Remember that place you always liked to go to? Maybe you visited it every year, or maybe you were there just once as a child. Now that you have more money, you could afford to buy some property there, provided you rent it out. But can you really profit from a rental property, or will extra costs eat away at returns?
Investment or pleasure?
The first thing to decide when looking to buy a rental property is whether you expect to make money off the property or whether you just want a vacation home and are using the rental idea as an excuse for a purchase.
Daytona-Beach. Licensed under public domain via Wikimedia Commons.
While there's nothing wrong with buying a piece of property for personal enjoyment if you can spare the cash, you shouldn't just assume that renting out your property will cover all the bills.
In fact, other expenses (covered in greater detail in a moment) can turn some properties into money losers even if being rented out on a regular basis.
On the other hand, if you want to buy a property for investment purposes, all the same due diligence should be performed as if you were buying a stock, bond, or other typical investment.
This means assessing all costs, risks, and benefits and having a thorough look over the property to ensure that your property is as high quality as your other investments.
Taxes
Just because you don't live in the house doesn't mean it's property tax-exempt. In fact, property taxes can often be higher on non-primary residences because they don't qualify for the homestead exemption. To find out these numbers, do your own research and contact a tax professional, since a small rate change can mean big long-term costs for you as a property owner.
Unlike long-term capital gains and qualified dividends, rental income does not receive a special lower tax rate. Rental income is taxed like ordinary income under IRS rules and thus will be subject to a higher tax rate than similar long-term gains from stocks. When calculating profit potential, be sure to factor in the taxman's cut.
Condition and maintenance
Licensed under Creative Commons Zero, public domain dedication via Wikimedia Commons.
When you buy shares in a company, one share is, for the most part, as good as the next. But rental properties mean a whole new level of hands-on examination. Problems with the roof? Electrical issues? Termites? Mold? Any one of these issues could mean thousands more in repair costs and that eat right into your bottom line. They can even eat into your top line; after all, it's not as if you can rent the place out while a construction crew is tearing it apart.
It's always good to give a property a good look over before you buy, but it's an even better idea to hire a professional home inspector. While it will cost some upfront, unless you really know where to look, an inspector will examine places and identify things you may have never thought of.
This factors into the next point: maintenance. Just as you do work on your house, you will have to keep the rental property in shape. That means landscaping on the outside, keeping the inside running, and repairing or replacing anything that breaks down. Unless you can do all this yourself and are going to do the work to keep two properties up and running, there will be additional costs to factor in here.
Rental agencies
Do you know enough people to fill your property to a profitable level? If you do, great! But if you don't, you will probably need to hire a rental agency or effectively become one yourself.
Like real estate agents selling homes, rental agents usually take a percentage of the rent as a commission. In exchange, you get listed and promoted by the agency while it takes care of the reservations. Some agencies will even provide routine maintenance such as lawn mowing and housekeeping.
But not all rental agencies are created equal. Some perform better, some have more properties in your area, and services vary by agency. While better agencies may charge higher fees, don't just go with the agency that has the lowest fee. Sometimes that one will be a true bargain, but other times you'll quickly find out why it's so cheap.
Insurance
Found a nice condo on the coast? Better get the insurance ready. When hurricanes come, they bring enough floods and winds to trash any new seaside investment. Insurance companies know this well and charge accordingly, so be prepared to pay if you want rental-property peace of mind.
But what you pay now may not necessarily be what you pay in the future. After a particularly bad hurricane season, insurance companies can take the opportunity to increase rates to reflect what they perceive as increased risk.
Also, if you make any renovations to your property, be sure to tell the insurance company and get those covered as well. It's more than a rough day in the market when a major storm wiped out your $300,000 property and the insurance company is sending you a $200,000 check.
Rising sea levels
The National Oceanic and Atmospheric Administration, or NOAA, notes that sea levels have "been steadily rising at a rate of 0.04 to 0.1 inches per year since 1900." The agency further states: "This rate may be increasing. Since 1992, new methods of satellite altimetry (the measurement of elevation or altitude) indicate a rate of rise of 0.12 inches per year."
Now, 0.12 inches per year may not sound like much, but a rental property is a long-term investment, so that rise will continue to add up year after year, even accelerating if current trends continue.
While higher sea levels won't necessarily flood your property on their own, they will bring the storm surge closer during storms, something insurance companies may adjust their rates for ahead of time. For many people, rising sea levels are not an imminent threat. but they are among the many things to consider when purchasing a coastal rental property.
Playing real estate speculator
Picking up quality undervalued properties can be a good investment, but there are definitely exceptions to this rule. Unlike a stock, which has an opportunity cost only when sitting in your portfolio doing nothing, real estate carries all the extra costs I've mentioned here.
So it's great to get a good deal upfront on a property, but be sure to either have a viable plan to rent it out to cover costs or a realistic exit plan to move it along.
If you still want to buy
Despite all of what I've mentioned, I'm not dead set against the purchase of rental properties. Properly run, the right property can both appreciate in value and generate income for the owner.
But before you sign on the dotted line, make sure to factor in all the extra costs and risks associated with this type of investment.
