When Arlington resident Jesse Shapiro wanted to diversify his investment portfolio with real estate, he recognized quickly that he didn’t want to buy a place in the Washington area.
“Housing costs in this region are prohibitive, and I didn’t want to risk buying something that’s 10 times the median price of a home in other parts of the country,” Shapiro says. “At the same time, it can be difficult to invest long-distance if you don’t know enough about other real estate markets.”
With the help of Roofstock, an online real estate investment platform, Shapiro and his wife purchased a single-family house in a suburb of Raleigh, N.C., in January.
The decision to buy locally or long distance is one of many to make if you want to join the world of real estate investors. The first essential decision is to determine whether you want to buy and flip a property or invest for long-term appreciation and cash flow from rents.
According to the National Association of Realtors’ 2017 Investment and Vacation Home Buyers Survey, investment home purchases rose 4.5 percent in 2016 to 1.14 million, up from 1.09 million in 2015. The survey found that most individual investors bought property to generate income in recognition of the demand for single-family house rentals.
“If you want to invest in real estate, you need to know your strategy,” says Rick Sharga, chief marketing officer of Ten-X, an online real estate marketplace based in Irvine, Calif., that owns Auction.com. “Most people focus on buying property cheaply, but if you plan to become a landlord, then price is less of an issue. In that case, cash flow is most important, and you want to buy something that will be ready to rent quickly and for more than your costs.”
There are 19 million single-family house rentals in the United States, according to “Landlord Land,” a white paper produced in February by Irvine, Calif.-based ATTOM Data Solutions and Reno, Nev.-based Clear Capital. The vast majority of the rentals — 79 percent — are owned by small-time landlords with only one or two properties.
Invest locally or long-distance
Everyone is naturally more comfortable investing in a local market, but sometimes you can’t get a reasonable return on your investment, says Greg Rand, chief executive of OwnAmerica, a Charlotte-based brokerage for investors of single-family rental homes.
“The yield is what matters with real estate investing, and if the property prices are too high or the rent isn’t high enough, you can’t get a good return,” Rand says. “For many people, that means investing in a place that they are semi-comfortable with, such as a place where they have vacationed or have some kind of connection.”
It’s essential to understand the characteristics of any market before you invest, such as the trends for job growth and population growth, Rand says.
“Historically, 70 percent of people buy an investment property within an hour of their home because it’s convenient and they know the area,” says Gary Beasley, chief executive of Roofstock in Oakland, Calif. “That’s fine if you live in a market with good rental demand, and there’s no danger of a recession. But it makes more sense to diversify with an investment in another market, just in case job growth declines and rental demand drops at some point.”
Roofstock recently developed a “Neighborhood Ratings” index that compiles information on a variety of factors such as income, crime, schools, property values and the nature of the housing stock to help investors compare neighborhoods when buying remotely.
“We sell single-family homes that are tenant-occupied and provide investors with 3-D tours, a home inspection and demographic projections that help break down the geographic barrier to investing,” Beasley says. “We have advisers in different markets, as well as data to make it easier for investors.”
A real estate agent can help you evaluate the market and will also know about whether rents are going up or down, Sharga says.
Beasley says investors are particularly interested in buying in less costly markets, such as Florida, Atlanta, Texas, North Carolina and Las Vegas, especially when they live in high-cost housing markets.
“When you invest in rental property, it’s best to start modestly with a property on the fringes of development that’s not super-expensive but is in the path of progress,” says Dave Hawkins, managing broker of McEnearney Associates in Alexandria. Hawkins purchased two townhouses as an investment when he was in his 30s with the goal of using the properties to pay for college tuition for his children.
“We bought places where we could drive, so I could handle the property management,” Hawkins says. “It’s important to talk to a Realtor who can give you advice about the neighborhood and what could impact it, such as businesses moving in or out and plans for public transportation.”
Crunching the numbers
Although some investors pay cash for their property, many finance the purchase.
Beasley says the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) guidelines require a 20 percent down payment for an investment loan. Typically, the interest rate is slightly higher on investment loans, such as 4.5 percent when owner-occupied loans are at 4.0 percent.
“Roofstock provided the underwriting information I needed to invest long-distance, including market analysis, appraisals and home-inspection reports,” says Shapiro, who picked his investment property by looking at a variety of factors, such as the estimated value if he would need to sell within five years, the forecast for the rent and information on the property’s tenant.
“When I reviewed the return on investment I included the cost of financing the purchase,” says Shapiro, who made a 25 percent down payment on the approximately $100,000 property.
Shapiro shopped for a loan and ultimately chose his own lender, although Roofstock also provides investors with a list of potential lenders.
Rand says investors must do a costbenefit analysis, starting with an estimate of the annual rent, minus 5 percent for anticipated vacancies. They should then subtract all expenses, such as taxes, insurance, homeowners association dues, property management fees and maintenance costs, estimated at 10 percent of the gross rent to generate your net operating income.
The return on your investment is calculated by dividing your net operating income by your mortgage payment. For example, if you purchase a $100,000 property and your profit is $6,000, then your return on your investment is 6 percent. If your property goes up in value, then your return on your investment is even higher.
Hawkins says that your financial evaluation should also include the property condition and estimate of when you may need to replace appliances, heating or plumbing systems or the roof.
If you’re a local landlord, you can manage your property yourself if you have the time and the skills to maintain it. Alternatively, if you have a roster of good contractors, you can avoid the fee for a property management company. However, you also then need to screen your own tenants and handle their rent payments.
“You need to have the right attitude to be a landlord,” Hawkins says. “It can be a hassle and inconvenient, so if you want to avoid that, you should hire a property management company.”
Most long-distance investors need a property-management company to handle tenant issues and maintenance. Typically, property management companies charge about 8 percent of the rent, Rand says.
