3 Things to Know Before Buying a Rental Property

This article has been updated on 12/10/2014.

In the name of diversification, many will seek to spread their assets across a variety of different investment platforms, and rental properties can be an attractive alternative.

For this purpose, I recently sat down with Forde Britt, a commercial real estate broker with the Nichols Company in Charlotte, NC, who is well versed in many facets of the real estate industry. He is also an owner of rental property in his neighborhood near downtown Charlotte.


At first glance, buying a rental property can seem like an appealing investment opportunity. For example, if someone bought a four bedroom home for $200,000 with a $40,000 down payment, at today's rates, their 30-year mortgage payment would be right around $1,015 a month including taxes and insurance.

Charging a reasonable $450 per bedroom would mean that property could be rented out for $1,800 a month. It's a good rule of thumb to expect an 8% monthly management fee and an estimated 10% loss of income due to vacancy and maintenance expenses. So roughly 20% of that $1,800 will be taken off for expenses -- but all in all, the owner could expect to net almost $475 in his pocket each month.

Even if rent increased by just 1% per year after 30 years, the owner would collect $750,000 in rental payments, and pay a total of $375,000 in mortgage payments. If the value of the house just grew by 1%, the house would be worth almost $270,000 at the end of 30 years.

Provided the owner sold it after 30 years, they would have netted almost 2,100% return on their initial investment of $40,000 over the 30-year period, even after accounting for the 18% costs. That works out to a compounded annual return of roughly 10.7%.

Now, before you click over to Zillow to look for rental properties to buy in your area and run to Wells Fargo to get a mortgage -- it's important to know a 2,100% return over a 30 year time horizon is eye-popping at first glance.

But if you take that same $40,000 investment and put it in the S&P 500, at the historical average return of right around 8% per year, your return after 30 years would be roughly 900%. Remember, that number also excludes any potential major repairs or other expenses associated with owning a home.

In my conversation with Forde, he highlighted three things that anyone considering an investment in a rental property should keep in mind before they buy a home with the intention of renting it out.

1. You make your money when you buy it
Forde noted, "The best principle to have in any real estate transaction is that you make your money when you buy it, not when you sell it -- because if you pay too much for it, you're never going to make money."

Since many people who buy investment properties often don't buy one in their same neighborhood, or even in their same city, it's easy to be lured by what is perceived to be a good deal in an unfamiliar market. Yet just because a home is less expensive than those around it, or in an area on the "rebound," doesn't mean it's worth investing in.

Often, investors see a home at a low price and think they've found a great deal, but you must do your research and your homework on the area to truly evaluate whether or not it's a good investment.

Remember as Warren Buffett's mentor Benjamin Graham once said, "Price is what you pay; value is what you get," so always make sure you're making an investment when you begin. 

2. Know your worst-case exit scenario
Investors in any situation can be lured into thinking that only the good things will happen, and that's what they plan for, but it's vitally important to have an exit plan, too.

Source: Inha Leex Hale.

While investing in a rental property can certainly be a profitable and worthwhile investment -- don't allow it to be such a large part of your portfolio that losing returns from it could ultimately bring you down with it.

Forde wanted to highlight how critical it was to have an exit plan if "all of your assumptions don't work out." For example, if the home is unoccupied for a few months, the $800 monthly income instead turns into a $1,000 expense very quickly -- and that could result in dire consequences if the investor isn't prepared.

3. Be ready for the unexpected
With any investment decision -- and almost any decision at all -- things can quickly take unexpected turns. For example, if the HVAC unit and the water heater each go out on the same day, repairs could be north of $10,000 -- wiping out an entire year's worth of profit. In this, investors must see that houses can be great investments -- but are often full of unseen costs that correspond with them. Being both prepared and able to address those issues when they present themselves is critical.

While rental properties can be great investments, like all investments, their returns also correspond to their risks -- and now you have one expert's opinion on what to keep in mind before you make that critical decision to invest in one.

Real estate investors: Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Read/Post Comments (2) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 22, 2013, at 3:29 PM, prginww wrote:

    Great article Patrick! Personally my rental property is one of the best investments I've ever made. But we indeed took all the precautions mentioned in this article. One of the things that helps us most is that we set aside a cash cushion (in an interest bearing account) prepped for vacancies or unexpected expenses. This helps our sleep-at-night factor and ensures that we can weather out any tough times.

  • Report this Comment On March 20, 2014, at 2:42 PM, prginww wrote:

    Hi Patrick, I need some guidance on how to start off to buy rental properties.

    I am recently employed and have around 20k in savings. But I would like to make some kind of investment like this. I am in Los Angeles.

Add your comment.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2689616, ~/Articles/ArticleHandler.aspx, 9/25/2016 10:00:02 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 1 day ago Sponsored by:
DOW 18,261.45 -131.01 -0.71%
S&P 500 2,164.69 -12.49 -0.57%
NASD 5,305.75 -33.78 -0.63%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes