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Investing in real estate can be an excellent way to build wealth over time and create an additional income source, but it is also one of the more capital-heavy types of investments you can make. While you can get started in stock or mutual fund investing with just a few hundred dollars, that simply isn’t the case when it comes to buying rental properties.
With that in mind, before you start shopping for properties to invest in, it’s important to know that you can afford to become a rental property investor.
Having said that, the question of Can I afford to buy a rental property? isn’t a simple one. There are several considerations to think about before you can determine if you can afford to take the plunge into rental real estate investing:
- Are you financially ready to invest at all?
- Do you have enough money to buy a rental property?
- Will your property cover its ownership costs?
- Can you qualify for a rental property mortgage?
Let’s take a closer look at these four questions one at a time:
Are you financially ready to invest at all?
Before you even consider buying a rental property, it’s important to do a quick financial health checkup. In a nutshell, there are two basic financial things you should do before you become a rental property owner:
- Pay off high-interest debt: The average credit card’s interest rate is more than 17%. It’s possible to earn returns in this ballpark on rental real estate, but it isn’t exactly common, especially for new investors. The point is that it’s silly to invest money in the hopes of earning a 10%–15% annualized return (the most common range), while simultaneously paying a higher rate to borrow money. If you have high-interest credit card debt, you should aim to pay it off or at the very least get a 0% APR balance transfer before you buy a rental property.
- Establish an emergency fund: What good is an investment if you’ll have to sell it if you face any unexpected expenses? Before you start investing in real estate or anything else, it’s a good idea to build up a bit of an emergency fund to help you deal with unexpected expenses or financial hardships. Most financial planners suggest that you should aim to keep six months’ worth of expenses in an easily accessible place. This is certainly a good goal to aim for, but you don’t necessarily need to get there before you start to invest.
Do you have enough money to buy a rental property?
Once you’ve established that you’re ready to invest, the next step in rental property affordability is determining whether you have enough money to actually purchase a property. Obviously, this depends on the cost of the property itself. All other things being equal, it’s going to require more capital to buy a $300,000 property than a $100,000 home.
One common rookie mistake is assuming that the down payment is all you need, but that’s simply not true. Here’s a rundown of the various initial expenses you need to prepare for:
The down payment is the most obvious upfront cost associated with the purchase of a rental property, but many new investors aren’t quite sure how much to expect.
Generally speaking, you should expect your lender to require a minimum of 20% down, as it is nearly impossible to find private mortgage insurance (PMI) for an investment property mortgage. If you are an extremely well-qualified buyer and are purchasing a single-family rental property, it’s possible to get a conventional mortgage with a 15% down payment, but that’s about the only exception I’m aware of. Most lenders want at least 25% down, especially on multi-unit residential properties, so that’s a good figure to prepare for.
Alternatively, you can choose to buy a multi-unit property and live in one of the units, which can qualify you for low-down-payment mortgages designed for owner-occupants. This is known as "house hacking" and we’ll discuss it later in this article.
Unless the seller has agreed to pay for closing costs, you’ll need to budget for this as well. Closing costs can vary considerably and can be higher on investment properties than primary homes. For example, property taxes are often higher for investor-owned homes than for owner-occupants, and you’ll be expected to prepay a certain amount of your property taxes at closing. Origination fees also tend to be higher on investment property mortgages.
As I mentioned, closing costs can vary dramatically, and typically run anywhere from 2% to 5% of the property’s sale price, although higher closing costs aren’t unheard of.
If you buy a rental property that is 100% rent-ready and in overall great shape, you may not have to worry about this, but if you buy a property in need of any rehab, be sure to include this in your budget.
Your inspection report can be a good indicator of the need to budget for repairs, even if the property is in good working order. For example, I recently bought a property where everything was operational, but the inspection report revealed the water heater was on its last legs, so I set aside money to replace it shortly after closing.
If you obtain a mortgage for your rental property, your lender will often require a minimum balance in reserves -- typically between six and 12 months’ worth of mortgage payments.
