Today we'll be talking about buying real estate and whether it's a good idea to become an investor or landlord before purchasing a home for yourself.
Laura answers a listener’s question by reviewing tips to prioritize your financial goals and the ten main pros and cons of buying an investment property before your first home.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Hello, friends, and thanks for joining me on another weekly Money Girl episode!
My name is Laura Adams–I'm an award-winning personal finance author and creator of online money classes.
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Since 2008, I've been bringing you personal finance and small business tips that boost your financial wisdom, wellness, and security. I cover a range of topics and also interview subject matter experts and interesting folks from time to time.
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Today we'll be talking about buying real estate and whether it's a good idea to become an investor or landlord before purchasing a home for yourself. The topic comes from a listener named Andrea, who says:
"I've listened to your podcast for several years, following much of your guidance. I'm 28 years old and earn $80,000 yearly with solid job security. My employer doesn't offer a retirement plan, but I max out a Roth IRA yearly, have $20,000 in savings, and am debt-free.
I live in New Orleans and rent a gorgeous apartment in a beautiful neighborhood because I can't afford to buy a home in this expensive city. So, I'm wondering if I should buy a rental property in an affordable suburb or a neighboring town.
While taking on a mortgage and paying rent is a bit scary, in theory, the rent would cover my expenses. Buying an affordable investment property seems like a good way to build equity and grow my wealth at this stage in life. Do you think it would be crazy for me to buy a rental property before becoming a homeowner?"
Andrea, thank you so much for being a long-time listener and sending in this great question. I know many listeners are in similar situations. Home prices across the country have skyrocketed, and mortgage interest rates have increased significantly over the past couple of years, making homeownership less and less affordable.
What Andrea's considering, buying an investment property before a first home, has become a real estate trend. Many renters are buying reasonably-priced vacation homes to use for part of the year, rent on Airbnb, or lease annually. The idea is to find a desirable, affordable property and have tenants pay all or a substantial portion of your expenses and maybe have some profit left over.
This show will answer Andrea’s question by reviewing how to prioritize your financial goals and the ten main pros and cons of buying an investment property before your first home.
How to prioritize financial goals
Andrea, before making any significant financial decision, like buying real estate, reviewing your overall situation is critical to spot any potential risks or vulnerabilities. The first place you should always start is evaluating your emergency savings. Having a healthy cash cushion is essential, and I love that you already have $20,000 set aside.
A good rule of thumb is always to keep at least six months' worth of living expenses in an FDIC-insured high-interest savings account. With your pre-tax income of $80,000, I'd estimate your take-home pay is $68,000 or about $5,600 monthly.
Multiplying that amount by six is $34,000. So, I'd encourage you to sock away a bit more, such as an additional $10,000, so you have at least $30,000 in the bank for potential emergencies. Plus, if you want to buy an investment property, you'll need a substantial down payment, which I'll discuss in a moment.
The second big financial priority to address when making a big financial decision is any dangerous or high-interest debt. But Andrea is killing it with zero debt–many congratulations on being debt-free!
Your next financial priority is reviewing whether your retirement investing is on track. Andrea is wisely maxing out a Roth IRA every year, which would be $6,500 for 2023. Unfortunately, she doesn't have access to a workplace retirement plan where she could invest a lot more each year.
Ideally, Andrea should invest 10% to 15% of her pre-tax income for retirement. That equals contributions ranging from $8,000 to $12,000 annually, almost double what she's currently contributing on the high end. So, I'd recommend that she make up the difference and invest anywhere from an additional $1,500 to $5,500 a year if she can swing it.
Since Andrea's Roth IRA is maxed out, she could invest additional funds in a taxable, non-retirement brokerage account. Or she could save those extra funds to eventually put down on an investment property–more about how much she might need in a moment.
RELATED: How to Decide if You Should Rent or Buy a Home
5 pros of buying an investment property before a first home
Let's assume you or Andrea will buy a rental property before your first home. Here are five main pros to consider.
1. Receiving rental income.
Recurring income from an investment property can be fantastic. However, it's your net, after-tax income that matters, and I'll cover typical expenses coming up. If you can charge enough rent to pay known and surprise expenses, someone else will pay for your asset.
If you profit from an investment property, that extra income could help you save a down payment for your own home, another investment property, or any financial goal you have.
2. Being diversified.
Suppose your investments are allocated entirely to mutual funds or exchange-traded funds comprised of stocks or a combination of stocks and bonds. In that case, you may not have enough diversification in your portfolio.
