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I've been thinking about buying a second home and renting it out as an investment; a way to save and invest money for retirement.

I know that many folks are putting money away in stocks and mutual funds, and I wanted to consider alternatives.

The biggest advantage I can think of is that if I purchase a home as an investment, the home has strong intrinsic value; barring a cataclysmic economic crash, it will always be valuable (though the value may go up and down).

The basic idea is to save up a 20% down payment on a property and take out a mortgage, making most of the payments from rental income.

I am aware that this is not without risk. The property can decline in value. A tenant may damage the property or fail to pay rent.

On the other hand, in today's US economy, rental payments are close to mortgage payments, and once the mortgage payments are done, the rental payments can go straight into my pocket. Furthermore, while inflation is likely to raise the rental payments, the mortgage payments will stay the same.

What are the most important facts to keep in mind as I consider this?

JohnFx
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Vivian River
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    You might consider looking into Real Estate Investment Trusts (REITs). It is a way to gain exposure to real estate without all the hassle of tenants. – JohnFx Dec 16 '14 at 18:22
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    @JohnFx - Thought we had a good post that had a pretty exhaustive list of expenses to consider. Can't find just yet. – JTP - Apologise to Monica Dec 16 '14 at 18:30
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    "once the mortgage payments are done" -- how many years are you willing to wait before seeing income from this investment, and how much profit might it be making if invested elsewhere? Rental makes more sense if you already own the home you want to rent out than if you're buying it to rent. See also past answers regarding the difficulty of finding a suitable rental property (good condition, in neighborhood with high rental demand), keeping it filled, keeping it maintained (which is more than fixing tenant mistakes), etc. – keshlam Dec 16 '14 at 18:31
  • I think your proposal has many merrits and with some good planning, reseach and risk management your on a potential winning strategy - especially when most are telling you to not do it. "Be greedy when others are fearful and be fearful when others are greedy". – Victor Dec 16 '14 at 21:31
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    Another thing to keep in mind is the mortgage interest rate on an investment property will be higher than your home mortgage, and require a larger down payment (20%-25%), and are generally harder to qualify for. – KeithB Dec 16 '14 at 21:52
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    possible duplicate of What's the catch in investing in real estate for rent? – chx Dec 19 '14 at 01:25

5 Answers5

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Here would be the big two you don't mention:

  1. Time - How much of your own time are you prepared to commit to this? Are you going to find tenants, handle calls if something breaks down, and other possible miscellaneous issues that may arise with the property? Are you prepared to spend money on possible renovations and other maintenance on the property that may occur from time to time?

  2. Financial costs - You don't mention anything about insurance or taxes, as in property taxes since most municipalities need funds that would come from the owner of the home, that would be a couple of other costs to note in having real estate holdings as if something big happens are you expecting a government bailout automatically? If you chose to use a property management company for dealing with most issues then be aware of how much cash flow could be impacted here. Are you prepared to have an account to properly do the books for your company that will hold the property or would you be doing this as an individual without any corporate structure? Do you have lease agreements printed up or would you need someone to provide these for you?