This is a good start, but you may want to err on the side of caution and wait until you have more cash in reserve than you think you’ll need. Maybe your property will sit vacant for a few months after you buy it. Maybe something major will break, like the HVAC system. Before you buy a rental property, it’s best to be sure that even if setbacks happen, you can absorb them without having to dip into your personal savings.
Will your property cover its ownership costs?
If you’ve established that you can afford the upfront costs to purchase a particular rental property, the next step is making sure the property won’t be a money-drain after you buy it. In short, you need to make sure that you’ll get positive cash flow.
In other words, if a property rents for $1,000 per month but you’re paying $1,200 per month in various expenses, it’s going to drain your bank account over time. On the other hand, a property that brings in $1,200 and costs $1,000 will cause your bank balance to increase as time goes on, which is a far more desirable outcome. So, you need to learn some basic cash flow analysis.
Rental income -- How much should you expect?
The first component in cash flow analysis is the property’s rental income. If the property is already rented, this is easy. If it isn’t, your real estate agent can be a good source for an estimate, and you can also order a rent appraisal that can let you know what to expect (if you obtain a mortgage, your lender might order a rent appraisal that you can use).
Many investors -- myself included -- have rules of thumb when it comes to rental income. For example, I won’t buy a rental property unless the purchase price is at most 100 times the expected monthly rent. So, if I expect a home will rent for $1,000 with minimal work, I’m willing to pay as much as $100,000. This is a pretty common rule and can help you separate the better property deals to pursue.
There are lots of potential costs of owning a rental property, but for cash-flow purposes, we’re just going to focus on the recurring expenses. These can include, but aren’t necessarily limited to:
- Mortgage payments
- Property taxes
- Hazard insurance
- Property management fees
- Any utilities you pay
- Lawn maintenance
- Pest control
Don’t forget about vacancies and maintenance
It’s not enough to simply subtract your operating expenses from your income. That’s a common mistake and you’d essentially be planning for an ideal scenario forever.
At some point, your property will be vacant -- maybe it just needs a couple weeks’ worth of repair work between tenants, or maybe your real estate market will slow down and the property will sit vacant for a few months at some point. Similarly, at some point, you’ll need to spend some money on maintenance.
There’s no way to predict these situations with 100% accuracy or to know when they will occur, so it’s important to set aside a portion of the rent you collect to cover them when they happen. My personal rule is to set aside about 15% of the rent I collect for vacancies and maintenance -- but I’ll adjust this a bit higher if the property is older and slightly lower if the property is brand new.
Cash flow example
Here’s a real-world example of the cash flow from a property I bought last year. The property is a triplex (three units), and rents for a total of $2,500 per month.
As far as operating expenses go, here’s what I pay:
- $1,600 (approximately) for my mortgage payment, including taxes and insurance
- $250 (10% of the rent) for property management
- $100 for lawn maintenance and pest control
This brings my total operating expenses to $1,950. Setting aside 15% of the rent for vacancies and maintenance takes up another $375 per month, which makes my total estimated ownership expense $2,325 per month.
So, my cash flow from the property is estimated to be $2,500 in rent minus $2,325 in expenses, or $175 per month. Of course, if the property doesn’t end up needing any maintenance and remains occupied 12 months every year, my actual cash flow will be significantly higher. However, it’s far better to prepare for a realistic scenario and be pleasantly surprised if things go well.
Many investors have specific cash flow requirements. Maybe they need a certain minimum amount of cash flow each month, or they want a specific percentage yield on their invested capital. Personally, I simply require that my investment properties produce positive cash flow after assuming a reasonable amount for vacancies and maintenance, but it’s important to tailor any rules of thumb to your own investment goals and income requirements.
Can you qualify for a rental property mortgage?
If you’re planning on paying cash for your rental property, you can skip this section. If not, you’ll need to qualify for an investment property mortgage, which can be just as important to your affordability question as the other items on the list. After all, if you have enough money for a down payment and have identified a rental property that produces great cash flow, it doesn’t really matter unless you can obtain financing to buy it.