Owning real estate–either by acquiring physical property, contributing equity to syndication opportunities, or investing in a company that owns income properties–gives you exposure to an asset class less volatile than the financial markets.
3. Having price appreciation.
While U.S. home prices vary significantly by location and can go up and down in the short term, they've historically increased over the long term. According to the Shiller U.S. National Home Price Index, home values have increased 7.3% over the past ten years. However, depending on location, condition, and income potential, vacation and rental property values may have higher appreciation.
4. Leveraging equity.
As you build equity in an investment property, you typically have options for leveraging it. For instance, you may qualify to refinance your mortgage for a lower interest rate and reduce your monthly payments. Or you might do a cash-out refinance to tap your property’s equity to buy another investment.
5. Getting tax benefits.
Rental property owners enjoy excellent tax benefits, including:
The investment property tax benefits get complicated, so I won’t go into more detail here. I highly recommend consulting with a tax professional before you purchase an investment property to ensure you fully understand your benefits and responsibilities as a landlord.
ALSO READ: 5 Ways to Become an Active or Passive Real Estate Investor
5 cons of buying an investment property before a first home
Here are five cons of buying an investment property before a first home.
1. Making a high down payment.
Most investment property lenders have more stringent underwriting requirements for non-owner occupied properties than for owner-occupied. For instance, you typically must pay a higher down payment, such as a minimum of 20% to 25%, plus closing costs.
Lenders may also require a lower debt-to-income ratio and more income than borrowing for a home you'd occupy. Additionally, you may need a cash reserve to cover six months of loan payments if your income dries. And you'll need more cash for repairs and ongoing maintenance.
For example, if you want to buy a rental property for $200,000, you may need to pay 20% down ($40,000) and finance $160,000, paying about $1,300 a month in principal and interest. You'd need to pay closing costs ranging from 3% to 6% ($6,000 to $12,000), have a six-month payment reserve ($7,800), plus at least 1% to 3% for annual repairs ($2,000 to $6,000).
Ideally, you'd need about $55,800 to $65,800 saved before purchasing the property, although it may be possible to have less.
2. Needing better credit.
Real estate investors typically need better credit than regular home borrowers to qualify for a loan. For example, you may need a FICO score of at least 620 to qualify for an investment property loan.
Lenders know tenants and rental markets can be unpredictable, which makes investment properties riskier to lenders. To compensate for those risks, they charge higher interest rates. So, loans for investment properties generally cost more and require a larger down payment.
3. Managing tenants.
Even with a property manager who carefully screens potential tenants, you can end up with people who can't or won't pay you. They may severely damage your property, bring in multiple pets that aren't allowed, break leases, do illegal things, or disappear at night without taking any of their belongings.
Unfortunately, I've had tenants do all those things! I highly recommend finding a good local property manager to handle day-to-day issues like clogged toilets, leaky faucets, noisy neighbors, rent collection, overseeing repairs, evictions, and compliance with landlord-tenant laws. Managers usually charge 10% to 15% of each monthly rent for a complete package of services.
4. Paying ongoing expenses.
There are many expenses associated with short- and long-term rentals, including:
Do your best to determine what rent you'd need to be profitable and if it's realistic. Investors can control some expenses, but you can't predict annual property taxes and insurance increases. If you're unsure about a property's potential costs, consult a local real estate expert specializing in rentals or an active property management company.
5. Having potential losses.
The biggest drawback of buying an investment property before a first home is having losses that hurt your finances instead of helping them. You'll still have many expenses if you have an extended vacancy with no rent.
I can tell you from personal experience that owning a rental property isn't a guaranteed way to make money. The market or neighborhood can go down, causing you to accept a lower rent than you'd like, operating expenses can be higher than you expect, or it can take a frustratingly long time to find a qualified tenant. During the financial crisis in 2008, housing prices dropped about 20%, which was devastating for property owners who got forced to sell for less than they paid.
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Should you buy an investment property before a first home?
Whether you or Andrea should buy an investment property first depends on your income, savings, stage in life, and financial goals. Most people buy their primary home before an investment to get familiar with homeownership and perhaps build some equity. Plus, it typically requires less upfront cash.
Buying and managing an investment property can undoubtedly bring financial challenges if you don't consider all the potential expenses and outcomes carefully. However, investors can enjoy many income and tax benefits that improve their cash flow and net worth. Done correctly–especially with help from a real estate agent, mortgage professional, and tax advisor–it can be a strategy for building wealth.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.