He says technology has made it easier for people to invest long-distance, because there are national property management companies with branches in multiple markets that can connect automatically with tenants and owners.
Roofstock provides investors with a list of two or three property managers in the market where they are purchasing a home, including their fees. The chosen property manager then coordinates directly with the investor.
Although real estate investing can be profitable, there are four main pitfalls investors should avoid:
● Being over-leveraged: If your mortgage is too high and the rent barely covers your expenses, you could lose money if your tenant doesn't pay one month. Rand recommends keeping 10 percent of the gross annual rent in a separate account for maintenance and reserves. "Don't spend your last dollar on a real estate investment," he says.
Beasley recommends keeping 1 percent of the property value in a reserve account and adding to that account periodically.
● Frequent vacancies: Turnover is the fastest way to fail, Rand says. Landlords need to screen their tenants to make sure they have the means to pay the rent and good credit. "One of the biggest risks is in the length of time your rental stays vacant," Sharga says.
● Chasing too-high returns: Rand says you should expect returns in the mid-single digits. "This is a get rich slowly proposition," he says. "If you're trying to get quicker returns, you're likely to buy a lower priced property and have more turnover. It's better to buy a quality home in an area with good schools where people will stay longer."
● Thinking short-term: Beasley says investors need to look at rental property as a long-term investment that can build wealth over time. "You're buying through different real estate cycles, but if you don't have too much debt, you don't need to worry about selling even if the property value declines," says Beasley. "Keep in mind that even if home values drop, rents usually don't. This can be a good hedge in the event of another real estate downturn."
Insuring your property
Rental properties require a landlord insurance policy, also known as a dwelling policy, which is typically a little costlier than a traditional homeowner’s insurance policy, says Laura Adams, a senior insurance analyst for InsuranceQuotes.com in Austin.
“Insurance data shows that rental properties have more claims and higher dollar claims than primary residences,” Adams says.
A typical landlord policy covers physical damage to the property for a covered disaster, such as a fire or a hailstorm, along with personal property belonging to the owner, such as a lawn mower or furniture.
You also need to find out whether you need flood insurance and whether insurance rates are particularly high in the area where you intend to invest, such as along the coast of Florida, because high insurance premiums will cut into your profit.
“Liability coverage is included in a landlord policy because of the potential of being sued if a tenant or a guest is injured on the property,” Adams says. “Landlords may want to look at all of their assets that could be at financial risk and purchase an umbrella policy for added coverage.”
Landlords can require tenants to buy renter’s insurance to cover the tenant’s personal property and to provide their own liability protection.
Adams suggests that another option could be to place the property in a limited liability business structure to increase your personal protection.
“If you place your investment property in a business structure, then the only assets at risk are those within the business, not your other assets,” she says.
Legal and tax issues
Whether you are investing in property long-distance or locally, it’s important to make sure you are complying with local laws and with the rules of a homeowners association. In the Washington area, Virginia is considered to have more landlord-friendly laws, whereas the District and Maryland have more tenant-friendly laws. For example, Hawkins points out, all tenants in the District have the first right of refusal if you want to sell your property, which could delay the sale.
“If you have a local lawyer and are investing long-distance, you can ask your lawyer for a referral to someone familiar with local laws,” says Jeff Bell, chief executive of LegalShield in Ada, Okla., a company that provides legal services in every state for a monthly fee.
A real estate agent will know whether a market is landlord- or tenant-friendly, says Sharga, who adds that it might be best to invest someplace else if your area is unfriendly to landlords.
“Your safest bet is to talk to a local real estate attorney,” Sharga says. “But you also need to make sure that the homeowners association allows rentals. If you’re buying a condo, make sure that you know what percentage of the units can be rented, and how many are currently rented. The last thing you want is to buy an investment property that you can’t rent.”
Bell says that legal issues that can plague landlords include a difficult tenant who pays late or not at all.
“A lawyer can help you determine the best way to formally communicate issues about nonpayment to prevent the necessity of an eviction and to be compliant with local laws,” Bell says. “For example, in some jurisdictions, you can take late fees out of your tenant’s security deposit, but in others that would be illegal.”
Other legal issues include whether sublets are allowed and whether you can collect any rent if a tenant breaks a lease, Bell says.
“It’s important to make sure your rental agreement is written appropriately with everything spelled out, especially about the condition of the property and the return of a security deposit,” Bell says.
Consult a tax adviser to assist you with the nuances of tax deductions for an investment property.
“When you’re researching where to invest, you should also ask whether there are different property tax rates for homeowners versus investors,” Rand says.
It’s tempting to do a quick estimate of how much it costs to buy a property and how much you can charge for rent. But here are other expenses to include in your calculation:
● Financing costs including a down payment, closing costs, and mortgage principal and interest
● Landlord insurance
● Property taxes
● Homeowners association dues
● Ongoing maintenance
● Periods of vacancies
● Property management fees
● Be prepared with savings for a down payment and cash reserves of 1 percent of the property value or 10 percent of the gross rent to cover vacancies and repairs.
● Do your research on the real estate market, including both the purchase market and rental market.
● Talk to local real estate investors or real estate agents who work with investors to understand the market and pricing.
● If the property is part of a condominium or homeowners association, make sure you can rent the property and that you can comply with all association rules.
● Decide whether you have the time and skills or contractors to manage the property yourself, or whether you’d prefer to hire a property management company.
● Buy appropriate insurance to cover the property and your liability.
● Consider establishing an LLC for each investment property for liability protection.
● Carefully screen your tenants or hire someone to screen them to avoid issues with nonpayment of rent or too many vacancies.
● Plan for future repairs and maintenance, especially if you anticipate keeping the property for 20 years or more.