Real estate is one of the biggest purchases most people will make in their lifetime. A home or other type of primary residence often becomes the most valuable asset that most people will acquire. It often becomes a source of income for retirement if they downsize or move to a less expensive area, or the largest source of inheritance they pass onto other generations.
But for savvy investors, real estate in the form of rental properties can also be a significant source of income they can use to pay down their primary residence and/or use to fund their retirement savings. There are a number of reasons why rental properties are such good investments, including …
• Appreciation: Over time, most properties will appreciate in value, even with little to no upgrades.
• Cash Flow: Rental properties can generate positive cash flow on a monthly basis. As long as your rental income is greater than your expenses, you will have added income flowing in each month.
• Tax Benefits: In addition to the income, rental properties can be the source of large tax deductions as well. These include property taxes, maintenance repairs and insurance, to name a few.
• Depreciation: What’s more, the government allows you to write off losses according to a depreciation schedule, even if your property is actually increasing in value.
• Leverage: You don’t have to come up with the total cost of a property in order to purchase it. Just like when you bought your primary residence, you can use a mortgage to finance a rental property. What your mortgage company lends you is what’s considered your leverage.
• Mortgage Payments: Factored into your rental property costs will be your monthly mortgage payment, which means your tenants will be paying down your mortgage for you, while you earn cold-hard cash in your pocket in the meantime. This increases your equity in your asset while you earn positive cash flow.
Now that you know some of the benefits of owning a rental property, you might be ready to jump headfirst into investing. What you need to recognize, though, is there are significant costs associated with purchasing and operating a rental property. In fact, these upfront and ongoing costs are the main barrier to entry for most potential real estate investors.
Let’s examine the most common costs so you can better see how much money you would need to buy a rental property. To make things simpler, we’ll be using a $100,000 home as a baseline for costs.
A Down Payment of At Least 20%
The beauty of purchasing a rental property is you don’t have to fund the entire investment upfront. As we mentioned above, you can use the power of leverage to use a mortgage to fund the majority of the purchase price of your income property. That being said, there are significant upfront costs you will incur to do so, with the largest of these being your down payment.
When you purchased your primary residence, you were most likely offered a number of options to finance the purchase through a mortgage, depending on your financial situation at the time. These could have included a conventional loan, an FHA loan, a USDA loan or even a VA loan, to name a few.
Each of these mortgages come with different financial qualification standards, and each have different down payment requirements. It’s possible, for example, that you made a down payment of only 3.5 percent of your primary residence’s total purchase price, if you went with an FHA loan.
Since your rental property will most likely be the second home you purchase, and probably even your second mortgage, a lender will often require you to make a down payment of at least 20 percent. Some lenders may even require a 25 percent down payment, depending on your financial situation and how many mortgages you have.
A 20 percent down payment is a significant amount of cash for most individuals, even if you’re purchasing a relatively inexpensive house. A 20 percent down payment on a $100,000 home will be $20,000.
Closing Costs of 3-5%
In addition to the down payment, you’ll be responsible for other costs associated with the acquisition of the property. These are generally referred to as closing costs and will including things such as:
• Upfront interest and insurance on the property
• Appraisal fees
• Recording and origination fees for the mortgage and deed
• Tax certificates
In all, you can expect that you’ll pay about 3-5 percent of the home’s total purchase price in closing costs. For the same $100,000 home, that’s another $3,000 to $5,000 you’ll have to come up with at closing.
One way to reduce or eliminate this would be to negotiate closing costs into the purchase price of the home so the seller of the property pays all or a portion of them instead of you. That’s never a guarantee, though, so ensure you’re planning to pay for the closing costs yourself.
Repair or Upgrade Costs of 10% (Or More)
It’s likely that the home you are purchasing as a rental property will require at least some repairs and/or upgrades in order to get it in tip-top shape to show to potential tenants. How much it will cost to make these repairs and/or upgrades will obviously depend on the condition of the home you are purchasing.
That being said, you can almost always assume your property will require a few thousand dollars to get it up to snuff. It’s also a good idea to have a few thousand more dollars on hand for unseen repairs that you’ll discover need to be made when you get into the home and start digging around.
At the very least, you should consider setting aside 10 percent of the home’s purchase price to make these repairs and be left with a good chunk of change in reserves in case more repairs are necessary. For this $100,000 home, this equates to another $10,000.
Monthly Carrying Costs of Roughly $650
There will be a period of time between when you close on the home and when a tenant will begin leasing your property. During that time, you’ll be doing repairs to the home (or having a contractor do it for you), getting the property ready to show, listing your property for rent, showing your property to potential tenants and then finalizing lease details.
In the meantime, you will be paying monthly carrying costs in the form of your mortgage principal and interest, home insurance and property taxes. For this example, we’ll assume you purchased a home that meets the average in terms of home insurance and property taxes for the United States, and you qualified for the lowest current monthly interest rate.
In that situation, your monthly carrying costs would be $634.79, with this breakdown:
• Monthly principal and interest (3.92 percent): $378.21
• Monthly property taxes ($2,279 annual average): $189.92
• Monthly hazard insurance ($800 annually): $66.67
Your specific carrying costs will vary based on your actual interest rate, property tax amount and hazard insurance amount, but this at least gives you a baseline from which to work. How many months you’ll pay these carrying costs will also depend, of course, on how long it takes from closing day to day one of your tenant’s lease.
A safe assumption is that it will take three to five months to get your property fixed up and rented successfully. In this scenario, that would equate to anywhere from $1,904.37 to $3,173.95 in total carrying costs.
What’s the Total Cost of Your Investment?
Now, all you have to do is add up all of your costs to figure out how much money you would need to buy a rental property. Again, we’re assuming that:
• The purchase price of the property was $100,000.
• You made a down payment of 20 percent.
• You paid for all of the closing costs.
• You set aside 10 percent for repairs/upgrades and emergency funds.
• You paid carrying costs for three to five months.
In this scenario, you would need roughly $35,000 to $39,000 to buy a rental property, broken down this way:
• Down payment: $20,000
• Closing costs: $3,000-$5,000
• Repairs/upgrades: $10,000
• Carrying costs: $1,900-$3,700
This can serve as a basic guideline for you when you’re deciding whether to purchase a home as a rental investment property. To estimate how much it will cost you upfront to purchase a home for this purpose, simply plug in the final purchase price, closing costs and monthly mortgage, taxes and insurance payments into the formulas above.
HomeUnion® Can Help You Find the Right Property
Once you’ve decided to invest in real estate, HomeUnion® can help you find the perfect home to be your income-generating rental property. Partnering with HomeUnion® allows you to invest in real estate as easily as investing in the stock market.
HomeUnion® allows you to invest in properties in hot markets around the country, not just in the market that’s closest to where you live. And by offering proprietary, proven research tools, HomeUnion® puts the power of knowledge in your hands.
Visit us online or call us at (866) 250-5610 to find out how you can start earning income through a rental property today.