JB King
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    This could be the start of a decent list. Thought we had one, but not seeing it. Insurance, repairs, maintenance. Repairs divide to minor, such as a leaky faucet, to the major, roof replacement, heating system, etc. Maintenance includes snow, landscape, etc. Rule of thumb is that all expenses (not including mortgage) will eat up half the rent. – JTP - Apologise to Monica Dec 16 '14 at 18:38
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    @JoeTaxpayer - I own a number of investment properties (long term) in Australia and my maintenance and other costs (excluding mortgage) are no where near half the rent. How often would you replace a roof? We did a refurbish on our live in home 7 years ago for about $3000 and it is still looking like a brand new roof. Also interest rates in Australia are higher than those in the USA and all our investment properties were positively geared about 3 years after we bought them. I think your costs may be overly estimated as not everything will go wrong at once. – Victor Dec 16 '14 at 21:24
  • You hope that not everything will go wrong at once. – Vivian River Dec 16 '14 at 23:25
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    @Victor - the 50% includes property tax, insurance, etc. I didn't make the number up, the number assumes an average over time. I just finished a rehab on a 3 family house, so the clock just started on the roof, bathrooms and all appliances. I hope to run below the 50% number for the first 5-7 years. Happy to report my ratios once the place is rented out. – JTP - Apologise to Monica Dec 17 '14 at 00:13
  • @RiceFlourCookies - I have been a property investor for over 23 years and I can tell you from 23 years experience that things do not all happen at once (even though you sometimes feel they do just because 2 or 3 things happen in a short period of time). In those 23 years I would say on average we have had 2 to 3 repairs per property per year. If you can't handle 2 to 3 repairs every 52 weeks then property investing may not be for you. – Victor Dec 17 '14 at 06:11
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    I registered for this site just so I could upvote this answer. As someone who made just such an investment about 8 years ago, I wish I'd understood the (not so) hidden costs of an investment property. You should also add having an emergency fund for the property--similar to the emergency/buffer fund for unexpected personal emergencies. And you can't overstate the time involved as well. Example: this weekend I was about to go Xmas shopping, when the furnace gave out. I spent the afternoon dealing with it instead of buying presents. And that was a near painless resolution (minor issue). – cr0m Dec 17 '14 at 21:00
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What are the most important facts to keep in mind as I consider this?

IMHO, the most important consideration to keep in mind is - do you really want to be in the landlord business, and if so, how much experience do you have in this business?

  • Investments don't call you are 2:00 AM complaining about the toilet
  • Investments don't trash things when skipping out
  • Investments don't potentially sit empty for months at a time
  • Investments don't have 'tenants rights'
  • Investments never need to be evicted
Joe Strazzere
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    To be fair, you can always hire someone to manage it for you. – Joe Dec 16 '14 at 20:08
  • I actually meant a management company, not an employee, sorry! Of course adding employment into the mix would be a mess. – Joe Dec 16 '14 at 20:31
  • How many people really do all of that themselves? I've looked at this semi-seriously for the future; I've never once even considered doing the management side myself. Yes, you lose another 10%-ish going through a management company, but then it's your management company's responsibility to find tenants, and your management company's responsibility to be called at 2AM about a toilet. (I've seen the benefits of a good management company first-hand from the other side, having rented a condo that was being managed by a good mangement company, before I bought my current place.) – neminem Dec 16 '14 at 23:07
  • I have heard good things about management companies. I'm told that another advantage to using a management company is that when that toilet does break at 2 AM, not only do they answer the call, but they will save you money via their relationships with professionals they work with. – Vivian River Dec 17 '14 at 02:22
  • @JoeStrazzere - in 23 years as a property investor of multiple properties I have never been called at 2am (nor any other time between 9pm to 8am, I have never had a tenant trashing things or skipping out, and the longest time I have had a property vacant is about 6 weeks (usually rented out in 1 to 3 weeks and that is being very strict and selective). The secret is in choosing the right tenants in the first place. – Victor Dec 17 '14 at 06:19
  • @RiceFlourCookies - good luck in your new business venture. – Joe Strazzere Dec 17 '14 at 11:26
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    @Victor, you've been lucky and/or must live in an area where rentals are scarce. Probably both. Even the normal wear and tear on a property (not to mention damage) means that I normally expect at least a month of vacancy after a move out, and then normally another month while people apply, interview, are rejected, etc. YMMV, my property has three rental units. – cr0m Dec 17 '14 at 21:04
  • @cr0m - yes it is always luck when someone can do something better than you! I was lucky when I bought properties when everyone was saying don't buy property your crazy if you do, or maybe I saw opportunity whilst most others saw fear. So I must be having so much luck that it has continued for over 23 years and 17 properties over that time. Maybe I am just more experienced than you and have developed a better way of doing things. – Victor Dec 17 '14 at 22:32
  • @Victor, I apologize for not giving you more credit for being good at what you do, that was not my intention. I would love to hear about your technique for avoiding tenants who damage your properties and leave without paying rent. – cr0m Dec 18 '14 at 22:43
  • @cr0m - this is probably not the place for a lengthy discussion on the matter, but if you asked it as a question I would be happy to go through the criteria and process we use. – Victor Dec 18 '14 at 22:47
  • I think an answer here would be on topic--certainly preventing that sort of thing is something to keep in mind, no? – cr0m Dec 18 '14 at 23:11
  • @cr0m - I don't think an answer here on selecting tenants would be appropriate, however I have included abbreviated details in this Answer to this Question and its comments. – Victor Dec 21 '14 at 04:48
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First off, I would label this as speculation, not investing. There are many variables that you don't seem to be considering, and putting down such a small amount opens you to a wide variety of risks. Not having an "emergency fund" for the rental increases that risk greatly. (I assume that you would not have an emergency fund based upon "The basic idea is to save up a 20% down payment on a property and take out a mortgage".)

