000 rent into the account each month, you'll be accumulating $500 a month, or $6,000 in one year.
Keep saving for the next property
Meanwhile, continue to put as much as you can afford into savings. Combining your personal savings with the excess cash flow from your duplex will get you into your next property quickly. If you add $500 a month of your own savings to the example above, you'll accumulate $12,000 each year toward the down payment on your next investment unit.
Live in the house for two years
When you qualify for an owner-occupied loan, you need to stay in the house for at least one year or else you're committing fraud. But many lenders won't let you count the income from a property toward qualifying for your next loan until you have two years of landlord experience with that house, so you might as well stay. After two years, you can move out, rent both sides, and buy your next unit. Alternatively, if you have 25-30 percent equity in the home you would be able to count the income without the two years’ experience.
The 25 percent rule
Note that most lenders will only count 75 percent of the revenue from your rental property, to allow for expenses and vacancies. In the example above, the income from the duplex is $2,000 a month when both sides are rented out. But the lender is only going to count 75 percent of that revenue, or $1500 a month, against the expenses. If your costs are also $1500 a month, they will credit $0 of monthly income for that investment. You need revenues of 25 percent more than your mortgage so the house doesn't count against you when you're applying for the next loan.
The low down payment and relatively easy qualifications of an FHA loan make this financing a perfect match for a beginning investor. You can live in one side of the property, pay yourself rent, and quickly accumulate the cash you'll need for your next property. Meanwhile, you'll be gaining valuable first-hand experience in real estate investing and property management.
Benefits and Drawbacks to Managing Rental Property
With rental rates seeing an exponential increase around the world (especially in urbanized areas), many property owners are looking to invest in the rental market by either purchasing a rental property or renting out their own homes. While being a landlord can prove a lucrative business, there are a few factors to bear in mind before entering the world of renting.
There are some excellent benefits to owning and managing a rental portfolio.
Provided you can secure a tenant, owning a rental property can be a great way to ensure a stable monthly income. You can then use this income to pay off your mortgage on the property; if there is none, then the rental income is almost entirely profit (after paying for taxes, insurance, etc.).
Owning a rental property can be used as a great alternative to selling a home, especially if that home is no longer your primary residence. Turning such properties into rentals mean that they continue to work for you while continuing to appreciate in value. Once the value of the home reaches a level where you are comfortable to sell, or you simply want to move on from the property, you will then get to enjoy the higher selling price.
Since being a landlord is similar to running a business, you will be able to write off a large variety of expenses against the rental income you receive, lowering your tax obligation at the time you file your tax returns. Mortgage interest, repairs, travel, legal and accounting fees, and insurance all are costs that you usually can write off against rental income.
Despite the many wonderful benefits of owning and managing rental properties, there are also some drawbacks to consider, such as:
Tenants can be hit or miss
Trying to find a dependable tenant can sometimes be a bit of a crap-shoot. No matter how many background checks, interview questions, or reference checks you do, some bad apples are bound to slip through the cracks. If you do wind up with a bad tenant, it can be a thoroughly unpleasant experience; unpaid rent, damage to the property, and general miscommunication can result in costly repairs and loss of future rental income.
Investing in property has a high barrier to entry
If you are thinking of purchasing a rental property for an investment, there is a high barrier to entry. To enter the rental market, you will need considerable up-front capital in the form of a down payment towards a mortgage. You will also need to budget money for repairs, maintenance, and potential unpaid rent.
Being a landlord can be time-consuming
Being a landlord is not a hands-off affair. If you are directly managing the property, you will need to be available to your tenants to resolve any issues with the property or the rental agreement. You must also be prepared to act quickly if or when something does go wrong. You will need to set aside time to do your due diligence on potential tenants, conducting open homes, interviews, background checks and the like. It is possible to work with a management company to deal with these issues on your behalf, but there will, of course, be an additional cost for such a service.
Like all investments, there are benefits and drawbacks to owning a rental property. Whether or not you should enter that market depends entirely on your circumstances, and the amount of time and effort you are willing to invest in being a landlord. However, if you decide that owning and managing rental properties might work for you, it can certainly be highly lucrative.
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