Investing in Residential Properties
Most successful real estate investors got their start by investing in residential real estate. Aspiring commercial investors who’d prefer to learn to walk before they run can find comfort in the residential rental property market. Residential real estate investors purchases single-family homes and lets someone else carry the monthly burden.
Purchasing residential income properties is still considered one of the more lucrative investments available. Not only does it establish a steady monthly cash flow, but long-term appreciation of such properties has been known to finance many an investor’s retirement fund.
Investing in single-family homes is considered one of the best ways to ease your way into the commercial real estate market. The fundamentals of cash flow, tenancy issues and maintenance are essentially the same, but on a much more manageable level for first time investors.
Single-family homes, which recently have averaged higher appreciation than many other types of property investments, can be a great way for an investor to earn a steady monthly income. Buying into a property with up to four units doesn’t usually require special financing and state and local tax codes actually reward home ownership over many other types of investments.
Most property investors start their portfolios with single-family homes for good reason. It offers tax advantages over commercial investments, requires less cash out of pocket, and can be done with conventional financing. It is definitely less daunting to those who aren’t yet experts in commercial ownership.
Investors will learn some basic principles and terminology that are unique to this trade at the residential stage that will carry through their investment careers. So, before venturing out to scout for properties, you’ll want to familiarize yourself with some of the following examples – many of which will carry over to the commercial world should you decide to explore that opportunity in the future.
Gross Income vs. Net Income: Gross income is the amount you expect to bring in each month in rent. Net income is your gross income minus your expenses. Expenses include interest, taxes, insurance, utilities not covered by the renter, maintenance, etc. Principal is generally not considered an expense, but should certainly be accounted for when calculating your cash flow. Net income (also known as net operating income) is the amount available to pay the mortgage, principal and interest before taxes, interest and amortization and after subtracting expenses, including bad debt.
Due Diligence: Even if you don’t know it by name, chances are you’ve practiced this with all of your investments. Performing adequate research is highly recommended with any real estate investment. Unlike many other investments such as stocks or bonds, real estate is not very “liquid”, and undoing a bad investment can be extremely costly in both time and money. Residential property investments, like all other ventures, require due diligence, or researching the history of the investment, the soundness of facts related to it and the feasibility of a profit.
LTV. This means loan to value, and is a term used in financing a property. It is the ratio, expressed as a percentage, of the sum of the mortgages secured by a property compared with the property’s value. A property with a value of $100,000 that has a mortgage of $80,000 has a 80% LTV.
PITI: Short for: principal, interest, taxes and insurance; the four main components of a mortgage if the taxes and insurance are rolled into the payment. This is the formula lenders use to figure out your monthly expenses when they underwrite your loan. For example, on a 30-year, $100,000 loan with an 8 percent interest rate, an insurance plan that costs $300 per year and $1,000 in annual taxes, your PITI would be $842.09.
Positive Cash Flow: What every investor strives for. Simply put, it means that the total income from the property exceeds all of the expenses. This extra income is what retirement plans are made of.
Negative cash flow: This is just what it sounds like. It means that the amount you get in rent is not enough to cover all of your expenses. In order to rent your property in the current market, you’ll need to charge less for rent than the total sum of the monthly expenses.
Vacancy Rates: The rate at which you can expect your property to sit idle. The downside of a single-family home investment is that if it is vacant, the rate is 100 percent. Alternately, if you own four units and one is vacant, your vacancy rate is 25 percent. The upside is that single-family homes have more stable rental rates compared to multi-family units.
When vacancy rates are high, you should expect lower rents than in previous years. If cash flow is of the utmost importance, you may have to loosen some of your restrictions such as allowing pets. On average, residential investors should plan on taking as much as a 10 to 20 percent income reduction to account for vacancy rates and non-payment of rent (which essentially is equivalent to vacancy, collectively called “bad debt”.)
Lenders will look at two main components when considering a residential loan: the investment potential of the real estate and the borrower’s personal credit history. Typically, for an income property, banks will require a 20% down payment plus closing costs. Loan fees vary but average about 1 – 2 percent of the purchase price. You should also be prepared to provide statistics such as local vacancy rates and average rent prices.
Twenty percent down is small change compared to other investments and getting into residential ownership with only a few thousand dollars upfront makes this a feasible venture, especially for the beginning property investor.
As long as you buy into a property with four or less units, the IRS considers your investment non-commercial, which means you’ll take the depreciation over 27.5 years compared to the 39 years for commercial real estate. There are also several deductions that investors can take off their taxes such as repairs, travel expenses, management fees, etc. Although these items may seem like small amounts, they can add up to a decent size deduction. Many property owners neglect to count all of their costs, a mistake that could cost thousands of dollars a year in additional tax payments. You should consult with a tax professional who is well-versed in property ownership taxation in order to ensure you’re not overpaying.
Unless you are extremely knowledgeable about home repair or have the time and inclination to learn, you may want to hire a property management company to handle any repairs your property needs and to collect the monthly rent check. Even if you have the know-how to maintain the property, handling renter’s issues can take a considerable chunk of your time. However, the fee for the service can be costly, ranging up to 10 percent of the monthly rental income. It’s also feasible to start out as your own handyman and rent collector, especially if you start small with one or two-unit properties. Later, when you’re too busy vetting out new investment deals, you can switch to a management firm to handle the daily labor.
A residential lease is an agreement designed to make it clear to your tenant what is expected from them. However, a lease is also a complicated mix of statutory and common laws, which vary by location. Because rental laws are so different, experts recommend using an approved form for your area. There are a few issues that all property owners should address in their leases, including abandonment, alterations, sub-letting, default, criminal activity, landlord access, disclosures, maintenance, parking, payment of rent, security deposit, utilities and surrender of premises, just to name a few. Protecting yourself and your property is the bottom line. Be sure to collect an adequate damage deposit and spend the money to do a credit and background check on your prospective tenants. When in doubt, it is a good idea to consult with a real estate attorney.
Residential property investing requires a lot of research on your part and perhaps takes up enough time in maintenance, marketing and rent collection to become a part-time job. However, investors who choose their properties wisely will likely find that residential housing can offer a substantial profit as well as a chance to build a new career as a property investor.
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