This type of speculation lent a hand in the housing bubble.

Is your home paid off? If not you can reduce your personal risk (by owning your home), and have a pretty safe investment in real estate. Mission accomplished.

My hope for you would be that you are also putting money in the market. Historically it has performed quite well while always having its share of "chicken littles".

Pete B.
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  • How is investing long term in an investment property speculation? – Victor Dec 16 '14 at 21:32
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    No kidding on unexpected expenses. If the A/C goes out in a rental property and needs a $6,500 replacement. If it is your own house you can sweat it out and live with fans while you save up money to pay for the repair. If you have tenants you need to pay to have it fixed immediately. Sometimes you may even have to pay repairmen overtime to get an issue fixed promptly on weekends/nights. – JohnFx Dec 16 '14 at 22:27
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    @JohnFx - are you kidding, I have installed A/C in rental properties at a range of $2000 to $2500. And installing a new A/C is not an emergency - most reasonable tenants understand that some repairs may take a couple of days to organise. Like I said over exaggeration. – Victor Dec 16 '14 at 22:38
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    In Texas we take our AC seriously! :) – JohnFx Dec 16 '14 at 23:46
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    @Victor if you have $x and buy a property to rent it out, then it is an investment. If you borrow $x to buy a property to rent it out, as the OP is planning, then the combined deal (mortgage+purchase) is speculation and has rather different risks due to the leverage. – Peteris Dec 18 '14 at 15:17
  • @Peteris - you are kidding right - you clearly don't understand the definition of speculation. Firstly the OP plans to put a sizable downpayment, secondly the OP plans to hold the property long term. If the OP was speculating in property firstly the downpayment and holding timeframe would be as small and short as possible - that is flipping the property as one example. Just because someone borrows part of the funds to buy an investment does not make it speculation. – Victor Dec 18 '14 at 21:05
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Started to post this as a comment, but I think it's actually a legitimate answer:

Running a rental property is neither speculation nor investment, but a business, just as if you were renting cars or tools or anything else. That puts it in an entirely different category.

The property may gain or lose value, but you don't know which or how much until you're ready to terminate the business... so, like your own house, it really isn't a liquid asset; it's closer to being inventory. Meanwhile, like inventory, you need to "restock" it on a fairly regular basis by maintaining it, finding tenants, and so on. And how much it returns depends strongly on how much effort you put into it in terms of selecting the right location and product in the first place, and in how you market yourself against all the other businesses offering near-equivalent product, and how you differentiate the product, and so on.

I think approaching it from that angle -- deciding whether you really want to be a business owner or keep all your money in more abstract investments, then deciding what businesses are interesting to you and running the numbers to see what they're likely to return as income, THEN making up your mind whether real estate is the winner from that group -- is likely to produce better decisions. Among other things, it helps you remember to focus on ALL the costs of the business.

When doing the math, don't forget that income from the business is taxed at income rates, not investment rates. And don't forget that you're making a bet on the future of that neighborhood as well as the future of that house; changes in demographics or housing stock or business climate could all affect what rents you can charge as well as the value of the property, and not necessarily in the same direction.