With that in mind, there are two main types of mortgages you can get to buy a rental property. I’ve used both, so here’s what you need to know about getting approved for each type.
The term conventional mortgage is a broad one that generally refers to a loan that comes from a bank and isn’t explicitly guaranteed by a government agency. Generally, this means that the loan meets the lending standards of Fannie Mae or Freddie Mac, but it doesn’t have to. For example, a jumbo loan refers to a bank-originated mortgage that exceeds certain lending limits set by Fannie or Freddie and is very common in the investment property world.
For the purposes of this discussion, what you need to know about a conventional investment property mortgage is that you’ll need to personally qualify for the loan. These generally cannot be made to any other type of entity, such as an LLC.
This means that your personal credit, income, employment history, and assets will need to be sufficient to justify the loan. You can consider some of the property’s expected rental income for qualification purposes, but for the most part, your personal qualifications are what the lender will be looking at. Where investors often run into trouble is if the investment property’s mortgage payment would make your debt-to-income (DTI) ratio too high for the lender’s standards.
As the name implies, an asset-based loan is mainly dependent on the underlying asset -- in this case, the rental property you’re attempting to buy.
To be clear, you’ll still typically need to meet the lender’s credit standards. However, the loan approval isn’t dependent on your personal income or employment qualifications. The last time I obtained an asset-based investment property loan, my lender didn’t even ask to see my tax returns or any other income documentation.
On the contrary, the main qualification is whether the rental property you want to buy will deliver enough cash flow to justify the mortgage. Asset-based lenders use a metric known as the debt service coverage ratio, or DSCR, when evaluating loan applications. This is the estimated rental income expressed as a multiple of the monthly mortgage payment including taxes and insurance. For example, if an asset-based lender requires a DSCR of 1.3, this means that if your mortgage payment will be $1,000, the property needs to bring in a rental income of $1,300.
In addition to ignoring your personal DTI ratio, another big advantage of asset-based investment property loans is that they don’t need to be made to you as an individual. In fact, many asset-based lenders prefer to loan to an LLC.
To be clear, asset-based loans tend to be more costly than conventional loans. In my experience, conventional investment property loans tend to have interest rates of 0.50%-0.75% higher than the average primary residence rate, but the premium is typically 2% or more on an asset-based loan. Still, these can be great ways to finance investment properties in many cases as long as the property still generates positive cash flow despite the higher cost of the loan.
House hacking can be an alternative if you can't afford a rental property
If you can’t qualify for an investment property mortgage, or don’t have an adequate down payment, you might want to consider a house hacking investment. This can be a great way for first-timers with flexible living situations to dip their toes into the rental property investing world.
Here’s the basic idea: A house hack involves buying a two- to four-unit residential property, living in one of the units, and renting out the others.
There are some big advantages to this investment strategy, mainly involving the fact that the property can be classified as your primary residence. You can obtain a mortgage with a lower down payment and favorable interest rate, for example. FHA mortgages on primary residences (even with multiple living units) can be obtained with just 3.5% down. You can also get the lower owner-occupied property tax rates that exist in many areas. And when you eventually sell the property, you may be able to exclude any capital gains from income tax.
In fact, my first real estate investment was a house hack. Shortly after we got married, my wife and I bought a duplex and lived in one side while renting out the other. The rental income covered most of the mortgage payment, so we were able to live extremely cheaply while building equity in a more valuable property than we would have purchased on our own.
To be clear, there are pros and cons to house hacking, so be sure to read our guide to house hacking to determine if it might be a good way for you to start your rental property investing journey.
Did you answer yes to all four questions?
To sum it up, there are several factors that determine rental property affordability. It isn’t enough to just have enough money in the bank now. You need to be sure that your financial health is strong enough to invest, that you can cover all of the costs of buying a property with some cushion in case things go wrong, that the rental property won’t deplete your savings after you buy it, and that you’re able to obtain financing.
If you answered yes to all of the questions discussed here, you could indeed be ready to take the plunge into investment property ownership.
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