It may absolutely be the right place to put some of your money. It may not. Explore all the possible outcomes before making the bet, and decide whether you're willing to do the work needed to influence which ones are more likely.

keshlam
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  • Yes property investing should be treated as a business, however many people who own one or maybe two investment properties don't treat it as a business. They usually treat it as a long term investment. Others who buy renovate and then sell for hopefully a profit in quick succession may treat it as a busness too. The difference is whether you have a plan and processes in place to whether it is a business or not. So buying rental properties can be treated as investing, speculation or as a business - it largely depends on your timeframe and whether you have a plan and proccesses in place. – Victor Dec 21 '14 at 04:39
  • If you don't have a plan and process, I'd drop it all the way down to gambling, and gambling badly. But that's my own biases. – keshlam Dec 21 '14 at 04:41
  • Most people who buy and hold investments do it without having a plan. – Victor Dec 21 '14 at 05:04
  • @Victor: Once again, we agree that we disagree. Maybe I'm just not cynical enough. – keshlam Dec 21 '14 at 05:10
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Real estate is not an investment but pure speculation. Rental income may make it look like an investment but if you ask some experienced investor you would be told to stay away from real estate unless it is for your own use.

If you believe otherwise then please read on :

Another strong reason not to buy real estate right now is the low interest rates. You should be selling real estate when the interest rates are so low not buying it. You buy real estate when the interest rate cycle peaks like you would see in Russia in months to come with 17% central bank rate right now and if it goes up a little more that is when it is time to start looking for a property in Russia. This thread sums it up nicely.

Parminder Singh Chahal
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  • I'm having trouble understanding the logic here. Why would someone prefer to enter into a note with 17% interest as opposed to a note with 4-5% interest? ..selling at low interest makes sense because that should increase demand. (i.e. More people will qualify, therefore selling should be easy.) But I can't understand preferring to buy at high interest. I'm not mocking you. This is a legit question as neither this post nor your other thread really go into "why" this should make sense to me. – elrobis Dec 19 '14 at 16:02
  • That 17% interest rate has to stay up for some time for the housing market to see a downturn. When interest rates stay up for an extended period of time a lot of buyers that could only afford to pay their mortgage payments because of the lower interest rates which meant low monthly payments will be forced out of the market either due to repossession or they sell their property as they cannot afford the monthly payments. It is a lengthy process and higher or lower interest rates have to stay that way long enough to have an impact for you to benefit from it. – Parminder Singh Chahal Dec 19 '14 at 16:15
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    Higher interest rates translates into lesser number of buyers and lower prices as a result. This is just one factor but is a major one. – Parminder Singh Chahal Dec 19 '14 at 16:31
  • Ok ^ makes sense to me, but still, wouldn't you lose to interest what you would otherwise lose to a higher price? Is the thinking that you buy at high interest then hope to ReFi later at low interset? ..or buy outright? The former sounds like risky speculation, and the latter sounds like an option available only to the rich. – elrobis Dec 19 '14 at 16:35
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    This is why I posted that link. As explained there you get a floating rate loan when interest rates are at peak. Interest rates have cycles but lengths can varry. When you buy at peak interest rates your interest rate keeps coming down as centeral bank reduces and you end up with a property which you bought at lower price and paid higher interest rate for some time but the pace at which house prices increase on a reducing interest rate regime is far greater as opposed to the opposite. Buying outright is always a better option. – Parminder Singh Chahal Dec 19 '14 at 16:43
  • Having said all the above, I still maintain that real estate is pure speculation just like Gold and should only be bought for your own consumption. – Parminder Singh Chahal Dec 19 '14 at 16:46
  • Ok I'm starting to understand. One more. What about a foreclosure, which represents immediate equity. Is that not an all-around solid deal in a low-interest scenario? – elrobis Dec 19 '14 at 16:50
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    If one has good knowledge and buys at an auction then yes but properties that are labeled as foreclosure and are put on market by estate agents still cost a lot. They are foreclosure only name sake. Auctions are where you should be looking at and that too smaller units as that's where demand will build up as interest rates go up. – Parminder Singh Chahal Dec 19 '14 at 16:59
  • You don't just buy because interest rates have gone up, you buy when you see demand has dried up due to interest rates going up - you will see properties remaining on the market for lengthy periods of time, and sellers dropping prices in order to get a sale. If you see the majority of auctions being passed-in and only one or 2 bidders at most at auctions, then this is the time to buy. You will find that interest rates will start dropping not long after to try and stimulate both the property market and the economy. If you have a plan, property investing is not speculation but a business. – Victor Dec 21 '14 at 04:31